Coal

Highlights US natural gas prices will remain well supported over the April-October injection season, as the global economic expansion gains traction, particularly in Europe, which also is refilling depleted storage levels. China's natgas demand is expected to rise more than 8% yoy, and EM Asia consumption also will be robust, which will revive US liquified natural gas (LNG) exports. Exports of US light-sweet crude into the North Sea Brent pricing pool – currently accounting for close to half the physical supply underpinning the global oil-price benchmark – also will increase over the course of the year, particularly in the summer, when maintenance will markedly reduce the physical supply of crudes making up the Brent index. At the margin, coal demand will increase in the US, as industrial natgas demand and LNG exports incentivize electric generators to favor coal. Higher-than-expected summer temperatures in the US also would boost coal demand.  This will be tempered somewhat in Europe, where carbon-emissions rights traded through €50/MT for the first time this week on the EU's Emission Trading System (ETA). We expect US LNG and oil exports to revive this year (Chart of the Week) and remain long natgas in 1Q22. Feature The importance of US LNG and crude oil exports out of the US Gulf to the global economy is only now becoming apparent. As demand for these fossil fuels grows and the supply side continues to confront a highly uncertain risk-reward tradeoff, their importance will only grow. In natgas markets, US LNG cargoes out of the US Gulf balanced demand coming from Asia and Europe this past winter, which was sharply colder than expected and stretched supply chains globally. As a widening economic recovery from the COVID-19 pandemic spurs industrial, residential and commercial demand, and inventories in Europe and Asia are re-built in preparation for next winter, US LNG exports will be called upon to meet increasing demand, particularly since they are priced attractively vs regional importing benchmarks, with differentials vs the US presently $4+/MMBtu vs Europe and $5+/MMBtu vs Asia (Chart 2).1 Chart of the WeekUS LNG, Oil Export Growth Will Rebound Chart 2Lower US Natgas Prices Encourage LNG Exports In oil markets, an ongoing kerfuffle in the pricing of Brent Blend brought about by falling North Sea crude oil production makes American light-sweet crude oil exports from the Gulf (i.e., WTI produced mostly in the Permian Basin) account for almost half of the physical supplies in this critical benchmark-pricing market.2 US LNG Exports Will Increase US natural gas prices will remain well supported as the global economic expansion gains traction, and the US and Europe open the April-October injection season well bid (Chart 3). US inventories are expected to end the Apr-Oct injection season at just over 3.7 TCF according to the EIA, very close to where they ended the 2020 injection season. Chart 3US, Europe Rebuild Storage Higher US LNG exports, industrial, commercial and residential demand will be offset by lower consumption from electric generators this year, netting to a slight decline in overall demand. The EIA expects generators to take advantage of lower generating costs to be had burning coal to produce electricity, a view we share given the current differentials in the forward curves for each fuel (Chart 4).3 On the supply side, the EIA's expecting output to remain unchanged from last year at just under 91.5 BCF/d in 2021. Higher LNG exports, even as generator demand is falling, pushes prices higher this year – averaging $3.04/MMBtu this year – which leads to a slight increase in output in 2022. For our part, we continue to expect higher prices during the November-March heating season than currently are clearing the market and remain long 1Q22 $3.50/MMBtu calls vs. short $3.75/MMbtu calls. As of Tuesday night, when we mark to market, this position was up 20.8% since inception on 8 April 2021. Chart 4Lower Prices Will Favour Increased Coal Demand Natgas demand could surprise on the upside during the injection season if air-conditioning demand comes in stronger than expected and production remains essentially unchanged this year. This could reduce LNG exports and slow the rate of inventory refill in the US, which could further advantage coal as a burner fuel for generators in the US. The US National Weather Service's Climate Prediction Center expects above-average temperatures for most of the US population centers this summer (Chart 5). This could become a semi-permanent feature of the market if current temperature trends persist (Chart 6). Based on analyses’ run by the NOAA's National Centers for Environmental Information, 2021 "is very likely to rank among the ten warmest years on record," with lower (6%) odds of ranking in the top five hottest years on record.4 Chart 5Odds Of Hotter Summer Rising Chart 6Higher Global Temperatures Could Become A Recurring Phenomenon The Crude Kerfuffle As the Chart of the Week shows, US exports of light-sweet crude oil peaked at ~ 3.7mm b/d in February 2020, just before the COVID-19 pandemic hit the world full force. Exports out of the US Gulf – i.e., WTI priced against the Midland, TX, gathering hub – accounted for ~ 95% of these volumes. With exports currently running ~ 2.5mm b/d, more than 1mm b/d of readily available export capacity remains in place. Additional volumes will be developed as dredging of the Corpus Christi, TX, progresses. While the surge in US crude oil production has subsided in the wake of the pandemic, it most likely will revive as the markets return to normal operating procedure, additional dredging operations are completed, and storage facilities are built out.5 Existing and additional export capacity of the US's light-sweet crude could not arrive at a more opportune time for the Brent market, which remains in a state of uncertainty as to whether markets will have to adjust to CIF contracts or a work-around to the existing FOB pricing regime, which can be augmented to accommodate increasing WTI volumes.6 This will have to be sorted, as this is the future of the market's most important pricing index (Chart 7). The buildout in crude-oil exporting capacity – and natgas LNG exporting capacity, for that matter – ideally accommodates shale-oil- and -gas assets, which can be ramped up quickly to meet demand, and ramped down quickly as demand falters. The quick payback – 2 to 3 years – on these investments allow the producers to expand and contract output without the massive risks longer-lived conventional assets impose. As OPEC 2.0's spare capacity is returned to the market, this will be a welcome feature of a market that most likely will require oil and gas supplies for decades, despite the uncertainty attending oil-and-gas capex during the transition to a low-carbon energy future. Chart 7Permian Replaces North Sea Losses Bottom Line: As the future of hydrocarbons evolves, the LNG and crude oil exported from the US Gulf will occupy an increasingly important role in these markets. Oil and gas producers are making capex decisions under increasingly uncertain conditions, which favor exactly the type of resources that have propelled the US to the position of the world's largest producer of these fuels – i.e., shale-oil and -gas. Production from these resources can be ramped up and down quickly as prices dictate, and have quick paybacks (2-3 years), which means capital is not tied up for decades as a return is earned.7   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 begins returning 2mm b/d to the market this month, expecting to be done by July. Half of these volumes are accounted for by Saudi Arabia, which voluntarily cut output by 1mm b/d earlier in the year to help balance the market. In line with our maintained hypothesis that OPEC 2.0 prefers prices inside the $60-$70/bbl price band, we expect the return of curtailed production to be front-loaded so as to bring prices down from current levels approaching $70/bbl for Brent (Chart 8). If, as we expect, demand recovers sooner than expected as Europe leans into its vaccination program, additional barrels will be returned to the market to get prices closer to a $60-$65/bbl range. Base Metals: Bullish The International Copper Study Group (ICSG) forecast copper mine production will increase by ~ 3.5% in 2021 and 3.7% in 2022, after adjusting for historical disruption factors. This forecasted increase – after three years of flat mined production growth – is due to a ramp-up of recently commissioned and new copper mines becoming operational in 2021. An improvement in the pandemic situation by 2022 will also boost mined copper production, according to the ICSG. 2020 production remained flat as recoveries in production in some countries due to constrained output in 2019 balanced the negative impacts of the pandemic in others. In Chile, the largest copper producer, state-owned Codelco and Collahuasi reported strong results in March. However, this was countered by a continued downturn at BHP’s Escondida. The world’s largest copper mine saw a drop in production for the eighth consecutive month. This mixed output resulted in a decline in total production of 1.2% year-on-year in March. Precious Metals: Bullish COMEX palladium touched a record high during intraday trading on Tuesday, reaching $3,019/oz due to continued tight market conditions (Chart 9). On the supply side, Nornickel is recovering from flooded mines, which occurred in February. By mid-April, one of the two affected mines was operating at 60% capacity; however, the company's other mine is only expected to come back online by early June. On the demand side, strength in US vehicle sales and a global economic recovery from the pandemic buoyed the metal used in catalytic converters. Palladium prices closed at $2,981.60/oz on Tuesday. Ags/Softs: Neutral Corn again traded above $7/bu earlier in the week on the back of drought-like dry weather conditions in Brazil's principal growing regions and surging US exports, according to Farm Futures. Chart 8 Chart 9   Footnotes 1     Stronger demand from China – where consumption is expected to rise more than 8% yoy – and EM Asia will continue to support LNG demand through the year.  S&P Global Platts Analytics expects Chinese natural gas demand to reach 12,713 Bcf in 2021, up 8.4% from the previous year.  Chinese national oil company Sinopec is slightly more conservative in its outlook, expecting gas demand of ~ 12,006-12,184 Bcf in 2021, up 6-8% from 2020.  China’s average annual increase in natural gas demand is expected to exceed 716 Bcf in the 14th FYP and reach 15,185 Bcf in 2025. 2     Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies for a discussion. 3    In Chart 3, we plot a rough measure of coal- vs natgas-fired generation economics for these fuels based on their average operating heat rates published by the EIA. We would note that a carbon tax would erase much of the benefit accruing to coal at this point in time. 4    Please see NOAA's Global Climate Report - March 2021. 5    Please see Low Rider - Corpus Christi's Ship Channel Dredging Will Streamline Crude Oil Exports published by RBN Energy 3 May 2021. 6    The OIES analysis cited above concludes, "… the volumes of the FOB deliverable crudes are diminishing and some change, bolstering the contract is certainly needed. The most likely compromise is to retain the existing FOB Brent with an inclusion of CIF WTI Midland assessment, netted back to an FOB equivalent North Sea value."  We agree with this assessment.  Please see CIF Brent Benchmark? published 3 March 2021 by the Oxford Institute for Energy Studies, p. 8. 7     Please see Is shale activity actually profitable? Size matters, says Rystad published 7 February 2019.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced Chart 2US Natgas Inventories Return To Five-Year Average US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing Chart 4US LNG Exports Set Records In November And December 2020 US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Chart 10       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights Yesterday we published a Special Report titled EM: Foreign Currency Debt Strains. We are upgrading our stance on EM local currency bonds from negative to neutral. Before upgrading to a bullish stance, we would first need to upgrade our stance on EM currencies. We recommend receiving long-term swap rates in Russia, Mexico, Colombia, China and India. EM central banks’ swap lines with the Fed could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures warrant weaker EM currencies. For the rampant expansion of US money supply to produce a lasting greenback depreciation, US dollars should be recycled abroad. This is not yet occurring. Domestic Bonds: A New Normal Chart I-1Performance Of EM Domestic Bonds In The Last Decade In recent years, our strategy has favored the US dollar and, by extension, US Treasurys over EM domestic bonds. Chart I-1 demonstrates that the EM GBI local currency bond total return index in US dollar terms is at the same level as it was in 2011, and has massively underperformed 5-year US Treasurys. We are now upgrading our stance on EM local currency bonds from negative to neutral. Consistently, we recommend investors seek longer duration in EM domestic bonds while remaining cautious on the majority of EM currencies. Before upgrading to a bullish stance on EM local bonds, we would first need to upgrade our stance on EM currencies. Still, long-term investors who can tolerate volatility should begin accumulating EM local bonds on any further currency weakness. Our upgrade is based on the following reasons: First, there has been a fundamental shift in EM central banks’ policies. In past global downturns, many EM central banks hiked interest rates to defend their currencies. Presently, they are cutting rates aggressively despite large currency depreciation. This is the right policy action to fight the epic deflationary shock that EM economies are presently facing. There has been a fundamental shift in EM central banks’ policies. They are cutting rates aggressively despite large currency depreciation. Historically, EM local bond yields were often negatively correlated with exchange rates (Chart I-2, top panel). Similarly, when EM currencies began plunging two months ago, EM local bond yields initially spiked. However, following the brief spike, bond yields have begun dropping, even though EM currencies have not rallied (Chart I-2, bottom panel). This represents a new normal, which we discussed in detail in our October 24 report. Overall, even if EM currencies continue to depreciate, EM domestic bond yields will drop as they price in lower EM policy rates. Second, the monetary policy transmission mechanism in many EMs was broken before the COVID-19 outbreak. Even though central banks in many developing countries were reducing their policy rates before the pandemic, commercial banks’ corresponding lending rates were not dropping much (Chart I-3, top panel). Chart II-2EM Local Bond Yields And EM Currencies Chart I-3EM ex-China: Monetary Transmission Has Been Impaired   Further, core inflation rates were at all time lows and prime lending rates in real terms were extremely high (Chart I-3, middle panels). Consequently, bank loan growth was slowing preceding the pandemic (Chart I-3, bottom panel). The reason was banks’ poor financial health. Saddled with a lot of NPLs, banks had been seeking wide interest rate margins to generate profit and recapitalize themselves. With the outburst of the pandemic and the sudden stop in domestic and global economic activity, EM banks’ willingness to lend has all but evaporated. Chart I-4 reveals EM ex-China bank stocks have plunged, despite considerable monetary policy easing in EM, which historically was bullish for bank share prices. This upholds the fact that the monetary policy transmission mechanism in EM is broken. Mounting bad loans due to the pandemic will only reinforce these dynamics. Swap lines with the Fed cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. In brief, EM lower policy rates will not be transmitted to lower borrowing costs for companies and households anytime soon. Loan growth and domestic demand will remain in an air pocket for some time.    Consequently, EM policy rates will have to drop much lower to have a meaningful impact on growth. Third, there is value in EM local yields. The yield differential between EM GBI local currency bonds and 5-year US Treasurys shot up back to 500 basis points, the upper end of its historical range (Chart I-5). Chart I-4EM ex-China: Bank Stocks Plunged Despite Rate Cuts Chart I-5The EM Vs. US Yield Differential Is Attractive   Bottom Line: Odds favor further declines in EM local currency bond yields. Fixed-income investors should augment their duration exposure. We express this view by recommending receiving swap rates in the following markets: Russia, Mexico, Colombia, India and China. This is in addition to our existing receiver positions in Korean and Malaysian swap rates. For more detail, please refer to the Investment Recommendations section on page 8. Nevertheless, absolute-return investors should be cognizant of further EM currency depreciation. EM Currencies: At Mercy Of Global Growth Chart I-6EM Currencies Correlate With Commodities Prices The key driver of EM currencies has been and remains global growth. The latter will remain very depressed for some time, warranting patience before turning bullish on EM exchange rates. We have long argued that EM exchange rates are driven not by US interest rates but by global growth. Industrial metals prices offer a reasonable pulse on global growth. Chart I-6 illustrates their tight correlation with EM currencies. Even though the S&P 500 has rebounded sharply in recent weeks, there are no signs of a meaningful improvement in industrial metals prices. Various raw materials prices in China are also sliding (Chart I-7). In a separate section below we lay out the case as to why there is more downside in iron ore and steel as well as coal prices in China. Finally, the ADXY – the emerging Asia currency index against the US dollar – has broken down below its 2008, 2016 and 2018-19 lows (Chart I-8). This is a very bearish technical profile, suggesting more downside ahead. This fits with our fundamental assessment that a recovery in global economic activity is not yet imminent. Chart I-7China: Commodities Prices Are Sliding Chart I-8A Breakdown In Emerging Asian Currencies   What About The Fed’s Swap Lines? A pertinent question is whether EM central banks’ foreign currency reserves and the Federal Reserve’s swap lines with several of its EM counterparts are sufficient to prop up EM currencies prior to a pickup in global growth. The short answer is as follows: These swap lines will likely limit the downside but cannot preclude further depreciation. With the exception of Turkey and South Africa, virtually all mainstream EM banks have large foreign currency reserves. On top of this, several of them – Brazil, Mexico, South Korea and Singapore– have recently obtained access to Fed swap lines. Their own foreign exchange reserves and the swap lines with the Fed give them an option to defend their currencies from depreciation if they choose to do so. However, selling US dollars by EM central banks is not without cost. When central banks sell their FX reserves or dollars obtained from the Fed via swap lines, they withdraw local currency liquidity from the system. As a result, banking system liquidity shrinks, pushing up interbank rates. This is equivalent to hiking interest rates. The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Hence, the cost of defending the exchange rate by using FX reserves is both liquidity and credit tightening. In such a case, the currency could stabilize but the economy will take a beating. Since the currency depreciation was itself due to economic weakness, such a policy will in and of itself be self-defeating. The basis is that escalating domestic economic weakness will re-assert its dampening effect on the currency. Of course, EM central banks can offset such tightening by injecting new liquidity. However, this could also backfire and lead to renewed currency depreciation. Bottom Line: EM central banks’ swap lines with the Fed are primarily intended to instill confidence among investors in financial markets. They could be used to fend off short-term speculative attacks on EM currencies. Nevertheless, they cannot prevent EM exchange rates from depreciation when fundamental pressures – global and domestic recessions – warrant weaker EM currencies. What About The Fed’s Money Printing? Chart I-9The Fed Is Aggressively Printing Money The Fed is printing money and monetising not only public debt but also substantial amounts of private debt. This will ultimately be very bearish for the US dollar. Chart I-9 illustrates that the Fed is printing money much more aggressively than during its quantitative easing (QE) policies post 2008. The key difference between the Fed’s liquidity provisions now and during its previous QEs is as follows: When the Fed purchases securities from or lends to commercial banks, it creates new reserves (banking system liquidity) but it does not create money supply. Banks’ reserves at the Fed are not a part of broad money supply. This was generally the case during previous QEs when the Fed was buying bonds mostly – but not exclusively – from banks, therefore increasing reserves without raising money supply by much. When the Fed lends to or purchases securities from non-banks, it creates both excess reserves for the banking system and money supply (deposits at banks) out of thin air. The fact that US money supply (M2) growth is now much stronger than during the 2010s QEs suggests the recent surge in US money supply is due to the Fed’s asset purchases from and lending to non-banks, which creates money/deposits outright.  The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: 1. US imports should expand, reviving global growth, i.e., the US should send dollars to the rest of the world by buying goods and services. This is not yet happening as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. 2. US investors should channel US dollars to EM to purchase EM financial assets. In recent weeks, foreign flows have been returning to EM due to the considerable improvement in EM asset valuations. However, the sustainability of these capital flows into EM remains questionable. The main reasons are two-fold: (A) there is huge uncertainty on how efficiently EM countries will be able handle the economic and health repercussions of the pandemic; and (B) global growth remains weak and, as we discussed above, it has historically been the main driver of EM risk assets and currencies.  Bottom Line: The Fed’s outright money printing is the sole reason to buy EM risk assets and currencies at the moment. Yet, EM fundamentals – namely, its growth outlook – remain downbeat. Overall, we recommend investors to stay put on EM risk assets and currencies in the near-term. Investment Recommendations Chart I-10China: Bet On Lower Long-Term Yields We have been recommending receiving rates in a few markets such as Korea and Malaysia. Now, we are widening this universe to include Russia, Mexico, Colombia, China, and India. In China, the long end of the yield curve offers value (Chart I-10, top panel). The People’s Bank of China has brought down short rates dramatically but the long end has so far lagged (Chart I-10, bottom panel). We recommend investors receive 10-year swap rates. Fixed-income investors could also bet on yield curve flattening. The recovery in China will be tame and the PBoC will keep interest rates lower for longer. Consequently, long-dated swap rates will gravitate toward short rates.  We are closing three fixed-income trades: In Mexico, we are booking profits on our trade of receiving 2-year / paying 10-year swap rates – a bet on a steeper yield curve. This position has generated a 152 basis-point gain since its initiation on April 12, 2018. In Colombia, our bet on yield curve flattening has produced a loss of 28 basis points since January 17, 2019. We are closing it. In Chile, we are closing our long 3-year bonds / short 3-year inflation-linked bonds position. This trade has returned 2.0% since we recommended it on October 3, 2019. For dedicated EM domestic bond portfolios, our overweights are Russia, Mexico, Peru, Colombia, Korea, Malaysia, Thailand, India, China, Pakistan and Ukraine. Our underweights are South Africa, Turkey, Brazil, Indonesia and the Philippines. The remaining markets warrant a neutral allocation. Regarding EM currencies, we continue to recommend shorting a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Heading South Chart II-1Steel, Iron Ore And Coal Prices: More Downside Ahead? Odds are that iron ore, steel and coal prices will all continue heading south (Chart II-1). Lower prices will harm both Chinese and global producers of these commodities. Steel And Iron Ore The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. First, Chinese output of steel products has not contracted even though demand plunged in the first three months of the year, creating oversupply. Despite falling steel prices and the demand breakdown resulting from the COVID-19 outbreak, Chinese crude steel output still grew at 1.5% and its steel products output only declined 0.6% between January and March from a year ago (Chart II-2). Chart II-2Steel Products Output In China: Still No Contraction The profit margin of Chinese steel producers has compressed but not enough to herald a sizable cut in mainland steel production. Despite oversupply, Chinese steel producers are reluctant to curtail output to prevent layoffs. This year, there will be 62 million tons of new steel production capacity while 82 million tons of obsolete capacity will be shut down. As the capacity-utilization rate (CUR) of the new advanced production capacity will be much higher than the CUR on those soon-to-be-removed capacities in previous years, this will help lift steel output.   Second, Chinese steel demand has plummeted, and any revival will be mild and gradual over the next three to six months. Construction accounts for about 55% of Chinese steel demand, with about 35% coming from the property market and 20% from infrastructure. Additionally, the automobile industry contributes about 10% of demand. All three sectors are currently in deep contraction (Chart II-3). Looking ahead, we expect that the demand for steel from property construction and automobile production will revive only gradually. Overall, it will continue contracting on a year-on-year basis, albeit at a diminishing rate than now. While we projected a 6-8% rise in Chinese infrastructure investment for this year, most of that will be back-loaded to the second half of the year. In addition, modest and gradual steel demand increases from this source will not be able to offset the loss of demand from the property and automobile sectors. The oversupplied conditions in the Chinese steel market will become even more aggravated over the next three to six months. Reflecting the disparity between weak demand and resilient supply, steel inventories in the hands of producers and traders are surging, which also warrants much lower prices (Chart II-4).   Chart II-3Deep Contraction In Steel Demand From Major Users Chart II-4Significant Build-Up In Steel Inventories   Chart II-5Chinese Iron Ore Imports Will Likely Decline In 2020 Regarding iron ore, mushrooming steel inventories in China and lower steel prices will eventually lead to steel output cutbacks in the country. This will be compounded by shrinking steel production outside of China, dampening global demand for iron ore. Besides, in China, scrap steel prices have fallen more sharply than iron ore prices have. This makes the use of scrap steel more appealing than iron ore in steel production. Chinese iron ore imports will likely drop this year (Chart II-5). Finally, the global output of iron ore is likely to increase in 2020. The top three producers (Vale, Rio Tinto and BHP) have all set their 2020 guidelines above their 2019 production levels. This will further weigh on iron ore prices. Coal Although Chinese coal prices will also face downward pressure, we believe that the downside will be much less than that for steel and iron ore prices. Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. Prices had not dropped below this level since September 2016. In the near term, prices could go down by another 5-10%, given that record-high domestic coal production and imports have overwhelmed the market (Chart II-6). Coal prices have already declined nearly 27% from their 2019 peak. They recently declined below 500 RMB per ton – the lower end of a range that the government generally tries to maintain. However, there are emerging supportive forces. China Coal Transport & Distribution Association (CCTD), the nation’s leading industry group, on April 18, called on the industry to slash production (of both thermal and coking coal) in May by 10%. It also proposed that the government should restrict imports. The CCTD stated that about 42% of the producers are losing money at current coal prices. The government had demanded producers make similar cuts for a much longer time duration in 2016, which pushed coal to sky-high prices.  The outlook for a revival in the consumption of electricity and, thereby, in the demand for coal is more certain than it is for steel and iron ore. About 60% of Chinese coal is used to generate thermal power. Finally, odds are rising that the government will temporarily impose restrictions on coal imports as it did last December – when coal imports to China fell by 70% as a result. Investment Implications Companies and countries producing these commodities will be hurt by the reduction of Chinese purchases. These include, but are not limited to, producers in Indonesia, Australia, Brazil and South Africa. Iron ore and coal make up 10% of total exports in Brazil, 6% in South Africa, 18% in Indonesia and 32% in Australia. Investors should avoid global steel and mining stocks (Chart II-7). Chart II-6Chinese Coal Output And Imports Are At Record Highs Chart II-7Avoid Global Steel And Mining Stocks For Now   We continue to recommend shorting BRL, ZAR and IDR versus the US dollar. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart II-1Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.1 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Chart II-3No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view.

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well Chart I-13German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Chart II-3No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

Special Report

Highlights The pace of "de-capacity" reforms in China will continue to diminish, with declining shutdowns of inefficient capacity and rising advanced capacity over the next 12-15 months. Coal prices may have less downside than steel prices due to more resilient domestic demand, and lower production growth for the former than the latter. Meanwhile, iron ore prices may have limited downside and could outperform steel prices due to increasing shutdowns of domestic iron ore mines. Go long September 2019 thermal coal and iron ore futures versus September 2019 steel rebar futures. Chinese coal producers' shares may outperform Chinese steel producers' shares. Feature This April, our Special Report titled, "Revisiting China's 'De-Capacity' Reforms," painted a negative picture for steel and coal prices over 2018 and 2019 on diminishing pace of "de-capacity" reforms and rising steel and coal output.1 So far, our call has not yet played out. Both steel and coal prices have been firm over the past five months (Chart 1A). Meanwhile, iron ore and coking coal have also rebounded (Chart 1B). Chart 1ASteel And Coal Prices: More Upside Ahead? Chart 1BIron Ore And Coking Coal Prices: Following Steel And Coal Prices? In this report, we return to the analysis we laid out back in April, with the goal of identifying whether or not the rally in steel and coal prices will continue. Another major question to answer is why share prices of coal and steel companies have continued to plunge, even though coal and steel prices have held up well. In brief, our research findings still suggest that steel and coal prices are likely to fall over the next 12-15 months on a diminishing pace of de-capacity (less shutdowns of old capacity) and rising advanced capacity. We also reckon that coal prices may have less downside than steel prices over the next 12-15 months due to more resilient domestic demand and smaller production growth compared to steel; we conclude by outlining a long/short trade opportunity tied to this view. Understanding The Recent Price Rally The recent strength in both steel and coal prices has been due to a tighter supply-demand balance than we expected: Steel Falling steel product output and still-solid steel demand growth have pushed up steel prices this year. While crude steel production has had strong growth so far this year (9% year-on-year and 50 million tons in volume), total output of steel product has actually declined by 20 million tons (2.7%) year-on-year during the same period (Chart 2). Steel products, including rebars, wire rods, sheets and other items, are made from crude steel and consumed in end consumption. Tianjin province - a city very close to Beijing - accounted for more than 100% of the reduction of steel product output, as 40% of the province's operating capacity was shut down due to the city's "de-capacity" policy and increasingly stringent environmental regulations. In addition, Chinese steel products production had already experienced huge cut last year by nearly 100 million due to the government's "Ditiaogang" de-capacity policy.2 As a result, strong crude steel output growth this year has not been able to lift steel product production from contraction, creating a shortage in Chinese steel product supply. To put it in perspective, total steel products production for the first eight months of this year is at a five-year low. Chart 2Falling Steel Product Output Amid Strong Crude Steel Production Growth Chart 3Steel Demand Has Been Robust As Well Meanwhile, massive pledged supplementary lending (PSL) injections - the People's Bank of China's direct lending to the real estate market - had extended property sales and starts beyond what appeared to be a sustainable trajectory, thereby lifting steel demand to some extent3 (Chart 3). Hence, weaker-than-expected steel products supply combined with slightly better demand than we anticipated have tightened the Chinese domestic steel market further, and underpinned high steel prices. Coal Similarly, the rebound in coal prices has also been due to declining output and strong demand growth. Chinese coal output turned out to be much weaker than we expected due to extremely stringent and frequent environmental and safety inspections on coal output (Chart 4). Back in mid-2017, in order to curb pollution, China demanded that coal mines plant trees, boost efficiency, cut down noise and seal off facilities from the outside world as part of a new "green mining" plan. This year's inspection have been even more stringent. Operations among coal mines, coal-washing plants and coal storage facilities were halted immediately if inspection teams found they failed to meet the related standards. As a result, Chinese coal production contracted 1% for the first eight months of this year. Chart 4Weaker-Than-Expected Coal Output Chart 5Resilient Thermal Coal Demand On the demand side, electricity generation from thermal power has remained quite robust at 7% (Chart 5). Again, coal prices have rebounded as the domestic coal supply-demand balance has tightened. Will Steel And Coal Prices Continue To Rise? The short answer is no. Many of the drivers underpinning the recent rally in steel and coal prices are set to fade over the next 12-15 months: Steel Steel prices will likely weaken in 2019 on rising steel product output and faltering steel demand growth. First, production of both crude steel and steel products will rise considerably next year, as the steel sector's de-capacity target is almost reached and new advanced capacity will come on stream faster to replace old or inefficient capacity that has already exited the market. Table 1 showed the 82% of this year's steel de-capacity target was already achieved by the end of July, leaving not much in the way of additional de-capacity cuts needed through the remainder of 2018. If this year's de-capacity cut target of 30 million tons is fulfilled over the next two months, there will be no need for any more capacity cuts in 2019, as the high end of the 2016-2020 de-capacity target (150 million tons) will be fully met this year. Table 1Supply-Side Reform - Capacity Reduction Target And Actual Achievement Record-high profit margins that Chinese steel producers are currently enjoying will also help boost steel production (Chart 6). This was the main driver behind this year's strong growth in crude steel output, despite more stringent environmental policies and ongoing de-capacity efforts. In addition, falling graphite electrode prices and increasing graphite electrode production will facilitate the expansion of cleaner electric furnace (EF) steel capacity and production in China (Chart 7). Chart 6Steel Producers' Profit Margin: At A Record High Chart 7Rising Graphite Electrode Supply Will Facilitate EF Steel Output EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. The availability of graphite electrode has been one major bottleneck for the development of EF capacity. As of late 2017, there were about 524,000 tons of new graphite electrode capacity under construction, most of which will be completed within the next two years. This will nearly double the current capacity of 590,000 tons. As this capacity gradually enters into the market, graphite electrode prices will drop further, encouraging more EF steel projects. In 2017, newly added EF steel capacity was about 30 million tons, and EF steel production increased by about 24 million tons (47% year-on-year). With rising graphite electrode supply, EF capacity this year is expected to add 40 million tons, resulting in about a 25-30 million ton increase in EF steel output. In 2019, based on the government's goal of 15% of total steel production being EF steel by 2020, we expect another 25-30 million tons new EF capacity to come online. This alone would translate into 3-4% rise in steel product production in 2019. Second, while steel supply is rising, the demand outlook seems more pessimistic. Our September 13 Special Report titled, "China's Property Market: Where Will It Go From Here?" concluded that the Chinese property market is facing increasing downside risks. Diminishing PSL direct financing from the central bank and shrinking funding sources for Chinese real estate developers point to a considerable slowdown in property starts and construction, which will eventually lead to faltering demand for steel. Chinese auto output growth is weak, with the three-month moving average growth registering a 6% contraction this September. The government has boosted infrastructure projects. This will support steel demand to some extent, but it is unlikely to offset demand weakness from the down-trending property market. The property market is the biggest steel-consuming sector, accounting for 38% of total Chinese steel consumption - much higher than the 23% share from the infrastructure sector. Bottom Line: Steel prices may stay high over the next two or three months due to low inventories and heating-season production controls within the steel industry. Nonetheless, steel prices are vulnerable to the downside over the next 12-15 months on rising steel product output and faltering steel demand growth. Coal Coal prices will likely decline over the next 12-15 months, but the price downside may be less than that of steel. First, on the supply side, coal output will rise only moderately (i.e., 2-3%) in 2019. There are three drivers pushing up Chinese coal output. The government in May asked domestic coal producers to ramp up coal output, as current coal market supply has been tight this year. Particularly, the National Development and Reform Commission (NDRC) demanded that the top three coal produce provinces (Shanxi, Shaanxi, and Inner Mongolia) increase their aggregated coal output by at least 300,000 tons per day as soon as possible. However, the June-July environmental inspections within the major producing province of Mongolia resulted in a 14 million ton year-on-year drop in the province's coal output. If the 300,000 ton per day increase is realized in 2019, it will be equivalent to nearly 100 million tons of new coal supply next year, which is about 2.8% growth from 2017's output of 3.52 billion tons. Based on government data, 660 million tons of capacity is currently under construction, which includes new technologically advanced capacity that has already been built and ready to use but has not yet received government approval. If 30% of the under-construction capacity comes to market in 2019 and runs at a capacity utilization rate of 70%, it will translate into about 140 million tons of new coal supply next year, which is about 4% growth from last year. Due to too-strict production policies during the winter heating season, there was a coal supply crisis last winter. This year, the government is likely to implement a less stringent production policy for coal. In this case, coal producers will likely produce more to take advantage of seven-year-high profit margins (Chart 8). Chart 8Coal Producers' Profit Margin: At A Multi-Year High However, at the same time there are also two drivers dragging down coal output. Table 1 above shows that at the end of July, only 53% of this year's coal de-capacity target and 65% of the government's 2016-2020 coal capacity reduction target had been achieved. This implies that Chinese coal producers still need to cut 70 million tons of old coal capacity through the remainder of 2018 and another 210 million tons of inefficient capacity in the coming two years (2019 and 2020) - possibly 105 million tons of cuts in each year. Similar to steel, coal de-capacity reforms are also diminishing (e.g. a 150-million ton reduction target in 2018 versus a 105 million-ton reduction target in 2019). However, different from steel, the remaining de-capacity target for coal is still quite significant. With continuing the implementation of its de-capacity plan, excluding the three major producing provinces, the remaining provinces that in general have smaller-scale coal mines may face further cuts in their coal production. For the first eight months of this year, 13 out of the 22 non-top-three coal-producing provinces registered a contraction in coal output. Environmental policies will likely remain strict, given the country seems determined to improve its air quality. More frequent inspection and/or stricter policies will further curb coal production. On balance, we still expect overall coal output to increase moderately (i.e., 2-3%) next year. Second, on the demand side, coal demand growth will weaken only slightly due to robust thermal coal consumption for thermal power generation (Chart 5 above). We expect Chinese electricity consumption to grow at 5-6% next year - a touch lower than this year - on strong demand from both the residential and service sectors. Most of the growth will likely be supplied by thermal power, as some 72% of total electricity generation is currently thermal power. In addition, the government has limited hydropower and nuclear power projects coming onstream next year. In the meantime, coal consumption for heating will likely be replaced by natural gas or electricity, and coking coal demand may fall due to EF steel expansion and more use of scrap steel in blast furnaces. Bottom Line: Coal prices are likely to head south on rising supply and weakening demand growth next year. In addition, we expect coal prices to fall less than steel prices over the next 12-15 months on a tighter supply-demand balance for the former than the latter. What About The Iron Ore Market? The outlook for iron ore prices is becoming less downbeat. Iron ore prices may have limited downside and could outperform steel prices over the next 12-15 months - due to increasing shutdowns of mainland iron ore mines. Government data show that Chinese domestic iron ore output contracted 40% year-on-year in the first eight months of this year (Chart 9). About 60% of the decline was from Hebei - the province that has probably imposed the strictest environmental policies among all the provinces targeting ferrous- and coal- related industries - due to its proximity to the capital, Beijing. Chart 9Significant Drop In Domestic Iron Ore Output Profit margins for iron ore miners has tanked to a 15-year low due to rising production costs on environmental protections. The number of loss-making enterprises as a share of the total number of iron ore companies has reached a record high (Chart 10). Although EF steel capacity additions will contribute to most of the growth in crude steel output next year, non-EF crude steel capacity, which uses iron ore as its main input, will also increase to some extent. This will also lift iron ore demand, which will lead to further declines in port inventories and rising imports (Chart 11). Chart 10Iron Ore Producers' Profit Margin: At A 15-Year Low Chart 11Chinese Iron Ore Imports Are Likely To Go Up Bottom Line: We are less bearish on iron ore prices and expect them to outperform steel prices. Chinese iron ore imports will likely grow again. Investment Implications Three main investment implications can be drawn from our analysis. Price ratios of thermal coal/steel rebar and iron ore/steel rebar have fallen to record low levels (Chart 12). As we expect thermal coal and iron ore prices to outperform steel, we recommend going long September 2019 thermal coal futures/short September 2019 steel rebar futures and going long September 2019 iron ore futures/short September 2019 steel rebar futures on Chinese exchanges in RMB. Chinese coal imports including both thermal coal and coking coal could remain strong, which would at a margin be positive news for Chinese major coal importers Australia, Indonesia, Russia and Mongolia. In the meantime, Chinese iron ore imports are likely to rebound in 2019 as well. This will be positive news for producers in Australia, Brazil and South Africa. Chart 12Both Thermal Coal And Iron Ore Will Likely Outperform Steel Chart 13Coal Producers' Shares May Outperform Steel Producers' Stocks Despite stubbornly high coal and steel prices, Chinese share prices of coal producers and steel producers have still plunged (Chart 13, top and middle panel). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of their peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. Based on our analysis, Chinese steel producers' share prices are still at risk of falling steel prices, while coal-producing companies may benefit from rising production and limited downside in coal prices. Hence, Chinese coal producers' shares may continue to outperform steel producers' shares with the price ratio of the former versus the latter just rebounding from three-year lows (Chart 13, bottom panel). Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease see Emerging Markets Strategy Special Reports "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, and "Revisiting China's De-Capacity Reforms", dated April 26, 2018, available at ems.bcaresearch.com. 2 Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality and also lead to environmental degradation. As "Ditiaogang" is illegal in China, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Consequently, last year's significant removal of "Ditiaogang" and statistical issues have caused the big divergence between crude steel production expansion and steel products output contraction since then. 3 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. Sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. We project this will boost steel and coal output by 5.2% and 4.7% respectively, this year at a time when demand is set to slow. Steel, coal, iron ore and coke prices are all vulnerable to the downside. Share prices of the companies and currencies of countries that supply these commodities to China are most at risk. Feature Last November, our report titled, "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," painted a negative picture for steel and coal prices over 2018 and 2019.1 Since then, after having peaked in December and February respectively, both steel and thermal coal prices have so far declined by about 20% from their respective tops (Chart 1). In the meantime, iron ore and coking coal have also exhibited meaningful weakness (Chart 2). Chart 1More Downside In Steel And Coal Prices Chart 2Iron Ore And Coking Coal Prices Are Also At Risk In this report, we revisit the topic of de-capacity reforms and examine how Chinese supply side reforms in 2018 will affect steel and coal prices. The key message is as follows: Having implemented aggressive capacity reduction over the past two years, the authorities are shifting the focus of supply side reforms from "de-capacity" to "replacement" of already removed capacity with technologically advanced capacity. This means the scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. In addition, sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. From an investing standpoint, this means both steel and coal prices are still vulnerable to the downside. Both could drop by more than 15% from current levels over the course of 2018. Diminishing Scale Of "De-Capacity" Reforms Reducing capacity (also called "de-capacity") in the oversupplied steel and coal markets has been a key priority within China's structural supply side reforms over the past two years. Steel Table 1 shows that the capacity reduction target for steel in 2018 is 30 million tons, which is much lower than the 45 million tons in 2016 and 50 million tons in 2017. Table 1Capacity Reduction: Target And Actual Achievement In addition, between May and September 2017, the "Ditiaogang"2 removal policy eliminated about 120 million tons of steel capacity, and sharply reduced steel products production. Most of Ditiaogang capacity was completely dismantled last year. Therefore, there is not much downside to steel production from Ditiaogang output cutbacks going forward. Furthermore, between October and December 2017, environmental policies aimed at fighting against winter smog also cut steel products output substantially, which pushed steel prices to six-year highs in December (Chart 3). Chart 3Policy Actions And Market Dynamics: Steel Sector In particular, in the last quarter of 2017, to ensure fewer smog days around the Beijing area, Tianjin's steel products output was reduced by 50% from a year earlier. The second biggest contribution to total steel output decline occurred in Hebei - the largest steel-producing province in China - where steel output plummeted by 7%. Excluding Tianjin and Hebei, national steel products output fell only by 3.9% from a year ago. As a long-term solution to ameliorate ecology and air quality around Beijing, the government is aiming to reduce the heavy concentration of steel production in Tianjin and Hebei by shifting a considerable portion of steel capacity to other regions in 2018 and following years. These two provinces together accounted for about 30.6% of the nation's steel products output in 2016; their share dipped to 27.6% in 2017. As a result, next winter the required production reduction from these regions to achieve the air quality targets in Beijing will be smaller. In short, the scale of specific policy driven steel output reduction in 2018 will be meaningfully lower than last year. Coal For coal, despite the same target as last year (150 million tons), the actual capacity cut this year will be much less than last year's actual reduction of 250 million tons, which exceeded the 150 million-ton target. Amid still-high coal prices, the authorities will be more tolerant of producers not cutting too much capacity. Plus, with nearly two-thirds of the 2016-2020 target for capacity cuts having already been achieved in the past two years, there is much less outdated capacity in the industry (Table 1 above). In addition, the government's environment-related policies also led to a decline in total national coal output between October-December 2017 (Chart 4), with Hebei posting the biggest cut in coal output among all provinces. Chart 4Policy Actions And Market Dynamics: Coal Sector However, the authorities shortly thereafter relaxed restrictions on coal output, as the country was severely lacking gas supply for heating. In January and February of this year, the authorities reversed course, demanding that producers accelerate new advanced capacity replacement and increase coal production. Bottom Line: The scale of China's "de-capacity" reforms are diminishing, resulting in a lessening production cuts. Installing Technologically Advanced Capacity China's supply side reforms have included two major components - reducing inefficient capacity and low-quality supply that damaged the environment while boosting medium-to-high-quality production that is economically efficient and ecologically friendly. In brief, having removed significant obsolete capacity in the past two years, the policy focus is now shifting to capacity replacement. The latter enables China to upgrade its steel and coal industries to become more efficient and competitive worldwide, as well as ecologically safer. To guard against excessive production capacity of steel and coal, the authorities are reinforcing the following replacement principle: the ratio of newly installed-to-removed capacity should be less or equal to one. Two important points need to be noted: First and most important, the zero or negative growth of total capacity of steel and coal does not necessarily mean zero or negative growth in steel and coal output. For example, while total capacity for crude steel and steel products declined 4.8% and 1.8% year-on-year in 2016 respectively, output actually increased 0.5% and 1%. Despite falling total capacity, rising operational capacity could still contribute to an increase in final output. Total capacity (measured in tons) for steel and coal production includes both operational capacity and non-operational capacity, the latter representing obsolete/non-profitable capacity. As more technologically advanced capacity is installed to replace the already-removed one, both the size of operational capacity and the capacity utilization rate (CUR) will rise. Typically, advanced technologies have a higher CUR - consequently, production will grow. Second, an increase in the CUR of existing operational capacity will also result in rising output. In 2018, odds are that both the steel and coal industries in China will have non-trivial output increases as a result of new advanced capacity coming on stream. Steel Since late 2015, in environmentally sensitive areas of the Beijing-Tianjin-Hebei region and the Yangtze River Delta and the Pearl River Delta, steel plants have been required to add no more than 0.8 tons of new capacity for every 1 ton of outdated capacity removed. For other areas, the same ratio is 1 or less. Electric furnace (EF) steel-producing technology - which is cleaner, more advanced and used to produce high-quality specialized steel products - has become the major type of new capacity addition. This technology is favored by both the government and steel producers. Chinese EF-based steel production accounted for only 6.4% of the nation's total steel output in 2016, far lower than the world average of 25.7% (Chart 5). The EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. Graphite electrodes, which have high levels of electrical conductivity and the capability of sustaining extremely high levels of heat, are consumed primarily in electric furnace steel production. Chart 6 demonstrates that prices of both graphite electrode and scrap steel have surged since mid-2017. This signifies that considerable new EF production capacity has been coming on stream. Chart 5Chinese Electric Furnace Crude Steel ##br##Production Will Go Up Chart 6Considerable New Addition Of##br## Chinese Electric Furnace Capacity Indeed, in 2017 alone, 44 units of EF were installed. In comparison, between 2014 and 2016, only 47 units of EF were installed. As the completion of a new EF installation in general takes eight to 10 months, all of EF capacity installed in 2017 - about 31 million tons of crude steel production capacity - will be operational in 2018. In addition, a report from China's Natural Resource Department indicates that as of mid-December there have been 54 replacement projects with total new steel production capacity of 91 million tons (including new EF capacity, new traditional capacity and recovered capacity). This compares to 120 million tons of capacity removed in 2016-'17. Assuming 60% of this 91 million tons capacity will be operating throughout 2018 at a utilization rate of 80% (the NBS 2017 CUR for the ferrous smelting and pressing industry was 75.8%), this alone will result in 43.6 million tons more output in 2018 from a year ago (5.2% growth from 2017 output) (Table 2). Table 2Strong Profit Margins Will Encourage Steel Production At the same time, strong profit margins will encourage steel makers to produce as much as possible to maximize profits (Chart 7). This will be especially true if the incumbent companies have to absorb liabilities of firms that were shutdown (please refer to page 14 for the discussion on this point). Facing more debt from shutdowns of other companies, steel incumbent producers would have an incentive to ramp up their production to generate more cash. Yet, we do not assume a rise in CUR for existing steel capacity. Hence, crude steel output growth in 2018 will likely be around 5.2%, higher than the 3% growth in 2017. This is in line with the top 10 Chinese steel producers' projected crude steel output growth in 2018 of 5.5%, based on their published production guidance data. The Ditiaogang and environmental policy caused a significant contraction in steel products growth in 2017, but will have limited impact in 2018 as discussed above. Eventually, increasing crude steel output will translate into strong growth in steel products output3 (Chart 8). Chart 7Strong Profit Margins ##br##Will Encourage Steel Production Chart 8Steel Products Production ##br##Will Rebound In 2018 Coal China's current coal capacity is about 5310 million tons, with 4780 million tons as operational capacity and the remaining 530 million tons as non-operational capacity, which has not produced coal for some time. As in general it takes roughly three to five years to build a coal mine, it will take a long time to replace the obsolete capacity. Yet there is hidden coal capacity in China. The China Coal Industry Association estimated last year that there was about 700 million tons of new technologically advanced capacity that has already been built and is ready to use, but has not yet received government approval. This is greater than the 530 million tons of coal production removed in the past two years by de-capacity reforms - equivalent to about 20% of China's total 2017 coal output. This hidden capacity originated from the fact that coal producers in China historically began building mines before applying for approval. However, since 2015, all applications for new coal mines have been halted. Consequently, in the past three years a lot of capacity has already been built but has not been put into operation. Some 70% of this hidden capacity includes large-scale coal mines, each with annual capacity of above 5 million tons. In comparison, China has about 126 million tons of small mines with annual capacity of 90,000 tons that will be forced to exit the market this year as they are non-competitive due to their small scale and inferior technology. Why do we expect this hidden capacity to become operational going forward? The authorities now allows trading in the replacement quota for coal across regions. Producers having these ready-to-use high-quality mines can buy the replacement quota from the producers who have eliminated the outdated capacity. The government wants to accelerate the process of allowing the advanced capacity to be in operation as fast as possible. The following policy initiative supports this: A new policy directive released this past February does not even require coal producers with advanced capacity to pay the quota first in order to apply for approval - they can apply for approval to start the replacement process first, and then have one year to pay for it. Economically, quotas trading makes sense. The mines with advanced technology that have lower costs and higher profit margins should be able to pay a reasonably high (attractive) price for quotas to companies with inferior technologies, so that the latter will be better off selling their quotas than continuing operations. The proceeds from the selling quotas will be used to settle termination benefits for employees of low-quality coal mines. Regarding our projections for coal output in 2018, assuming 30% of the 700 million tons of capacity among high-quality mines will be operational this year at a CUR of 78% (the NBS 2017 coal industry CUR was 68.2%), this alone will bring a 164 million-ton increase in coal output (4.7% of the 2017 coal output) (Table 3). Table 3Chinese Coal Output Will Rise By 4.7% In 2018 In addition, still-high profit margins could encourage existing coal producers to increase their CUR this year (Chart 9). Yet, we do not assume a rise in CUR for existing coal mining capacity. In total, Chinese coal output may increase 4.7% this year, higher than last year's 3.2% growth (Chart 10). Chart 9Strong Profit Margins Will Boost Coal Production Chart 10Coal Output Is Already Rising Bottom Line: Sizable technologically advanced new capacity is coming on stream for both steel and coal. This will boost both steel and coal output by about 5.2% and 4.7%, respectively, this year. Impact On Global Steel And Coal Prices In addition to diminishing capacity cuts and new technologically advanced capacity additions, the following factors will also weigh on steel prices: Relatively high steel product inventories (Chart 11, top panel) Weakening steel demand, mainly due to a potential slowdown in the property market4 Declining infrastructure investment growth (Chart 11, bottom panel). Chinese net steel product exports contracted 30% last year as steel producers opted to sell steel products domestically on higher domestic steel prices (Chart 12). Chart 11Elevated Steel Product Inventory##br## And Weakening Demand Chart 12China's Steel Product Exports ##br##Will Rebound Falling domestic steel prices may lead steel producers to ship their products overseas. In addition, the government has reduced steel products export tariffs starting January 1, 2018, which may also help increase Chinese steel product exports this year. This will pass falling Chinese domestic steel prices on to lower global steel prices. Between 2015 and 2017, about 1.6% of all Chinese steel exports were shipped to the U.S. Even if U.S. tariffs dampen its purchases of steel from China, mainland producers will try to sell their products to other countries. In a nutshell, U.S. tariffs will not prevent the transmission of lower steel prices in China to the global steel market. With respect to coal, in early April the Chinese government placed restrictions on Chinese coal imports at major ports in major imported-coal consuming provinces including Zhejiang, Fujian and Guangdong (Chart 13). The government demanded thermal power plants in those areas to limit their consumption of imported coal and use domestically produced coal. Clearly the government is trying to avoid cheaper imports flooding into the domestic coal market amid still elevated prices. This will help prevent a big drop in domestic coal prices but will be bearish for global coal prices. For example, 40% and 30% of Chinese coal imports are from Indonesia and Australia, respectively (Chart 14). These economies and their currencies are at risk from diminishing Chinese coal imports. Chart 13Chinese Coal Imports Will Decline Chart 14Indonesia and Australia May Face Falling ##br##Coal Demand From China For the demand side, continuing strong growth in non-thermal power supplies such as nuclear, wind and solar will curb thermal power growth in the long run and thus limit thermal coal consumption growth in China. This may also weigh on domestic coal prices and discourage coal imports. Bottom Line: The downtrend in domestic steel and coal prices will weigh on the global steel and coal markets. What About Iron Ore And Coking Coal? Iron ore and coking coal prices are also at risk: Chart 15Record High Chinese Iron Ore Inventory Given about 40% of newly installed steel capacity is advanced electric furnace (EF) based - which requires significant amounts of scrap steel rather than iron ore and coke - rising steel output will increase demand for iron ore and coke disproportionally less. As more Chinese steel producers shift to EF technology, mainland demand for iron ore and coke will diminish structurally in the years to come. Despite weakness in both domestic iron ore production and iron ore imports, Chinese iron ore inventories at major ports, expressed in number of months of consumption, have still reached record highs (Chart 15). This suggests rising EF capacity has indeed been constraining demand for iron ore. Increasing coal output will bring more coking coal and a corresponding rise in coke supply, thereby further depressing coke prices. Bottom Line: Global iron ore and coking coal prices are also vulnerable to the downside. Investment Implications From a macro perspective, investors can capitalize on these themes via a number of strategies: Shorting iron ore and coal prices, or these commodities producers' stocks. Chart 16Chinese Steel And Coal Shares:##br## Puzzling Drop Amid High Profit Going short the Indonesian rupiah (and possibly the Australian dollar) versus the U.S. dollar. Australia and Indonesia are large exporters of coal and industrial metals to China - they account for 30% and 40% of Chinese coal imports, respectively, so their currencies are vulnerable. Notably, although steel and coal prices are still well above their 2015 levels and producers' profit margins are very elevated, share prices of Chinese steel makers and coal producers have dropped almost to their 2015 levels (Chart 16). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of the peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. On a more granular level, rapidly expanding EF steel-making capacity in China will lead to outperformance of stocks related to EF makers, graphite electrode producers and domestic scrap steel collecting companies. First, demand for graphite electrodes continues to rise, as EF steel production expands. Prices of graphite electrodes may stay high for quite some time (Chart 6 above, top panel). Second, scrap steel prices may go higher or stay high to encourage more domestic scrap steel collection. Companies who collect domestic scrap steel may soon have beneficial policy support, which will create huge potential for expansion (Chart 6 above, bottom panel). Third, EF makers will also benefit due to strong sales of electric furnaces. As a final note, equity investors should consider going long thermal power producers versus coal producers as thermal power producers will benefit from falling coal prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, available at ems.bcaresearch.com. 2 "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. 3 The big divergence between crude steel production expansion and steel products output contraction last year was due to both the removal of "Ditiaogang" and statistical issues. "Ditiaogang" is often converted into steel products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. 4 Please see Emerging Markets Strategy Special Report, "China Real Estate: A New-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk Chart I-19China Will Be A Drag On Its Suppliers As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too Chart I-22Downside Risk To EM EPS The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS Chart I-24What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations