Asia

China's reflation policies have succeeded in reviving iron ore and steel prices, which are up 45.6% and 52.6% from their January lows, along with the profitability of domestic steelmakers.

The powerful short covering bounce in the S&P steel index is starting to fizzle. The latest upleg had been driven by a surge in Chinese domestic steel prices. That, combined with news that the country plans to reduce steel capacity in the coming three to five years, was enough to send shorts scrambling for cover. However, it will take time for the global steel market to rebalance. In the short run, the jump in Chinese steel prices has already encouraged domestic producers to re-ramp steel production (second panel). Persistent sluggishness in indicators of China's domestic consumption mean that steel inventories are likely to build as production picks up anew, which will put upward pressure on exports to the rest of the world. Fading construction growth and tightening lending standards in many developed countries suggest that increased steel supply from China will have a negative impact on steel prices. We reiterate our recent downgrade back to underweight. The ticker symbols for the stocks in this index are: BLBG: S15STEL - NUE, STLD, RS, X, CMC, ATI, WOR, CRS, AKS, TMST, HAYN, SXC, ZEUS. End Of The Steel Rally? End Of The Steel Rally?

It is widely perceived that China suffers from a massive capital misallocation problem. Our indicators defy this conventional wisdom.

The factors that drove the recent rally - Fed dovishness, China reflation, and a pickup in economic data - are largely over. 

Reflation continues to dictate short-term market moves. Behind this sugar-high, the global economic backdrop remains poor. Commodity currencies can rally for a few more weeks, but once markets refocus on Chinese and EM core weaknesses, commodity currencies will make new lows. Within the complex, favor the NOK and the CAD over the AUD and the NZD. Our portfolio remains positioned for additional yen strength.

The Fed's statement underscored its 'go slow' approach, with a June hike increasingly unlikely, but September and December still in play. The BoJ stood pat, reluctant to admit that NIRP was a flop soon after it was launched. Nevertheless, we expect fresh easing this summer. Chinese stimulus should last a few more months, but commodities will resume their structural downtrend thereafter. Remain tactically bullish risk assets; be prepared to turn more cautious in Q2.

Our sense is that the current reflation trade will extend into the summer, sending stock and commodity prices higher and the U.S. dollar down. Global government bond yields should rise during this phase. Beyond the near term, we expect these reflation trades to go into reverse. Stay defensive.

Monetary policy at systematically important central banks will determine the winners and losers in global ag export markets going forward. The evolution of fundamentals - supply, demand, and inventories - will remain essential drivers. Mother Nature is the wild card.

Policy easing works with a time lag, and the previous easing measures should continue to feed through to business activity. The recent decline in the trade-weighted RMB should lead to continued improvement in the industrial sector's performance for at least the next two quarters.