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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

Highlights Seasonal capacity restrictions in China during the winter heating months - when pollution from steel mills is particularly high - and continued efforts to limit particulate emissions in major cities will drive steel prices higher. The steel rebar market in China is backwardated, indicating physical markets are tight; inventories have been falling since mid-March. We expect prices to remain elevated going into the winter months, when capacity restrictions kick in. Ongoing capacity reductions in steelmaking will favor higher-grade iron ores, which will widen price differentials versus lower-grade ores. We are recommending a long China rebar futures on the SHFE in 1Q19 vs short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close, based on our research. Energy: Overweight. Loadings of Iranian crude are expected to be curtailed beginning this month, as the November 4 deadline for the imposition of U.S. secondary sanctions kick in. Our base case calls for the loss of 500k b/d of exports from Iran; our ensemble forecast includes an estimate of 1mm b/d. Base Metals: Neutral. BHP asked the Chilean government to intervene in the strike called by unions at its Escondida mine. Union officials delayed strike action while talks are being held. Negotiators have until August 14 to reach an agreement. Reuters reported Chile's copper production was up 12.3% y/y in 1H18 to 2.83mm MT.1 Precious Metals: Neutral. U.S. sanctions on trading gold and precious metals with Iran went into effect earlier this week. Ags/Softs: Underweight. Chinese imports of U.S. soybeans could fall 10mm MT over the next year, if pig and chicken farmers switch to lower-protein feed and substitutes like sunflower seeds, and boost local production of the legume, state-run news service Xinhua reported.2 The USDA expects U.S. exports of 55.52mm MT of soybeans in the 2018 - 19 crop year, down 1.22mm MT from last year. Feature Steel prices have performed exceptionally since the beginning of 2Q18, seemingly oblivious to Sino - U.S. trade tensions, a stronger USD, and risks to China's economy roiling other metal markets (Chart of the Week). The MySteel Composite Index we use to track steel prices is up 7% since the beginning of April. With demand growth leveling off, steel's price dynamics highlight the continued relevance of the market's supply-side developments. Most notably, Beijing's battle for blue skies: Winter capacity curbs, and, to a lesser extent, ongoing efforts to retire older, highly polluting capacity will keep prices elevated over the next 9 months. Winter Curbs: China's New Normal As we highlighted in our April 12 weekly, despite the much-ballyhooed reductions in China's steel capacity over the 2017 - 18 winter months, markets in China and globally remained relatively well supplied over the winter.3 However, several key changes this year suggest the impact of these measures will intensify this time around, keeping producers constrained in their ability to ramp up production of the metal. For one, the data suggest strong production levels amid the anti-pollution curbs last winter were a result of an increase in output from regions unaffected by the capacity restrictions (Chart 2). This went a long way in muting the impact of the restrictions in the heavily industrialized Beijing-Tianjin-Hebei region of northern China. Chart of the WeekSteel Oblivious To Pessimism Chart 22017/18 Winter Cuts: A Net Non-Event This year's curbs will broaden the regions targeted by anti-pollution restrictions. The campaign will encompass 83 cities, up from last year's 28, thereby reducing the potential production ramp up from regions not covered by these measures (Chart 3). This coming winter's closures will cover regions where producers traditionally account for 68% of China's steel output (Chart 4). Chart 3Second Annual Winter Capacity ##br##Restrictions Will Broaden Coverage... Chart 4...And##br## Impact The anti-pollution campaign is one of the three battles prioritized in Xi Jinping's plan for the coming years. These curbs will be implemented during the October 1, 2018 to March 31, 2019 heating season, extending the duration from last year's mid-November to Mid-March period. Because the minimal effect observed per last year's closures was due to specifying too narrow a range of plants and regions, not to non-compliance, we expect the measures announced for this coming winter to be fully implemented. These measures come amid already-tight market conditions. The steel rebar market in China is in backwardation - meaning a physical shortage is pushing up prompt prices relative to those further out the curve. Inventories have been falling since mid-March, reflecting supply-demand dynamics in other steel product markets. Thus, we expect prices to remain elevated going into the winter months. Capacity Impacts Are Difficult To Gauge Opaqueness and discretionary authority in the new rules clouds the outlook on how anti-pollution reforms will impact the steel market. This makes it difficult to estimate their impact with precision. This time around, China's State Council announced that curbs will be implemented in a more scientific and targeted approach, ensuring maximum efficiency to attain the targets. This means the constraints this year will depend on emissions in each region, which will be set at the discretion of local authorities.4 For example, steel mills in six key cities including Tianjin, Shijiazhuang, Tangshan, Handan, Xingtai and Anyang will be asked to keep capacity below 50% this winter, while producers in the rest of the Beijing-Tianjin-Hebei region will keep production running at less than 70% of capacity. Furthermore, a draft plan by the city of Changzhou - which planned to implement the curbs beginning August 3 - suggests production curbs may vary by company, depending on operational situations and emission levels.5 These restrictions are applied to capacity, rather than production. Without up-to-date and accurate information on crude steel-making capacity across the different regions, it is extremely difficult to accurately quantify the impact. Specifics of the plans are up to the discretion of local authorities. Thus, these restrictions can be applied to different stages in the steel-making process (Diagram 1), impacting furnaces, pig iron or sintering plants. In some cases, the output curbs are not only restricted to the winter heating months. Several regions have been implementing curbs throughout the year on an as-needed basis. The cities of Tangshan and Changzhou are two such examples, implementing restrictions during the summer months as well. Furthermore, all industrial plants in the city of Xuzhou remain shut. High profit margins at steel mills may incentivize the shuttered illegal furnaces to restart. The industry ministry acknowledges this threat, and claims it will carry out checks on these producers to ensure they do not come back online. Diagram 1Steelmaking Production Process: Restrictions Can Be Applied To Different Stages Without full knowledge of these details, quantifying the impact of these restrictions is a challenge. Morgan Stanley estimates the impact of these curbs on steel output to be 78mm MT during the winter period by assuming capacity utilization is restricted to 50% in the key cities, while the rest of the areas cut capacity by 30%. The estimated production loss from these restrictions accounts for 9% of China's 2017 crude steel output.6 China's Ongoing Capacity-Reduction Reforms Most of the planned permanent capacity shutdowns have already taken place. Of the targeted 150mm MT of cuts between 2016 and 2020, 115mm MT have already taken place over the past two years. Furthermore, 1H17 witnessed the closure of all illegal induction furnaces producing sub-par quality steel, estimated to account for 140mm MT of crude steel capacity (Table 1).7 Table 1De-Capacity Reforms Still Ongoing We expect the magnitude of cutbacks to slow considerably. Even though the industry ministry issued a statement in February that it plans to meet steel capacity reduction targets this year - two years ahead of schedule. Furthermore, mills face restrictions on new steel capacity. China's State Council announced it intends to prevent new steel capacity additions in the Beijing-Tianjin-Hebei, Guangdong province, and Yangtze River Delta regions, and a cap set at 200mm MT in Hebei by 2020. The capacity replacement plan, which allows a maximum of 0.8 MT of new capacity for each MT of eliminated capacity, will ensure capacity does not grow going forward. In fact, not all mills are eligible to take advantage of the replacement policy. Among others, now-shuttered induction furnace capacity, as well as producers that previously benefited from cash and policy support will not meet the requirements for this program. Steel And Iron Ore Prices Will Not Reconverge As a result of China's reform policies in the steel industry, iron ore prices have diverged from steel. Reduced steel production lowers demand for raw materials, including iron ore. This is reflected in falling Chinese iron ore imports amid contracting production (Chart 5). Chart 5Weak Demand For Iron Ore Chart 6EAF Penetration In China: Still Some Catching Up To Do China's reform and anti-pollution campaigns have had serious consequences on iron ore markets. For starters, China is encouraging the adoption of electric arc furnaces (EAF), rather than additional new blast furnaces.8 While the latter primarily uses iron ore, the former uses scrap steel. EAF penetration in China's steel industry significantly lags the rest of the world (Chart 6). This means that even if the capacity-replacement program allows eliminated furnaces to be replaced with newer, more up-to-date capacity, this will not spur demand for iron ore. Instead, we expect to see higher scrap steel prices (Chart 7). Furthermore, as we first highlighted in our January report, China's anti-pollution campaign coupled with high steel profit margins has incentivized the use of higher grade iron ore and iron ore pellets, widening the price spread between high- and low- grade ores (Chart 8).9 Chart 7EAFs Support Scrap Steel Demand Chart 8IO Grade Premiums Will Remain Elevated While high-grade ores are more expensive, they emit less pollution in the steelmaking process. Similarly, unlike fines, pellets which are direct charge feedstock, are not required to undergo the highly polluting sintering stage and can be fed directly into the furnace. China's Steel Dynamics Overshadow Global Markets The ongoing supply-side reforms in China are overshadowing events in other markets. Globally, steel is expected to remain in physical deficit this year (Chart 9). This is largely on the back of an increase in world ex-China demand, and the decline in Chinese supply, despite expectations of weaker Chinese demand, and increased supply from the rest of the world (Table 2). Chart 9Physical Steel Deficit Will Persist... Table 2...Despite Weaker Chinese Demand And Stronger RoW Supply These figures do not consider the impact of the ongoing Sino - U.S. trade dispute, which could evolve into a full-blown trade war, weighing on EM incomes and demand. In such a scenario, global demand for steel would take a hit, potentially shifting global markets into surplus. In theory, trade barriers on U.S. steel imports could lead to weaker domestic supply for American users and at the same time, leave more of the metal for use by the rest of the world. The net effect of that would be a higher price for American steel relative to the rest of the world. However, since May, 20,000 requests for steel tariff exemptions have been filed in the U.S., of which the Commerce Department has denied 639. To the extent that American steel users are able to obtain tariff exemptions, the impact of the barriers on global steel markets will be muted. Bottom Line: We expect China's steel market to tighten as we go into the winter season, during which capacity cuts will be broadened to 82 cities, from last year's 28. This will keep steel prices elevated. At the same time, we expect prices of 62% Fe material and lower iron ore grades to weaken, as appetite for the steelmaking raw material contracts during these months. Mills still running in the mid-November to mid-March period will have a preference for higher-grade ores and pellets, keeping premiums on these grades elevated. Barring a significant demand-side shock, expect more upside to steel prices and downside to iron ore prices over the coming 9 months. Based on our research, we are recommending a long China rebar futures on the SHFE in 1Q19 vs. short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "BHP asks for government mediation in talks at Chile's Escondida," published August 6, 2018, by uk.reuters.com. 2 Please see "Economic Watch: China can cut soybean imports in 2018 by over 10 mln tonnes," published August 5, 2018, by xinhuanet.com. 3 Please see Commodity & Energy Strategy Weekly Report titled "Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts," dated April 12, 2018, available at ces.bcaresearch.com. 4 Please see "Chinese steel output cuts to vary from mill to mill next winter," dated July 21, 2018, available at reuters.com. 5 The restrictions will not only apply to the city's steel mills, but also to copper smelters, chemical makers as well as cement producers. Please see "China's Changzhou plans to enforce output curbs in steel, chemical plants," dated July 30, 2018, available at reuters.com. 6 Please see "Shanghai steel resumes rise, coke rallies as China eyes winter curbs," dated August 2, 2018, available at reuters.com. 7 Low-quality steel produced by induction furnaces, also referred to as ditiaogang, is made by melting scrap steel using induction heat, preventing sufficient control over the quality of the steel. Platts estimates ditiaogang production in 2016 to be 30-50mm MT. As we explain in our September 7, 2017 Weekly Report titled "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," given that ditiaogang is illegal, these closures are not reflected in official steel production figures. Thus the closures of these mills have no impact on actual steel production, but instead raise the capacity utilization rates for Chinese steel producers. 8 China launched a carbon trading system in January 2018, which penalizes blast furnace operators with higher environmental taxes relative to EAF processes. 9 Please see Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

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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 Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@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; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Following up on last week's report, my colleagues Caroline Miller, Mathieu Savary, and I held a webcast on Wednesday to discuss the outlook for the dollar along with recent events. If you haven't already, I hope you find the time to listen in. Best regards, Peter Berezin, Chief Global Strategist Highlights Protectionism is popular with the American public in general, and Trump's base specifically. The sabre-rattling will persist, but an all-out trade war is unlikely. Trump is focused on the stock market, and equities would suffer mightily if a trade war broke out. The Pentagon has also warned of the dangers of across-the-board tariffs that penalize America's military allies. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. That's not the case today. The equity bull market will eventually end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Feature Q: What prompted Trump's announcement? A: Last week began with President Trump proclaiming that he would seek re-election in 2020. Then came a slew of negative news, including the resignation of Hope Hicks, Trump's White House communications director, and the downgrading of Jared Kushner's security clearance. All this happened against the backdrop of the ever-widening Mueller probe. Trump needed to change the subject. Fast. However, it would be a mistake to think that the tariff announcement was simply a distractionary tactic. Turmoil in the White House might have been the immediate trigger, but events had been building towards this outcome for some time. The Trump administration had imposed tariffs on washing machines and solar panels in January. Hiking tariffs on steel and aluminum - two industries that had suffered heavy job losses over the past two decades - was a logical next step. In fact, the 25% tariff on steel and 10% tariff on aluminum were similar to the 24% and 7.7% tariff rates, respectively, that the Commerce Department proposed as one of three options on February 16th.1 Protectionism is popular with the American public. This is especially true for Trump's base (Chart 1). Indeed, it is safe to say that Trump's unorthodox views on trade are what handed him the Republican nomination and what allowed him to win key swing (and manufacturing) states such as Ohio, Michigan, and Pennsylvania. Trump made a promise to his voters. He is trying to keep it. Q: Wouldn't raising trade barriers hurt the U.S. economy, thereby harming the same workers Trump is trying to help? A: That's the line coming from the financial press and most of the political establishment, but it's not as clear cut as it may seem. An all-out trade war would undoubtedly hurt the U.S., but a minor skirmish probably would not. The U.S. does run a large trade deficit. Economists Katharine Abraham and Melissa Kearney recently estimated that increased competition from Chinese imports cost the U.S. economy 2.65 million jobs between 1999 and 2016, almost double the 1.4 million jobs lost to automation.2 This accords with other studies, such as the one by David Autor and his colleagues, which found that increased trade with China has led to large job losses in the U.S. manufacturing sector (Chart 2).3 Chart 1Trump Is Catering ##br##To His Protectionist Base Chart 2China's Ascent Has Reduced##br## U.S. Manufacturing Employment Granted, China does not even make it into the top ten list of countries that export steel to the United States. But that is somewhat beside the point. As with most commodities, there is a fairly well-integrated global market for steel. Due to its proximity to Asian markets, China exports most of its steel to the rest of the region (Chart 3). That does not stop Chinese overcapacity from dragging down prices around the world. Chart 3Most Of China's Steel Exports Don't Travel That Far Q: Wouldn't steel and aluminum tariffs simply raise prices for American consumers, thereby reducing real wages? A: That depends. If Trump's gambit reduces the U.S. trade deficit, this will increase domestic spending, putting more upward pressure on wages. As far as prices are concerned, the U.S. imported $39 billion of iron and steel in 2017, and an additional $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. And even that would be a one-off hit to the price level, rather than a permanent increase in the inflation rate. In practice, it is doubtful that prices would rise by the full amount of the tariff (if they did, what would be the purpose of retaliatory measures?). Most econometric studies suggest that producers will absorb about half of the tariff in the form of lower profit margins. To the extent that this reduces the pre-tariff price of imported goods, it would shift the terms of trade in America's favor. Chart 4Does Trade Retaliation Make Sense ##br## When Most Trade Is In Intermediate Goods? There is an old economic theory, first elucidated by Robert Torrens in the 19th century, which says that the optimal tariff is always positive for countries such as the U.S. that are price-makers rather than price-takers in international markets. Put more formally, Torrens showed that an increase in tariffs from very low levels was likely to raise government revenue and producer surplus by more than the loss in consumer surplus. So, in theory, the U.S. could actually benefit at the expense of the rest of the world by imposing higher tariffs.4 Q: This assumes that there is no trade retaliation. How realistic is that? A: That's the key. As noted above, a breakdown of the global trading system would hurt the U.S., but a trade spat could help it. Trump was trying to scare the opposition by tweeting "trade wars are good, and easy to win." In a game of chicken, it helps to convince your opponent that you are reckless and nuts. Trump's detractors would say he is both, so that works in his favor. Trump has another thing working for him. Most trade these days is in intermediate goods (Chart 4). It does not pay for Mexico to slap tariffs on imported U.S. intermediate goods when those very same goods are assembled into final goods in Mexico - creating jobs for Mexican workers in the process - and re-exported to the U.S. or the rest of the world. The same is true for China and many other countries. This does not preclude the imposition of targeted retaliatory tariffs. The EU has threatened to raise tariffs on Levi's jeans and Harley Davidson motorcycles (whose headquarters, not coincidently, is located in Paul Ryan's Wisconsin district). We would not be surprised if high-end foreign-owned golf courses were also subject to additional scrutiny! But if this is all that happens, markets won't care. The fact that the United States imports much more than it exports also gives Trump a lot of leverage. Take the case of China. Chinese imports of goods and services are 2.65% of U.S. GDP, but exports to China are only 0.96% of GDP. And nearly half of U.S. goods exports to China are agricultural products and raw materials (Chart 5). Taxing them would be difficult without raising Chinese consumer prices. Simply put, the U.S. stands to lose less from a trade war than most other countries. Chart 5China Stands To Lose More From A Trade War With The U.S. Q: Couldn't China and other countries punish the U.S. by dumping Treasurys? A: They could, but why would they? Such an action would only drive down the value of the dollar, giving U.S. exporters an even greater advantage. The smart, strategic response would be to intervene in currency markets with the aim of bidding up the dollar. Chart 6Slowing Global Growth Is Bullish##br## For The Dollar Q: So the dollar could strengthen as a result of rising protectionism? A: Yes, it could. This is a point that even Mario Draghi made at yesterday's ECB press conference. If higher tariffs lead to a smaller trade deficit, this will increase U.S. aggregate demand. The boost to demand would be amplified if more companies decide to relocate production back to the U.S. for fear of being shut out of the lucrative U.S. market. The U.S. economy is now operating close to full employment. Anything that adds to demand is likely to prompt the Fed to raise rates more aggressively than it otherwise would. That could lead to a stronger greenback. Considering that the U.S. is a fairly closed economy which runs a trade deficit, it would suffer less than other economies in the event of a trade war. A scenario where global growth slows because of rising trade tensions, while the composition of that growth shifts towards the U.S., would be bullish for the dollar (Chart 6). Q: What are the implications for stocks and bonds? A: Wall Street will dictate what happens to stocks, but Main Street will dictate what happens to bonds. The stock market hates protectionism, so it is no surprise that equities sold off last week. It is this fact that ultimately got Trump to soften his position. Trump is used to taking credit for a rising stock market. If stocks flounder, this could make him think twice about pushing for higher trade barriers. As far as bonds are concerned, they will react to whatever happens to growth and inflation. As noted above, a trade skirmish could actually boost growth and inflation. Given that the economy is near full capacity, the latter is likely to rise more than the former. This, too, could cause Trump to cool his heels. After all, if higher inflation pushes up bond yields, this will hurt highly-levered sectors such as, you guessed it, real estate. Q: In conclusion, where do you see things going from here? A: Trade frictions will continue. As my colleague Marko Papic highlighted in a report published earlier this week, NAFTA negotiations are likely to remain on the ropes for some time.5 The Trump administration is also investigating allegations of Chinese IP theft. The U.S. is a major exporter of intellectual property, but these exports would be much larger if U.S. companies were properly compensated for their ingenuity. Chinese imports of U.S. intellectual property were less than 0.1% of Chinese GDP in 2017, an implausibly small number (Chart 7). If China is found to have acted unfairly, this could lead the U.S. to impose across-the-board tariffs on Chinese goods and restrictions on inbound foreign direct investment. Nevertheless, as noted above, worries about a plunging stock market will constrain Trump from acting too aggressively. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. Today, firms are struggling to find qualified staff (Chart 8). This suggest that Trump will stick to doing what he does best, which is taking credit for everything good that happens under the sun. Chart 7China Is Importing More IP From The U.S., ##br##But The "True" Number Is Probably Higher Chart 8Protectionism Makes Less Sense ##br##When The Labor Market Is Strong Ironically, the latest trade skirmish is occurring at a time when the Chinese government is taking concerted steps to reduce excess capacity in the steel sector, and the profits of U.S. steel producers are rebounding smartly (Chart 9). In fact, the latest Fed Beige Book released earlier this week highlighted that "steel producers reported raising selling prices because of a decline in market share for foreign steel ..."6 Chart 9Chinese Steel Exports Falling, U.S. Steel Profits Rising Meanwile, German automakers already produce nearly 900,000 vehicles in the U.S., 62% of which are exported. In fact, European automakers have a smaller share of the U.S. market than U.S. automakers have of the European one.7 A lot of what Trump wants he already has. The Pentagon has also warned that trade barriers imposed against Canada and other U.S. military allies could undermine America's standing abroad. This is an important point, considering that Trump invoked the rarely used Section 232 of the Trade Expansion Act of 1962, which gives the President broad control over trade policy in matters of national security, to justify raising tariffs. Trump tends to listen to his generals, if not his other advisors. He probably was not expecting their reaction. All this suggests that a major trade war is unlikely to occur. As we go to press, it appears that the White House will temporarily exclude Canada and Mexico from the list of countries subject to tariffs. We suspect that the EU, Australia, South Korea, and a number of other economies will get some relief as well. White House National Trade Council Director Peter Navarro has also said that some "exemptions" may be granted for specific categories of steel and aluminum products that are deemed necessary to U.S. businesses. That is a potentially very broad basket. The bottom line is that the equity bull market will end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances met with restrictive monetary policy, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House," U.S. Department of Commerce, February 16, 2018. 2 Katharine G. Abraham, and Kearney, Melissa S., "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper No. 24333, (February 2018). 3 David H. Autor, Dorn, David and Hanson, Gordon H., "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 4 A graphical illustration of this point is provided here. 5 Please see BCA Geopolitical Strategy, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018. 6 Please see "The Beige Book: Summary of Commentary on Current Economic Conditions By Federal Reserve District,"Federal Reserve, dated March 7, 2018. 7 Please see Erik F. Nielsen, "Chief Economist's Comment: Sunday Wrap," UniCredit Research, dated March 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

ハイライト 中国での環境改革は製鋼能力を引き続き削減しています。中国における違法な誘導炉施設の閉鎖も市場を引き締めています。公式の中国の鉄鋼生産が増えているように見えるのは、違法な誘導炉からの生産が報告されず（したがって計上されず）、閉鎖によって生じたギャップを埋めるために合法的な製鉄所の生産が増加していることを反映している可能性が高いです。 鉄鋼メーカーの利益は急増しており、少なくとも2018年前半までは中国における鉄鉱石需要は堅調に推移するでしょう。銅は2017年6月以降、供給の混乱と世界的な景気回復に伴う強い需要成長を受けて堅調に買われています。建設プロジェクトの配線や配管工事が中国で本格化するため、2018年前半にさらに上昇するものと予想します。その後は世界的な成長が中国の減速分を補うでしょう。 我々の分析は、全球の鉄鋼市場が2018年前半に引き締まることを示しています。中国ですでに起きているのと一致して、我々は上海先物取引所の2018年3月限鋼筋先物（人民元/トン建て）でタクティカルなロングポジションを取り始めます。本推奨には10%のストップロスを設定します。 エネルギー: オーバーウェイト。かつてコンセンサスと異なっていた我々の原油見通しは現在コンセンサスとなっているため、今晩の取引終了時にブレントとWTIの55ドル対60ドル/バレルのコールスプレッド（5月・7月受渡し）で利益確定を行います。これらのポジションは火曜日の終値でそれぞれ109.2%と123.5%の含み益が出ていました。売りが出れば、これらのフォワードカーブに沿って再度ロングを構築する好機となるでしょう。 ベースメタル: ニュートラル。銅は世界的な景気回復が続く限り今年も堅調に買われるでしょう。鉱山での多数の契約再交渉が今年の銅価格に対する追加の上方リスクとなります。 貴金属: ニュートラル。FRBが年内に4回利上げすると予想しているため、金に対して強気になるのは難しいです。ただし、中央銀行がハト派に傾く兆候、特に今年インフレが高まらない場合は金が上昇するでしょう。 農産物／ソフトコモディティ: アンダーウェイト。市場は金曜日のUSDA WASDEまでは様子見になるでしょう。トウモロコシを除いてアンダーウェイトを継続します。 特集 今週のチャート 鉄鉱石と鉄鋼価格は2017年に乖離した 2017年、鉄鉱石と鉄鋼の価格は乖離した 2017年、鉄鉱石と鉄鋼の価格は乖離した 中国の環境政策の措置により、2016年前半から2018年前半の間に世界の製鋼能力は1億トン削減されました。これは中国の鉄鋼価格に最も明確に表れており、2016年にほぼ80%上昇した後、2017年には30%以上上昇しました。北京が鉄鋼市場改革に注力し始めて以来の鉄鋼価格の総上昇率は135%にも達します。 鉄鉱石価格は2016年に鉄鋼と同様の上昇を示しましたが、2017年には大きく乖離し、3月中旬から6月中旬にかけて40%以上下落し、通年では前年比でほぼ8%下落して終えました（今週のチャート）。急騰する鉄鋼価格は中国の製鋼所の利益率を押し上げ、年末に向けて鉄鋼の重要原料である鉄鉱石需要を刺激しました：鉄鉱石価格は2017年末の2か月で20%上昇しました。 どのようにここまで来たか？中国の鉄鋼部門改革の振り返り 大気汚染削減を目的とした旧式で過剰な産業能力の排除を目指す改革の一環として、北京は2016～2020年の期間に1億～1.5億トンの鉄鋼能力を削減することを約束しました。これまでに推定1億トンの能力が閉鎖されています。 これらの改革に加えて、北京はスクラップ鋼を溶かして品質の劣る鋼を生産している小規模の誘導炉を閉鎖することを約束しました。これらの誘導炉は年次能力で8,000万～1.2億トンを占めると推定されていますが、実際の生産ははるかに少なく、S&P Global Plattsによれば2016年の生産は推定3,000万～5,000万トンでした。1 これは中国の粗鋼生産全体の7%未満です。 誘導炉からの生産削減は公式データには明確に現れていません — 中国の粗鋼生産はこれらの削減の中でも増加を続けており、これは我々が以前のリサーチで議論した通りです（チャート2）。2 国際鉄鋼協会のデータは、2017年の最初の11か月間で世界の鉄鋼生産が過去最高水準にあり、前年比で5%以上増加したことを示しています。同様に、世界生産の50%を占める中国の粗鋼生産は8月にピークを迎え、同期間の生産は過去最高を記録し、2016年同期間比で5.28%増加しました。 この生産の逆説は、多くの中国の誘導炉が違法であるためにその生産が公式の生産データに計上されていないという事実に起因します。合法的な製鋼所が閉鎖された誘導炉の減少を相殺するために生産を増やすと、公式の粗鋼生産数値は上昇します。 実際、中国の鉄鋼データをさらに検討すると、粗鋼生産数値から推測されるよりも中国の鉄鋼市場が実際にはより引き締まっていることが明らかです（チャート3）。以下の観察は供給がひっ迫していることを示しています： 中国の粗鋼生産は新たな記録を塗り替えていますが、China Stat Infoのデータは鋼製品について矛盾する状況を示しています。2017年3月から11月の鋼製品生産は前年同期比で3.46%減少し、1995年以来この期間での初の前年比マイナスとなりました。 誘導炉で生産された粗鋼は公式の粗鋼統計には含まれない可能性がありますが、それらの金属は最終的にワイヤー、棒材、レール、バーなどの鋼製品の製造に使われ、これらはこのデータに表れます。したがって、鋼製品の減少は粗鋼供給の低下が鋼製品の生産を押し下げていることを示唆しています。 中国の鋼製品の輸出は下落傾向にあります。理論的にはこれは国内需要の増加か海外需要の減少のいずれかによります。世界経済が健全であること、及び中国の鉄鋼生産に関して我々が把握している事実を考えると、前者の理論が妥当だと考えます。 2017年の最初の11か月で中国の鋼製品の輸出は前年比で30%減少しています。2016年の3.04%の前年比減少を除けば、これは2009年以来初の輸出の年間減少を示しています。国内供給が減少している中で、中国は国内の鋼材使用者の需要を満たすために輸出を削減した可能性が高いです。 中国のスクラップ鋼の輸入は2017年後半に落ち込みました。鉄鉱石を主原料とする高炉とは異なり、閉鎖された違法製鉄所はスクラップ鋼を誘導炉で溶かしています。これらの炉の排除と一致して、中国のスクラップ鋼輸入は2017年後半に前年比で14.35%減少しました。これはこれらの炉からのスクラップ鋼需要の低下を示すさらなる証拠です。 中国の鋼在庫は減少しています。実際、主要工業都市の鋼製品在庫は記録的な低水準にあります（チャート4）。これは需要が供給を上回る引き締まった市場の症状であり、中国の粗鋼生産数値と矛盾します。 チャート2 中国の粗鋼生産は過去最高を記録##BR##一方で鋼製品生産は減少 鋼製品の生産が減少する中、中国の粗鋼生産が過去最高を記録 鋼製品の生産が減少する中、中国の粗鋼生産が過去最高を記録 チャート3 中国の貿易データが示す証拠##BR##引き締まった市場 中国の貿易データは市場の逼迫を示す 中国の貿易データは市場の逼迫を示す チャート4 中国の鉄鋼在庫は減少している 中国の鉄鋼在庫が減少している 中国の鉄鋼在庫が減少している さらに、World Steel Association（WSA）によれば、同協会がデータを収集している66か国の設備稼働率は2017年7月～11月期で前年同期比で3.12ポイント上昇し平均72.64%となり、2016年同期間の平均69.52%から上昇しました。これらの観察は、公式の粗鋼生産数値が増加している一方で、実際の生産は低下し供給は引き締まっている証拠です。 鉄鋼価格が供給のひっ迫で支えられ続けるかどうかは、中国が過剰能力や品質の劣る鋼メーカーを恒久的に閉鎖することに成功するか、あるいは誘導炉操業者がこうした政策を回避して違法な鋼を市場に戻せるかどうかにかかっています。 少なくとも今冬は中国の改革が鉄鋼市場を支配する 12月中旬の中央経済工作会議の終了を受けて、中国当局は今後3年間の「三つの重大攻防戦」を発表しました。これは将来の経済繁栄にとって重要と見なされるもので、(1) 大きなリスクの防止、(2) 的を絞った貧困削減、(3) 汚染対策と要約されます。国際エネルギー機関（IEA）は大気汚染が年間約100万人の早期死亡を引き起こし、家庭内大気汚染が追加で120万人の早期死亡をもたらしていると推定しています。3 したがって、中国の大気質改善は社会的かつ健康面での主要目標です。 チャート5 中国の生産減少は##BR##世界生産に影響を与える 中国の鉄鋼生産量の減少は世界の生産量に影響を与える 中国の鉄鋼生産量の減少は世界の生産量に影響を与える これは大気汚染を減らし中国の空を浄化するための措置が鉄鋼セクターにとって非常に重要になることを意味します。環境保護省によれば、中国はスモッグの影響を受けやすい北部28都市で直径2.5マイクロメートル以下の浮遊粒子（PM2.5）濃度を前年比15%削減することを約束しています。鉄鋼産業は主に北京・天津・河北の北部地域に集中しており、この地域での大気汚染の主要な発生源の一つです。実際、工業排出、特に鉄鋼やセメント部門の排出がこれらの微小粒子の40～50%を占めていると報告されています。 中国の冬季スモッグ「戦略」は、スモッグが発生しやすい11月中旬～3月中旬の期間に鉄鋼、セメント、アルミニウムの生産を削減すること、ならびに家庭用石炭の使用、ディーゼルトラック、建設プロジェクトを制限することでこれらの汚染産業を標的にします。鉄鋼生産の削減は30～50%の範囲をターゲットとしており、Plattsの推計によれば冬季に3,300万トンの鉄鋼生産（2017年の中国の粗鋼生産見通しの約3.9%に相当）が停止される見込みです。実際、中国の環境大臣李干杰は「これらの特別キャンペーンは一度限りのものではなく、長期的なメカニズムの模索である」と述べています。4 したがって、これらの削減は中国の鉄鋼部門で繰り返される出来事になる可能性があります。 中国の公式な粗鋼数値はこれらの削減の影響を示し始めており、11月の粗鋼生産は前月比で8.6%減少し、前年比ではわずか2.2%の伸びにとどまり、7月以降の平均7.6%の前年比伸びから大幅に鈍化しています。その結果、世界の他地域では粗鋼生産がこれまで通りの伸びを示した一方で、11月の世界の鉄鋼生産は前月比でほぼ6%減少し、前年比では3.7%増と、2017年下半期以降に観測された平均6.6%の前年比成長率から大幅に減速しました（チャート5）。 この見通しに対するリスクは、これらの削減に対する遵守の弱さから生じます。山東省のアルミと鉄鋼の生産者による回避の報告があります。それでも、中国がこれらの改革に注力していることを考えると、広範な違反が起こるとは見ていません。 もう一つのリスクは需要側から来ます。環境アジェンダの一環として、北京は都市の主要公共プロジェクト（道路や水関連プロジェクト）の着工を春まで延期する計画を発表しました。ただし、この停止は鉄道、空港、手頃な価格の住宅などの「主要な生活関連プロジェクト」には影響を与える意図はありません。 建設は鉄鋼の最大の最終需要先であり、WSAによれば世界の鉄鋼の半分以上が建築物とインフラに使用されます — 建設部門の減速は鉄鋼需要を抑制します。5 他の主要な建設地帯が同様の政策を採用すれば、供給減の影響は需要の弱さによって相殺され、鉄鋼市場全体への影響は和らぐでしょう。 結論：今後数か月で中国の鉄鋼生産と輸出は減少すると予想されます。習近平氏が大気質改善に強い決意を示していることから、今冬の製鋼所の環境改革遵守は強いと予想します。これと中国の誘導炉からの生産減少は、市場が少なくとも2018年前半に一般的に思われているよりも引き締まる可能性を示唆しています。世界経済の回復と拡張がおおむね2018年を通じて継続する可能性が高いことを考えると、特に我々が予想するように中国以外の成長が中国の減速分を埋める場合、2018年下半期も鉄鋼市場は引き続き堅調に推移する可能性があります。ただし、2018年3月の全国人民代表大会後に業界向けの実際の改革内容がどうなるかを見守る必要があります。6 鉄鋼の利益率が鉄鉱石需要を促す 過去2年間にわたる鉄鋼価格の著しい上昇と2017年の鉄鉱石の精彩を欠くパフォーマンスを受けて、中国の製鋼所の利益率は複数年ぶりの高水準に達しました（チャート6）。通常であれば、これは生産を促し、市場に供給が大量に流れ込み価格を押し下げるはずです。しかし、中国の環境改革は今後数か月で最も生産性の高い製鋼地域の生産を制限します。したがって、今冬に製鋼所による大規模な政策違反がない限り、価格が迅速に下落することは予想していません。 代わりに、製鋼所は生産制限が春に解除された際にフル稼働できるよう準備しています。そのため彼らは鉄鉱石在庫を積み増し、弱い鉄鉱石価格を利用しています。鉄鉱石市場が鉄鋼に追いつく前に、彼らは利益率を確保しようとしているのです。中国の鉄鉱石輸入は9月に過去最高を記録し、最新データでは輸入が前月比19%増となり、前年比では2.8%増となっています（チャート7）。 チャート6 健全な鉄鋼の##BR##利益率 鉄鋼の利益率は堅調 鉄鋼の利益率は堅調 チャート7 春に備え鉄鉱石を備蓄する鉄鋼メーカー 製鉄業者、春に備えて鉄鉱石の備蓄を増強 製鉄業者、春に備えて鉄鉱石の備蓄を増強 これは、抑制された鉄鋼生産期に我々が期待する動きと逆行しています。特に現在のように鉄鉱石在庫が健全な環境ではそうです。中国の在庫は年央のピークから下がりましたが、2017年第4四半期に再び上昇傾向に戻りました。これは冬季の生産能力削減と一致しており、製鋼所からの鉄鉱石需要の減少によるものと考えられます。この現象を説明する理論は二つあります： 1. 中国の製鋼所は安い鉄鉱石価格を利用して利益率をロックインしており、春に鉄鋼生産が再開した際に鉄鉱石価格が上昇すると見込んでいる。 2. 冬季の削減期間中、中国の製鋼所はブラジルやオーストラリアから輸入された高品位の鉄鉱石を要求している。これにより環境規制に違反せずに生産量を最大化できるようにしている。 環境配慮が鉄鉱石のスプレッドを拡大する 冬季の生産能力削減の結果として、最も汚染の激しい工程を削減するために高品位の原料に対する需要が強まっています。高品位の鉄鉱石は純度（鉄含有量）で定義され、高炉でより効率的に使用できるため、消費する鉄鉱石1トン当たりより多くの鉄鋼を生産でき、生産と利益を最大化します。これは引き締まった鉄鋼市場で利益率が高い状況では特に当てはまり、製鋼所は高品位を購入する余裕があり、生産効率を重視しています。 58%鉄含有の低品位ファインのディスカウントや、65%鉄含有の高品位のプレミアムは拡大しています（チャート8）。これは製鋼所が冬季の環境制限を法的に回避しつつもコンプライアンスを維持する方法を見つけたためです。さらに、より純度の高い鉱石は汚染が少なく、中国の環境方針に合致します。 また、鉄鉱石ペレットや塊鉱のプレミアムも拡大しています。塊鉱やペレットは高炉に直接投入できますが、ファインは高汚染の焼結工程が必要です。したがって、中国の環境改革はより高品位で汚染の少ない鉱石への需要を増加させています。 スプレッドを押し上げているもう一つの要因は、冶金コークス価格の上昇かもしれません（チャート6）。高品位の鉄鉱石はシリカが少ないため、精錬に必要な冶金コークスが少なくて済みます。中国の風聞では、最高の鉄含有量と最低のシリカ含有量を持つブラジルのカラジャス・ファインが高い需要にあると伝えられています。7 さらに、中国の輸入は低品位であるインド産の鉄鉱石が減少していることを示しています。7月～10月期でインドからの輸入は前年比で11.26%減少し、10月は前年比ほぼ25%、前月比で30%減となりました。これは製鋼所が低品位鉱石を敬遠しているという理論と一致します。一方で、ブラジルとオーストラリアからの輸入は引き続き堅調であると見込まれます（チャート9）。最新のAustralian Resources and Energy Quarterlyは、2018年にオーストラリアとブラジルの鉄鉱石輸出がそれぞれ5.4%と4.2%成長すると予測する一方、インドの輸出は前年比57.5%の減少が見込まれています。 チャート8 鉄鉱石の価格スプレッドは拡大 鉄鉱石の価格スプレッドの拡大 鉄鉱石の価格スプレッドの拡大 チャート9 環境懸念は高品位鉄鉱石の需要を支える 環境への懸念が高品位鉄鉱石の需要を支えるだろう 環境への懸念が高品位鉄鉱石の需要を支えるだろう 結論：冬季の生産削減に直面しても生産を高水準に保ち、強い鉄鋼価格から利益を得るために、製鋼所は高品位の鉄鉱石に頼り、その結果高品位と低品位のスプレッドが拡大しています。製鋼所が高品位鉱石で生産を維持できる程度が、冬季の生産削減が鉄鋼セクターに与える影響を和らげるでしょう。中国の環境重視が長期計画であることを考えると、これらのスプレッドは歴史的平均に戻るというよりは引き続き広い水準で推移すると予想します。 鉄鋼価格と銅市場 チャート10 鉄鋼消費は銅価格を予測するのに役立つ 鉄鋼の消費は銅価格の予測に役立つ 鉄鋼の消費は銅価格の予測に役立つ 銅市場は第4四半期に乱高下しました。赤色金属の価格は5月以降概ね上昇トレンドにあり、9月上旬には3.13ドル/ポンドで一度ピークに達し、同月後半には2.91ドル/ポンドまで下落しました。その直後、銅は10月中旬に3.22ドル/ポンドの新高値を付け、3年以上ぶりの高値となりました。第19回党大会のメッセージを受けた中国の減速懸念により、同金属は12月上旬に再びほぼ10%の下落を経験しました。実際、12月5日には4.65%の下落が見られました。この下落には明確な理由はないものの、LME在庫の約10万トンの増加、中国の減速懸念、及び年末前のポジション解消が混ざった影響と考えられます。それでも銅はその後これらの下落を取り戻し、年末は3.28ドル/ポンドで終えました。 我々の銅のモデリングでは、鉄鋼消費が将来の銅価格の挙動を予測する上で重要であることが分かりました。具体的には、中国の鉄鋼消費は6か月後の銅価格と有意な正の関係を持っています（チャート10）。これは建設部門が両金属の重要な最終需要先であることから説明できます。しかし、両素材は建設現場で必要とされるタイミングが異なります。鉄鋼製品は構造物の構築に使われ、プロジェクトの開始時点で必要となる一方、銅は電気配線や配管に使われ、プロジェクトの後半（およそ6か月後）に必要となります。 これは我々の発見と一致しており、鉄鋼は平均的に6か月のラグで最も重要であり — 構造物が建設されてから配管や配線が必要になるまでの平均期間を反映しています。需要側のファンダメンタルが鉄鋼と銅の市場を支配する場合、中国の鉄鋼消費は銅市場の有用な先行指標です。 政府の景気刺激と堅調な建設セクターが2017年の中国の鉄鋼需要を押し上げました。しかし、WSAの短期見通しによれば、今年は中国でのリフレーションの影響を受け需要は緩やかになる見込みで、世界的な強い成長がこれを一部相殺します。WSAは誘導炉の閉鎖が鉄鋼需要成長率を12.4%と過大に見せたと指摘し、2017年の中国の鉄鋼需要成長率はより妥当な約3%と見積もるべきであり、これにより世界の鉄鋼需要成長率は2.8%になると述べています。中国以外の鉄鋼需要は2017年に推定2.6%増加し、2018年には3%に達すると予想されています。一方で、中国の需要は2018年は横ばいと見込まれ、2018年の世界鉄鋼需要成長率は1.6%になると予想されています（表1）。 表1 鉄鋼需要（前年比成長率） 中国の環境改革が鉄鋼・鉄鉱石をけん引 中国の環境改革が鉄鋼・鉄鉱石をけん引 中国からの需要の緩和と供給側の安定性（あるいはその欠如）が今年の銅市場を支配します。需要面では、中国の鉄鋼市場は赤金属の将来の方向性に関する洞察を提供します。 結論：中国の鉄鋼需要はこれまで堅調に推移しており、今年も2017年の水準を維持すると見込まれるため、6か月の期間において銅価格が需要に起因して急落する可能性は低いと考えます。 ルカヤ・イブラヒム、アソシエイトエディター コモディティ＆エネルギー戦略 RoukayaI@bcaresearch.com 1 S&P Global Plattsが2017年3月6日に発表した「Will China's induction furnace steel whac-a-mole finally come to an end?（中国の誘導炉鋼のいたちごっこはようやく終わるのか？）」をご参照ください。 2 BCAリサーチのコモディティ＆エネルギー戦略 ウィークリーレポート「Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018（中国のリフレーションの減速は2018年の鉄鋼・鉄鉱石を抑制する）」、2017年9月7日発行をご参照ください。ces.bcaresearch.comで入手可能です。 3 IEAのWorld Energy Outlook 2016特別報告「Energy and Air Pollution（エネルギーと大気汚染）」をご参照ください。iea.orgで入手可能です。 4 「Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily（中国の地方当局がアルミと鉄鋼の能力抑制を回避するために偽データを使用）」、2017年12月26日発行をご参照ください。reuters.comで入手可能です。 5 worldsteel.orgの「Steel Markets（鉄鋼市場）」をご参照ください。 6 追加の議論については、BCAリサーチのコモディティ＆エネルギー戦略2017年11月9日号「Shifting Gears in China: The Impact On Base Metals（中国のギアチェンジ：ベースメタルへの影響）」をご参照ください。ces.bcaresearch.comで入手可能です。 7 「High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt（高中品位鉄鉱石ファインのスプレッドが史上最高の23.55ドル/乾燥トンに拡大）」、2017年8月22日発行をご参照ください。platts.comで入手可能です。 投資見解とテーマ 推奨 戦略的推奨 戦術的トレード コモディティ価格と取引参照表 中国の環境改革が鉄鋼・鉄鉱石を牽引 中国の環境改革が鉄鋼・鉄鉱石を牽引 2017年にクローズしたトレード

Highlights The stellar performance in metals over the past year resulted from a combination of favorable demand- and supply-side developments, propelled along, as always, by China's outsized effect on fundamentals. On the demand side, robust global growth is keeping metals consumption strong. On the supply side, environmental reforms in China and the shuttering of mills - as well as supply-side shocks in individual markets - continues to bolster prices. A weak U.S. dollar - which lost 6% of its value in broad trade-weighted terms - further supports these bullish conditions for metal markets. We expect China's winter supply cuts to dominate 1Q18 market fundamentals. As we move toward mid-year, we expect a soft and controlled slowdown in China, brought about by the Communist Party's goals of reducing industrial pollution and pivoting toward consumer-led growth. Although this will moderate demand from the world's top metal consumer, strong growth from the rest of the world will neutralize the impact of this slowdown. Energy: Overweight. Pipeline cracks in the critical Forties system in the North Sea highlight the unplanned-outage risk to oil prices we flagged in recent reports. We remain long Brent and WTI $55/bbl vs. $60/bbl call spreads in 2018, which are up an average of 47%, respectively, since they were recommended in September and October 2017. Base Metals: Neutral. Following a strong 1Q18, a moderate slowdown in China will be offset by growth in the rest of the world (see below). Precious Metals: Neutral. We continue to recommend gold as a strategic portfolio hedge, even though we expect as many as three additional Fed rate hikes next year. Ags/Softs: Underweight. The U.S. undersecretary for trade and foreign agricultural affairs warned farmers this week they "need to have a backup plan in the event the U.S. exits the North American Free Trade Agreement," in an interview with agriculture.com's Successful Farming. No specifics were offered. Canada and Mexico - the U.S.'s NAFTA partners - are expected to account for $21 billon and $19 billion of exports, respectively, based on USDA estimates for FY 2018. These exports largely offset imports of $22 billion and $23 billion, respectively, from both countries. The U.S. runs an ag trade surplus of ~ $23.5 billion annually. Feature Metals had another extraordinary year in 2017. The LME base metal index rallied more than 20% year-to-date (ytd) bringing the index up more than 50% since it bottomed in mid-January 2016 (Chart Of The Week). Chart of the WeekA Great Year For Metals Steel, zinc, copper, and aluminum led the gains. In fact, of the metals we track, iron ore is the only one in negative territory - having lost almost 8% ytd. Nonetheless, it has been on the uptrend recently - gaining ~ 24% since it bottomed at the end of October. Capacity reductions in China, where policymakers mandated inefficient and highly polluting mills and smelters in steel- and aluminum-producing provinces be taken offline, continue to affect the supply side in those metals most. As China churns out less of these commodities, competition for the more limited supply will pull prices for them higher. Nevertheless, a stronger USD - brought about by a more hawkish Fed - likely will cap significant upside gains, and prevent a repeat of this year's exceptional performance. Strong Global Demand Will Neutralize China Slowdown The Chinese economy is beginning to show signs of a slowdown. The Li Keqiang Index - a proxy for China's economic activity - has rolled over. Furthermore, the manufacturing PMI has plateaued following last year's rapid ascent (Chart 2). This deceleration is also evident in China's infrastructure data. Annual growth in infrastructure spending in the first three quarters of the year are below the four-year average. And, although spending grew 15.9% year-on-year (yoy) in the first 10 months of this year, the rate of growth is slower than the four-year average of 19.6% (Chart 3). Chart 2A China Slowdown Is In The Cards... Chart 3...Threatening A Pull Back In Metals Demand That said, it is important to point out that this is due to a significant decline in utilities spending growth, which accounts for ~ 20% of infrastructure investments. Investment in utilities grew a mere 2.3% in the first ten months of the year, in contrast with the average 15.7% yoy increase of the previous four years. In any case, the slowdown in China's reflation reflects President Xi Jinping's resolve to shift gears and emphasize quality over quantity in future growth strategies. Now that Xi has consolidated his power, we expect policymakers to build on the momentum from the National Communist Party Congress, and be more effective in implementing reforms going forward. As such, Beijing should be more willing to tolerate slower growth than it has in the past. Nonetheless, we do not anticipate a significant slowdown. More likely than not, policymakers will resort to fiscal stimulus if the economy is faced with notable risks. Consequently, a hard landing in China is not our base case scenario. In any case, strong global demand will neutralize a slowdown in China's metal consumption in 2018. Despite a deceleration in China, the IMF expects global growth to pick up in 2018 (Table 1). The Global PMI is at its highest level since early 2011, supported by strong readings in the Euro Area and the U.S. (Chart 4). In all likelihood, conditions for global metal demand will remain favorable in 2018. Table 1IMF Economic Forecasts Chart 4Strong Global Demand Will Neutralize##BR##Impact Of China Slowdown China Real Estate Will Slow; Major Downturn Not Expected Chart 5Slowing Real Estate Investment Is A Mild Risk We do not foresee significant risks to China's real estate market, which is the big driver of base-metals demand in that economy. Total real estate investment is up 7.8% in the first 10 months of the year - the strongest growth for the period since 2014 (Chart 5). Even so, it is important to note the slowdown in that sector. After growing 9% yoy in 1Q17, growth rates fell to 8% and 7% in 2Q and 3Q17, respectively. In fact, growth in October, the latest month for which data are available, came in at 5.6% yoy - significantly slower than the average monthly yoy rate of 8% in the first nine months of the year. The slowdown in floor-space-started is more pronounced. The area of floor space started grew 5% in the first 10 months of the year, down from an 8% expansion in the same period in 2016. October data showed a yoy as well as month-on-month contraction - 4.2% for the former, and 12.1% for the latter. This is the second yoy contraction in 2017, with July experiencing a 4.9% reduction in floor area started. Similarly, quarterly data shows a significant slowdown from almost 12% yoy growth rates registered in 4Q16 and 1Q17 to the mere 0.4% yoy growth in 3Q17. In addition, the growth rate in commodity building floor-space-under-construction has slowed down to 3.1% yoy in the first 10 months of 2017, down from almost 5% for the same period in the previous two years. Although the data are a reflection of Xi's resolve to tighten control of the real estate market, we do not expect a major downturn that will weigh on metal demand. As BCA Research's China Investment Strategy desk notes, strong demand in the real estate sector, coupled with declining inventories, will prevent a major slowdown in construction activity, even in face of tighter policies.1 A Stronger Dollar Moderates Upside Price Pressures In our modeling of the LME Base Metal Index, we find that currency movements are important determinants of the evolution of metals prices. More specifically, the U.S. dollar is inversely related to the LME base metal index. While U.S. inflation has remained stubbornly low, we expect inflation to start its ascent sometime before mid-2018, allowing the Fed to proceed with its rate-hiking cycle. Given our view that too few hikes are currently priced in for 2018, there remains some upside to the USD. Thus, while dollar weakness has been supportive for metal prices in 2017, a stronger dollar will be a headwind in 2018. A Look At The Fundamentals In terms of supply/demand dynamics in individual metal markets, idiosyncrasies in their current states, and variations in how China's environmental reforms manifest themselves will mean the different metals will follow different trajectories next year. Muted Consumption Mitigated Impact Of Supply Disruptions In Copper Copper production had a bumpy 2017, rocked by sporadic supply disruptions in some of the world's top mines.2 This led to a contraction in world refined production ex-China, which was offset by an increase in Chinese output (Chart 6). Although Chinese refined copper output grew a healthy 6% yoy in the first three quarters, this was nonetheless a slowdown from the 8% yoy expansion for the same period in 2016. Even so, increased Chinese copper production more than offset declines from other top producers. Refined copper production in the rest of the world contracted by 1.5% in the first three quarters, bringing world production growth to 1.3% - significantly slower than the average 2.6% yoy increase witnessed in the same period in the previous two years. The supply-side impact on the overall market was mitigated by a slowdown in consumption. Chinese consumption, which accounts for 50% of global refined copper demand, remained largely unchanged in the first three quarters of the year compared to last year. This follows a yoy increase of ~ 8% in Chinese demand vs. the same period in 2016. Demand from the rest of the world contracted by 0.6% yoy, down from a 2.5% yoy expansion in the same period last year. So, despite supply disruptions, the copper market remained balanced - registering a 20k MT surplus in the first three quarters of this year, following a 230k MT deficit in the same period in 2016. Recently, there is news of capacity cuts in Anhui province - where China's second-largest copper smelter will be eliminating 20 to 30% of its capacity during the winter.3 If the copper market is the next victim of China's environmental reforms, global balances may be pushed to a deficit. Although copper remains well stocked at the major warehouses, an adoption of these winter cuts by other copper producing provinces would weaken refined copper supply and support prices (Chart 7). Chart 6Copper Rallied On Back Of Supply-Side Fears Chart 7Copper Warehouses Are Well Stocked Steel Prices Will Remain Elevated Throughout Q1 China's steel sector has undergone significant reforms this year. In addition to the 100-150 mm MT of capacity cuts to be implemented between 2016 and 2020, Beijing has also eliminated steel produced by intermediate frequency furnaces (IFF).4 Even so, Chinese steel production - paradoxically - is at record highs. This comes down to the nature of IFFs, which are illegal and thus not reflected in official crude steel production data. However, growth in steel products - which reflect output from both official as well as illegal steel mills - has been flat (Chart 8). In addition, China's steel exports have come down significantly since last year, reflecting a domestic shortage in the steel industry. November data shows a 34% yoy contraction, and exports for the first 11 months of the year are down more than 30% from the same period last year. We expect Chinese steel production to remain anemic until the end of 1Q18, as mandated winter capacity cuts cap production in major steel-producing provinces. The near-term cutback in production will keep steel prices elevated. The spread between steel and iron ore prices during this period will remain wide as lower steel production translates into muted demand for the ore. This is also consistent with China's inventory data which shows that after falling since August, iron ore stocks have been building up since mid-October - in conjunction with the start of winter steel-capacity cuts. Indonesian Nickel Exports Bearish In Long Run, Not So Much In Near Term Ever since Indonesia's ban on nickel ore exports in 2014, worldwide production has been on the downtrend. In the previous two years, shrinking supply from China - which makes up about a quarter of global output - was the culprit of reduced world output, offsetting increases from the rest of the globe, and causing global production to contract by 0.2% and 0.5%, respectively (Chart 9). Chart 8Falling Exports And Flat Steel Products##BR##Output Reflect Closures In Steel Chart 9Deficit And Inventory##BR##Drawdowns Dominate Nickel... However, at 2.5%, the contraction in global output is significantly larger for the first three quarters of this year. What is noteworthy is that it is caused by shrinking production both from China - down ~ 7.5% - as well as from the rest of the world, where output is down ~ 1%. Nevertheless, a decline in demand from China - which accounts for almost half of global consumption - has softened the impact of withering production. Chinese demand for semi refined nickel shrunk 22% in the first three quarters of the year, more than offsetting the 9% growth in demand from the rest of the world. However, there has been a recovery in global demand since June. A 15% yoy growth in the third quarter from consumers ex-China drove a 5% yoy gain in global growth. Despite weak demand in 1H17, the nickel market recorded a deficit in the first three quarters of the year. In fact, nickel has been in deficit for the past two years. Going forward, Indonesia's gradual lifting of the export ban will prop up production. In fact, global yoy production growth has been in the green since June. However, while Indonesian ores are slowly returning to the global market, they remain a fraction of their pre-ban levels. Thus, prices will likely remain under upside pressure in the near term. Record Deficit And Significant Inventory Drawdowns Dominate Aluminum... Aluminum has been in deficit for the past three years. In fact, at 100k MT, the deficit in the first three quarters of 2017 is the largest on record for that period. This is reflected in LME inventory data which has been experiencing drawdowns since April 2014 - Falling from more than 5mm MT to ~ 1mm MT (Chart 10). Strong growth from Chinese producers - which account for more than half the world's primary production - kept global output growth strong, despite a decline from other top producers. However, falling Chinese production in August and September compounded the fall in output from the rest of the world, leading to a 3.5% yoy decline for those two months. In fact, September's Chinese output data marks the lowest production figure since February 2016. On the demand side, global consumption is up 6.2% yoy in the first seven months of 2017, reflecting a general uptrend in both Chinese consumption and, to a lesser extent, a greater appetite for the metal from the rest of the world. However, there has been some weakness from China recently. Chinese demand contracted by 2.9% and 9.6% yoy in August and September. While an 8.2% yoy increase in consumption from the rest of the world offset the August weakness from China, global demand shrunk by 5.8% in September. As with steel, supply-side reforms will dominate and keep aluminum prices elevated in the near term. ... Along With Zinc Demand Global zinc production has been more or less flat this year. The 2.7% decline from Chinese producers, which supply 46% of global zinc slab, was offset by a 2.4% increase in production from the rest of the world. On the demand side, although Chinese consumption - which accounts for almost half of global zinc slab demand - has been flat, strength from the rest of the world supported global demand, which is up 2.3% yoy for the first three quarters of the year (Chart 11). Chart 10...As Well As Aluminum... Chart 11...And Zinc Static supply coupled with increased demand has led the zinc market to a deficit of 500k MT - a record for the first three quarters of 2017. The deficit has continued to eat up zinc stocks, which have been in free-fall, since early 2013.   Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," published on December 7, 2017, available at Bloomberg.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Slow-Down in China's Reflation Will Temper Steel, Iron Ore in 2018,' dated September 7, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

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

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Highlights 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. 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. Both the steel and coal industries in China are becoming more efficient and more competitive, with low-quality output falling and high-quality supply rising. Feature Reducing capacity (also called "de-capacity") in the oversupplied commodities markets (e.g., steel, coal, cement, and aluminum) has been a key priority within China's structural supply side reforms over the past two years. The reforms were announced by President Xi Jinping in November 2015 and have focused primarily on steel and coal, and to a lesser extent on the aluminum and cement sectors. China's "de-capacity" reforms have been aiming to reduce inefficient productive capacity and low-quality output of the above mentioned commodities, as well as boost medium-to-high-quality production. The main focus of this report is to dissect China's supply side "de-capacity" reforms, and to assess their impact on steel, coal and iron ore prices. The de-capacity reforms were announced in late 2015 and, coincidentally, all major industrial commodities prices made a synchronized bottom in late 2015/early 2016 (Chart I-1). Chart I-1ASynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Chart I-1BSynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? China is the largest producer and consumer of various raw materials, ranging from steel and coal to base metals. Hence, two interesting questions arise: was it the "de-capacity" reforms or other factors that caused the various raw materials to bottom in early 2016 and rally thereafter? How will China's ongoing "de-capacity" reforms affect steel, coal, and iron ore prices going into 2018 and 2019? Progress Of "De-Capacity" Reforms Three main approaches have been used by policymakers with respect to de-capacity reforms: The government sets up capacity reduction targets and then implements concrete plans to achieve these targets. The government conducts inspections to ensure the reforms are being implemented or for environmental protection purposes. The government aims to eliminate outdated capacity by setting up electricity price rules (higher electricity prices for producers with inefficient technologies) as well as ordering banks to curtail lending to those producers. In terms of timelines, the Chinese supply side "de-capacity" reforms so far have been rolled out in three phases: Phase I: Initiation and preparation phase (2015 Q4 - 2016 H1): The first phase involved policy makers drawing related policies and capacity reduction targets in the steel and coal industries. Local governments and related SOEs began implementing the so-called "de-capacity" reforms. During this period, only 30% of the 2016 capacity reduction targets for both steel and coal markets were achieved. Phase II: The accelerating implementation phase (2016 H2): The second phase included a ramp-up of "de-capacity" reforms, with over 70% of 2016 steel and coal capacity reduction targets being implemented. Meanwhile, steel production disruptions increased due to more stringent environmental rules, more frequent inspections, and government-ordered closures of low-quality steel (called "Ditiaogang" in Chinese) production in Jiangsu and Shandong provinces. Phase III: The reform-deepening phase (2017): The third phase, implemented in the first half of this year, was a clamping down on overcapacity to eliminate all illegal sub-standard steel (Ditiaogang) production and capacity by the end of June 2017. To date, the Chinese authorities have succeeded in their "de-capacity" reforms in steel and coal: both the steel and coal industries in China have become more efficient, more competitive, and have much less obsolete excess capacity: The government's plan was to reduce capacity by 100-150 million metric tons in steel and 1 billion metric tons in coal within "three to five years." This equated to a 9-13% and 18% reduction of existing 2015 Chinese capacity in steel and coal, respectively. In addition, this is equivalent to 7-9% for steel and 10% for coal of 2015's global output (Table I-1). As of August 2017, within less than two years since the beginning of the supply side reforms, 77% of the steel "de-capacity" target (or 10% of 2015 capacity) and 52% of the coal "de-capacity" target (or 7% of 2015 capacity) have been achieved (Table I-1). Table I-1Chinese Supply-Side Reform - Capacity Reduction Target And Actual Achievement With declining capacity and rising production, the capacity utilization rates (CUR) of the steel and coal industries have increased meaningfully. The National Bureau of Statistics (NBS) reported that as of the third quarter of 2017, the CUR for the steel industry has risen to 76.7% (the highest since 2013, and an increase of 4.4 percentage points from a year ago). As for the coal sector, the CUR reached 69% (the highest since 2015, and an increase of 10.6 percentage points from a year ago). With outdated and illegal production capacity exiting the marketplace, the number of companies and the number of employees have declined significantly in both the steel and coal industries (Chart I-2 and Chart I-3). Since the start of the "de-capacity" reforms, the central government has allocated 100 billion yuan (0.1% of GDP and 3.6% of central government spending) to a special fund for the relocation of employees in the coal and steel industries. Chart I-2Consolidation In Chinese Steel ##br##And Coal Sectors: Fewer Companies... Chart I-3...And Fewer Employees Higher prices for steel and coal have greatly boosted producers' profitability. From January 2016 to September 2017, the number of loss-making enterprises as a share of all enterprises has dropped from 25% to 17% in the steel industry and from 34% to 21% in the coal sector. Improving financial conditions have enhanced steel and coal companies' ability to invest in industrial upgrades (i.e., more investment in advanced technologies and new equipment). Bottom Line: Chinese "de-capacity" reforms have been successfully implemented, which has improved economic efficiency in the steel and coal industries by reducing high-cost and low-quality supply, and by increasing lower-cost and high-quality output. Understanding The Cycle In this section, we try to connect the dots between the progress of China's supply side reforms, and steel and coal prices. Chart I-4A and Chart I-4B show the fascinating dynamics among policy actions, production and prices. Chart I-4APolicy Actions And Market Dynamics: Coal Sector Chart I-4BPolicy Actions And Market Dynamics: Steel Sector Here are our major findings: (A) Except for coal, Chinese "de-capacity" reforms were not the major trigger for the price bottom in major industrial commodities in early 2016. As the period from November 2015 to June 2016 was only the initiation stage of the reforms, not much steel capacity reduction - only 1.2% of total existing 2015 capacity - occurred in the first half year of 2016. Moreover, most of the reduced capacity was outdated capacity and probably had been offline for years. Therefore, the policy driven capacity cut in the first half of 2016 was unlikely the reason for the rally in steel prices. The reasons behind the bottom in raw materials prices in general and steel in particular during the first half of 2016 were the following: 1. Production cuts in both 2015 and the first half of 2016 was market-driven. In other words, it was not government reforms but natural market forces (the dramatic drop in raw materials prices in 2015) that caused company closures and declines in various raw materials output in both 2015 and the first half of 2016 (Chart I-4A). The price recovery in the first half of 2016 was not sufficient to make most producers profitable. 2. Remarkably, the authorities injected considerable amounts of credit and fiscal stimulus in late 2015 and early 2016. As a result, demand recovery was another major trigger for the synchronized bottom in early 2016. The rise in the aggregate credit and fiscal spending impulse led to a revival in property construction, automobile production and infrastructure investment in the first half of 2016 (Chart I-5). 3. Financial/speculative demand for commodities was also a driving force behind the early 2016 price recovery. Chart I-6 illustrates that Mainland trading volumes in various commodities futures surged in the first half of 2016, and specifically in coal in the third quarter of 2016, coinciding with their respective price spikes. Chart I-5Strong Demand Recovery In 2016 Chart I-6Speculative Buying In Early 2016 All of these factors contributed to the synchronized price bottom in early 2016 and the consequent price rally in the first half of 2016, in which Chinese "de-capacity" reforms only played a minor role, especially in the steel market. (B) Chinese "de-capacity" reforms were the determining factor for the coal price spike in 2016 and steel price appreciation in 2017. Coal in 2016: "De-capacity" reforms were behind the surge in coal and coke prices throughout 2016. In February 2016, the National Development and Reform Commission (NDRC) stipulated that domestic coal mines could operate no more than 276 working days in one year, down from 330 working days in the past. This was equivalent to the immediate removal of 16% of existing operating capacity off the market. Before this decision, Chinese coal production had already declined 2.5% in 2014 and 3.3% in 2015 (Chart I-4B on page 6). On top of this decision, the government enforced a 250 million metric ton capacity cut target in the coal industry in 2016. Furthermore, actual coal capacity reduction in 2016 was 116% of that year's target (Table I-1). The end result was a 10% decline in Chinese coal production during the period of January and September of 2016 from the same period of 2015, triggering an exponential rise in both thermal coal and coking coal prices (Chart I-1 on page 2). Coking coal is mainly used for coke production, and coke is employed as a fuel in smelting iron ore in a blast furnace to produce steel. Therefore, a shortage of coking coal combined with a revival in steel production made coke the best-performing commodity last year, with its price skyrocketing by 300%. Chart I-7Diverging Prices In 2017 Towards the end of last year, the authorities realized that "de-capacity" in the coal market was too aggressive, and began loosening up coal production restrictions in September 2016. Last November the NDRC further eased policy by allowing companies to operate 330 days a year again (Chart I-4B on page 6). In response to these adjustments, thermal coal, coking coal and coke prices all peaked in December 2016/early 2017 (Chart I-1 on page 2). This reveals how Chinese supply side reforms can be a determining factor for global commodities prices. Steel prices in 2017: Steel prices have exhibited a steady rally throughout 2017, even though prices for coal, coke and iron ore all declined. There has been considerable price divergence this year between steel, on one hand, and coal, coke and iron ore, on the other. Prices for thermal coal, coking coal, coke and iron ore all peaked in late 2016/early 2017, while prices for steel continued to rise and reached a six-year high in September, expanding profit margins for steel producers (Chart I-7). The resilience of steel prices this year was because the Mainland had dismantled all "Ditiaogang" capacity by the end of June 2017, resulting in an accelerated drop in steel products production (Chart I-4A on page 6). "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. "Ditiaogang" is often converted into 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. Both falling steel products production and surging scrap steel exports entail that the "Ditiaogang" capacity elimination policy has been very effective (Chart I-8). Chart I-8The Removal Of 'Ditiaogang' Has ##br##Been Successfully Implemented As reported by the government, about 120 million metric tons per year of "Ditiaogang" capacity has been eliminated, more than double this year's steel "de-capacity" target of 50 million metric tons. A considerable portion of the 120 million metric ton "Ditiaogang" capacity was still in operation early this year when "Ditiaogang" producers enjoyed higher profit margins than large steel producers. This rapid change created a sudden squeeze on steel products supply, which consequently boosted their prices. Bottom Line: China's "de-capacity" reforms have played a major role in driving the rallies in steel prices in 2017 and in the coal markets in 2016. In short, China's supply-side reforms have been effective in shaping prices and boosting efficiency in Mainland industries by eliminating weak/inefficient producers or forcing their industrial upgrade. However, the government efforts at times have also produced large price swings, as in the case of both coal and coke. The Outlook For 2018 And 2019 Given past success and the nation's leadership adherence to reforms, China will firmly proceed with its "de-capacity" reform strategy over the next two years. However, steel and coal prices are likely to decline going forward. The most aggressive phase of "de-capacity" reforms is now behind us. The pace of capacity reduction for both steel and coal will decrease over the next two years as more than half of the 2016-2020 target has already been achieved for both sectors. Both steel and coal producers currently enjoy near-decade high profit margins, and their profits have swelled (Chart I-9A and Chart I-9B). Not surprisingly, steel and coal producers have already sped up their investment in advanced technologies to augment their capacity - by introducing ecologically friendly equipment that can produce medium- to high-end quality products. Chart I-9AStrong Profits For Steel And Coal Producers Chart I-9BRising Profit Margins For Steel And Coal Producers Importantly, the capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity to replace obsolete capacity at a ratio of 1:1-1.25 (the range depends on region). In short, having eliminated the inefficient/outdated capacity, producers are now allowed to add as much capacity as they had before, but using efficient technologies. This will weigh on steel and coal prices as output gains and production costs will likely be lower with new technologies. In addition, Chinese steel producers are accelerating the expansion of advanced electric furnace (EF) capacity. At 6%, current Chinese EF steel output as a share of total steel production is much lower than the same ratio for the major world steel producers and the world average (Chart I-10). The Chinese government's target is to raise the share of EF crude steel production as a share of total production to 15% by 2020. It usually takes at least 1-2 years to build a new EF plant. Hence, newly installed EF capacity will likely come into operation in 2018-'19. On the whole, this points to lower prices for crude steel and steel products. The EF steel-making process only requires scrap steel and electricity to produce crude steel. It does not need either iron ore or coke. This is negative for iron ore and coke prices. With the abundance of used cars and used home appliances in China, the domestic availability of scrap steel has significantly improved over the past few decades. In addition, electricity prices for industrial use have declined by about 5% since March 2015. Therefore, easing resource constraints (availability of scrap steel) and lower electricity costs will facilitate EF steel capacity expansion in China. Some words about the policy-driven steel production cut during the winter season. More than two dozen cities in northern China drew up detailed action plans during September and October to fight the notorious winter smog. China has set a target to reduce the level of Particulate Matter (PM) 2.5 pollution by at least 15% in cities around the Beijing-Tianjin-Hebei region between October 2017 and March 2018. The new rules will require seasonal suspensions or production cuts of steel, aluminum and cement (with the most focus on steel) during the winter heating season from November 15 to March 15. Therefore, over the next four months, downside in steel and coal prices may be limited due to support from these output cuts. This also entails less short-term demand for coke and iron ore, prices for these commodities may remain under downward pressure. Nonetheless, Chinese crude steel output is set to continue rising over the next two years, which in turn will eventually reverse the recent decline in steel products production and assure expansion in steel products production in 2018-'19 (Chart I-11). Chart I-10Chinese Electric Furnace Crude ##br##Steel Production Will Go Up Chart I-11Steel Products Output Will Soon Catch Up For coal, production will accelerate in 2018. The NDRC expects coal production capacity to rise by a net 200 million metric tons this year as increases at more "advanced" mines exceed shutdowns of outmoded facilities. This will be a 50 million metric ton gain over this year's 150 million metric ton obsolete capacity reduction target. In addition, China's coal utilization rate as of the third quarter of 2017 was still below 70%, implying substantial additional capacity remains, potentially boosting coal output, so long as the government does not alter the 330 working-day rule. Importantly, on the demand side, China is aiming to reduce coal usage for electricity generation while promoting renewable energy like hydro, nuclear, wind and solar. This constitutes a structural headwind to coal prices. This is especially significant, given than China accounts for half of global coal consumption. The supply side reforms of the past two years (shutting down inferior capacity) along with the adoption of new, more efficient technologies, has already strengthened the competitiveness of Chinese steel and coal producers. This entails that China will soon resume net exports of steel products, and that its net imports of coal will drop (Chart I-12). This is bad news for international steel and coal producers, who in the past two years have benefited from higher steel and coal prices on the back of a revival in Chinese demand, and curtailed supply. Last but not least, our broad money impulse as well as the aggregate credit and fiscal spending impulse shows that economic growth in general and demand for industrial metals in particular are set to decelerate considerably in the next nine to 12 months or so (Chart I-13). Chart I-12China May Increase Its Net Steel Exports ##br##And Decrease Its Net Coal Imports Chart I-13Demand Is Set To Decelerate Chinese steel and coal markets will determine the direction of coke and iron ore prices, both of which will likely be headed lower as well. Coke: Rising coking coal output as a result of coal production ramping up will increase coke supply sizably. As an increasing share of steel output will come from non-coke-reliant EF capacity, coke demand growth will be constrained. Iron ore: Recovering domestic iron ore production could cap China's imports of iron ore (Chart I-14). First, a marginal rise in profit margins for Chinese iron ore domestic producers and a declining number of loss-generating companies heralds modest upside for iron ore output in China (Chart I-15). Chart I-14Chinese Iron Ore Output Will Rise Chart I-15Chinese Iron Ore Producers: ##br##Marginal Rise In Profit Margins Second, more vertical integration - a rising number of Chinese steel producers that have bought iron ore mines - will result in higher domestic iron ore output. Steel companies' current fat profit margins could prompt them to boost iron ore output from the mines that they have integrated into their production chain. Although profits from iron ore production specifically are likely to be limited. This will be the case especially if the government encourages them to do so. Last year, Chinese iron ore imports accounted for 87% of national total consumption - an all-time high. The authorities dislike such great dependence on resource imports, and the government will likely introduce policies such as reducing taxes for domestic iron ore producers or other efforts to boost domestic production. Bottom Line: 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. 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 path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. Ellen JingYuan He, Editor/Strategist EllenJ@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations