Commodities & Energy Sector
Highlights Dear Client, This week's BCA's Commodity & Energy Strategy contains our 2017 Outlook for Energy markets. After surprising the markets with a production cut last week, OPEC and Russia likely will do so again with a successful implementation of their agreement next year. Even if they only get buy-in on 60% to 70% of the 1.8 mm b/d in cuts they believe they've secured, production cuts and natural declines in production that are not reversed via enhanced oil recovery (EOR) will accelerate the drawdown in global crude oil and refined products inventories, which is the stated goal of the agreement. We expect the U.S. benchmark WTI crude prices to average $55/bbl next year, up $5 from our previous forecast, on the back of last week's announced cut. We are moving the bottom of the range in which we expect WTI prices to trade most of the time next year to $45/bbl and keeping the upside at $65/bbl. For 2018 and beyond, our conviction is lower: The massive capex cuts seen in the industry will place an enormous burden on shale producers and conventional oil producers - chiefly Gulf Arab producers and Russia - to offset natural decline-curve losses and meet increasing demand. Any sign either or both will not be able to move quickly enough to meet growing demand and replace natural declines could spike prices further out the curve. For the international benchmark, Brent crude oil, things get a bit complicated next year: As the spread between Brent and WTI prices widens - the Feb17 spread was pricing at ~ $2.10/bbl earlier this week (Brent over) - we expect U.S. WTI exports to increase from current levels averaging ~ 500k b/d, which should keep the price differential in check next year. For the near term, we are using a +$1.50/bbl differential (Brent over) for our 2017 central tendency, although this could narrow and invert as U.S. exports grow. We closed out our long Feb/17 Brent $50/$55 call spread last week - recommended November 3, 2016, expecting OPEC and Russia to agree a production cut - with a 156% indicated profit. We are taking profits of 80.6% on our long Aug/17 WTI vs. short Nov/17 WTI, basis Tuesday's close, and replacing it with a long Dec/17 vs. short Dec/18 WTI spread at today's closing levels, expecting backwardation to widen next year. We remain bullish U.S. natural gas near term, given reduced year-on-year production growth going into year-end. A normal-to-colder winter will be especially bullish. We remain long 2017Q1 natural gas, which is up 21.1% since we recommended the position on November 2, 2016. Longer term, we are neutral natgas, expecting production growth to resume in 2017. Kindest regards, Robert P. Ryan, Senior Vice President Feature KSA, Russia Deal Drives Oil Prices In 2017 The evolution of oil prices next year will be dominated by the agreement between OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, with Russia in the lead, to cut production by up to 1.8 mm b/d. The stated volumes to be cut are comprised of 1.2 mm from OPEC, 300k b/d from Russia, and another 300 from other non-OPEC producers. Later this week, other non-OPEC producers are scheduled to arrive in Vienna to discuss cuts they will pledge to make starting in January. Non-OPEC production is down ~ 900k b/d this year, according to the IEA's November Oil Market Report, so it is difficult to see where these cuts will come from. Outside Russia, Kazakhstan and Oman, anything coming out of the meetings with non-OPEC producers in Vienna this week will be decline-curve losses disguised as production cuts. Still, it means they're not funding EOR programs to replace lost production (e.g., China's 10% yoy losses). Even if actual cuts only amount to 60 - 70% of the volumes agreed at OPEC's November 30 meeting in Vienna, we expect OECD storage levels - combined commercial inventories of both crude oil and refined products - to fall some 10%, or 300 million bbls, to ~ 2.75 billion bbls by the end of 2017Q3. This would put stocks roughly at their five-year average levels, the stated goal of OPEC, and its reason for negotiating the production cut (Chart of the Week). In addition, this will flatten the forward Brent and WTI curves, and deepen an already-developing backwardation in WTI beginning with contracts delivering in December 2017 (Chart 2). This will reverse the contango structure in place since mid-2014, which allowed commercial OECD oil inventories to swell by 400 mm bbls, and non-OECD inventories to increase by 240 mm bbls, according to OPEC estimates. Chart of the WeekOPEC's, Russia's Goal: Normalize Storage##br## To Five-year Average Level Chart 2Backwardation Expected ##br##In WTI And Brent Analysts Expect Cheating On The Deal Most analysts expect cheating on this deal: OPEC's production is expected to fall to 33mm b/d following production cuts, from a record high in November of 34.2mm b/d, according to a Reuters poll.1 At 33mm b/d, OPEC's output would be 500k b/d above the targeted production level of 32.5mm b/d agreed at OPEC's November 30 meeting in Vienna with Russia (Table 1). In other words, most analysts think OPEC will only deliver 700k b/d of the 1.2 mm b/d it pledged to cut under this deal. We disagree. Table 1Allocation of OPEC Cuts This Deal's Going To Work: KSA And Russia Want And Need It OPEC's goal is to get inventories back to 5-year average levels. The Cartel's latest Monthly Oil Market Report puts the global stock overhang at 304mm over the 5-year average, just slightly over our calculated value to end October (Chart of the Week).2 To get stocks to the 5-year average level by the end of June 2017 - when the Vienna agreement runs out - would require an average weekly draw of ~ 11.7mm bbl in OECD oil and products stocks, or roughly 1.7mm b/d. Between normal decline-curve losses and the production cuts, if KSA and Russia got full compliance on this deal, it stands a good chance of meeting OPEC's goal by the end of June. Even if they don't and get, say, a total of 1.1 to 1.2mm b/d in cuts from OPEC and non-OPEC producers, the Agreement's storage goal will be achieved by the end of 2017Q3 or the beginning of Q4. Chart 3KSA And Russia Need To Back Off ##br##After Near-Vertical Output Increases Unlike past production-cut deals, we think there is a good chance KSA and Russia will get fairly high compliance on this agreement. Given the results of the Reuters survey on expected compliance, our out-of-consensus call is predicated on our belief this round of cuts is fundamentally different from what we've seen before. KSA and Russia - and their allies - want and need this deal. KSA and Russia have made their point by massively increasing production in a down market, but both now need to - and want to - back off of flogging their fields and driving prices lower (Chart 3). Given the extremely high dependence both have on oil revenues, they need higher prices.3 For starters, Russia was an active participant in this deal: its energy minister, Alexander Novak, told KSA's oil minister, Khalid Al-Falih, Russia would cut - not freeze - production in the lead-up to the November 30 meeting, and would contribute half the cut OPEC wanted from producers outside the Cartel. In addition, Vladimir Putin, Russia's president, was "directly involved" in the deal, mediating between KSA and its arch rival Iran, according to various press reports.4 Politically, after having invested so much capital, we do not think Russia will backslide on this agreement. There may be some fudging on what actually constitutes a "cut" - e.g., 2017Q1 maintenance that removes 200k b/d or so from production may be called a "cut" - but by Q2 we expect to see the full 300k b/d cut taken. By the same token, we do not think KSA will backslide on its commitment. Saudi's new oil minister Al-Falih invested considerable political capital in getting a deal done, as well, over the course of meetings in Algiers, Istanbul and finally around the November 30 Vienna meeting. Practically, both KSA and Russia have burned through considerable foreign reserves to fund government expenditures following the price collapse (Chart 4). By our estimates, KSA will have burned through $220 billion in reserves between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, equivalent to 30% of foreign reserves. Russia will have drawn down its official reserves by $77 billion over the same period, or 16% of its total holdings. Chart 4Lower Oil Prices Forced KSA And Russia ##br##To Burn Through Reserves In addition, both want to tap foreign direct investment (FDI) for cash, investments and technology, and will find it difficult to do so if oil markets remain chronically oversupplied and subject to large downdrafts as producers relentlessly increase production, as we noted in recent research.5 Both KSA and Russia are working on larger agendas next year and 2018. And both require higher prices. They cannot afford to run down reserves any further. Russia is looking to sell 19.5% of Rosneft, after the state pushed through a $5.2 billion merger with Bashneft in October. KSA is looking to issue additional debt, having raised $17.5 billion in October, and will look to IPO 5% of state-owned Aramco next year or in 2018. Both must convince FDI that money invested in their economies will not be wasted because oil production cannot be reined in. And, they both must attend to increasingly restive populations. As a result of the production cuts, KSA's and Russia's export revenues will increase: KSA's 2017 oil export revenues will increase by close to $17.5 billion, and Russia's will increase by ~ $9 billion, following the ~ $10/bbl lift in oil prices the agreement has provided. Both will be able to lever their production to support more debt issuance. KSA will need that leverage to pull off the diversification it is attempting under its Vision 2030 initiative. Russia needs higher prices for its secondary offering of Rosneft, and to get some much-needed breathing room for its budget after years of sanctions, recession and lower government revenues. We would not be surprised if Russia sees additional production cuts next year, which will goose prices a little and put a firmer support under the ~ $50/bbl floor (basis Brent crude oil prices). Given the dire straits in which Russia finds itself, the government likely will increase taxes in 2017, which will result in lower production at the margin. We expect, however, that this will be spun in such a way as to show that when Putin gets involved, positive results occur.6 KSA's Allies Will Cut; Iran And Iraq Are Maxed Out For Now We believe this is a deal that will hold up, which, net, will generate something along the lines of 1.1 to 1.2mm b/d in production cuts in 2017H1. UAE and Kuwait can be counted on to support KSA, as they always have, and cut. And Oman - now at 1mm b/d - will step up for a small slug of the cuts too, and have said they'll match OPEC up to a 10% cut. Iran and Iraq have taken production as far as it can go over the next six months to a year, and do not represent a threat to the KSA-Russia deal (Chart 5). Iran's maxed out - they're not capable of adding all that much to their current 3.7mm b/d output. Iraq could cheat, but we don't think they can go much above 4.5mm b/d, despite their assertion they're at 4.7 mm b/d. Besides, producing at 4.4mm b/d, per the agreement, will produce more revenue for them at higher prices than producing 4.7 mm b/d at lower prices (if they actually could get to that level), and they realize that. According to press reports, Iraq only signed on to the deal in Vienna after they saw the rally in prices following leaks a deal had been reached. Maybe at this time next year, they will have mobilized some FDI to get production ramping, but even that's doubtful. With the exception of Libya and Nigeria - both of which are exempt under this deal - everyone in OPEC outside Iraq, KSA and the GCC OPEC members is producing at max (Chart 6). Libya and Nigeria are equally likely to raise output as prices increase as they are to lose output. The higher prices go the more likely these states are to see increased violence, as warring factions within their borders vie for control of rising oil revenues. Internal conflicts have not been resolved: Any increase in prices accompanied by increased production gives the warring factions more to fight over. The expected value of their increased production next year is therefore zero. Chart 5KSA's Allies Will Support It;##br## Iran, Iraq Maxed Out Chart 6Most Of OPEC Ex Gulf States ##br##Also Are Producing At Max Levels U.S. Shale Production Will Rise We expect to see evidence of the cuts contained in the KSA-Russia deal to begin showing up in the February - March period, in the form of falling commercial inventory levels. The only thing that can destabilize the six-month KSA-Russia deal is U.S. shale-oil production coming back faster and stronger than expected (Chart 7). Pre-cut, we (and the U.S. EIA) estimated U.S. shale production would bottom in late 2017Q1, and then start re-expansion as rig counts rose to sufficient levels. However, overall 2017 production would be 200 - 300 kb/d lower than 2016 production. Chart 7If U.S. Shale Ramps Too Quickly ##br##KSA-Russia Deal Could Unravel If, as we expect, the higher oil price caused by the KSA-Russia deal results in an increase of only ~ 200 kb/d above this estimate, with the production response substantially occurring in the second half of 2017, there's a good chance this deal can hold together and get global commercial oil stocks down to average levels by September 2017. As we've argued, KSA and Russia already have to have factored that in. The apparent average breakeven for the U.S. producers (including a return on capital) appears to be ~ $55/bbl, which could pop above $60 from time to time next year as the long process of restoring U.S. production plays out.7 Having the international oil market pricing at the marginal cost of U.S. shale producers is a lot better for KSA, Russia and the rest of the distressed, low-cost sovereign producers than the low-$40s that cleared the market a few weeks ago. As long as the global market is pricing to shale economics at the margin, these states earn economic rent. Too fast a move to or through the $65 - $75/bbl range would no doubt produce a short-term revenue jump for cash-strapped producers - particularly those OPEC members outside the GCC. But it also would make most of the U.S. shales economic to develop, and incentivize the development of other "lumpy," expensive production that does not turn off quickly once it is brought on line (e.g., oil sands and deepwater). This ultimately would crash prices over the longer term, making it difficult for the industry to attract capital. This is not an ideal outcome for KSA's planned IPO of Aramco, or Russia's sale of 19.5% of Rosneft, or their investors. Even so, reinvestment has to be stimulated with higher oil prices in the not-too-distant future, most likely in 2018. Oil production so far has barely started to show the negative production ramifications of the $1+ trillion cuts to capex that will occur between 2015 and 2020, resulting in some 7mm b/d of oil-equivalent production not being available to the market. We expect the effects of this foregone production to show up over the next four years, and believe there is not much producers, particularly International Oil Companies (IOCs), can do to stop it, since their mega-project investments generally require 3-5 years from the time spending decisions are made until first oil is produced. Chart 8Accelerating Decline Rates And##br## Steady Demand Will Stress Shale Producers With such huge cuts to future expenditures, and enormous amounts of debt incurred by the IOCs to pay for the completion of legacy mega-projects that will need to be repaid ($130B in debt added in the past two years), OPEC could see a looming shortage of oil developing later this decade if IOC-sponsored offshore production falls into steep declines, as we think is likely. With U.S. shales accounting for a larger share of global production, the global decline curve will accelerate from our estimated current level of 8 - 10% p.a. This will be happening as oil demand continues to grow 1.2 - 1.5mm b/d over the 2017 - 2020 interval (Chart 8). These massive capex cuts seen in the industry since OPEC's market-share war was launched in November 2014 will place an enormous burden on shale producers and conventional oil producers - chiefly Gulf Arab producers and Russia - to offset natural decline-curve losses and meet increasing demand. Any sign either or both will not be able to move quickly enough to meet growing demand could spike prices further out the curve, as we've noted in previously. Investment Implications Of BCA's Oil View The KSA-Russia deal is short term - it expires in June, but is "extendable for another six months to take into account prevailing market conditions and prospects," according to terms of the Agreement contained in the OPEC press release of November 30. This forces investors to take relatively tactical positions in the oil markets, with some optionality for longer-dated exposure. We closed out our long Feb/16 Brent $50/$55 call spread last week - recommended November 3, 2016, expecting OPEC and Russia to agree a production cut - with a 156% indicated profit (using closing prices). We are taking profits of 80.6% on our long Aug/17 WTI vs. short Nov/17 WTI, basis Tuesday's close, and replacing it with a long Dec/17 vs. short Dec/18 WTI spread at today's closing levels, expecting backwardation to widen next year. This is a strategic recommendation, which also will give us exposure to higher prices by the end of 2017. We will look for overshoots on the downside to get long options exposures again, and longer dated exposures as well. Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see "OPEC expected to deliver only half of target production cut: Kemp," published online by reuters.com on December 6, 2016. OPEC has invited Russia, Colombia, Congo, Egypt, Kazakhstan, Mexico, Oman, Trinidad and Tobago, Turkmenistan, Uzbekistan, Bolivia, Azerbaijan, Bahrain and Brunei to meet in Vienna Dec. 10, according to Reuters. 2 Please see the feature article in last month's OPEC Monthly Oil Market Report published November 11, 2016, "Developments in global oil inventories," beginning on p. 3. 3 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," in the September 8, 2016, issue of BCA Research's Commodity & Energy Strategy Weekly Report. It is available at ces.bcaresearch.com. 4 Please see "Exclusive: How Putin, Khamenei and Saudi prince got OPEC Deal Done," published by reuters.com on December 1, 2016, and "OPEC Deal Hinged on 2 a.m. Phone Call and It Nearly Failed," published on line by bloomberg.com on December 1, 2016. See also Russia Today's online article "Putin 'directly involved' in OPEC reaching production cut deal," published December 2, 2016, on rt.com, which also details Putin's meetings months prior with KSA Deputy Crown Prince Mohammed bin Salman at the G20 meeting in China. 5 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com. 6 Lukoil officials are talking up production cuts and possible tax hikes in Iranian and Arab media: Here is an Iranian outlet (https://financialtribune.com/articles/energy/54595/lukoil-sees-60-oil-in-2017), and an Arab outlet with a longer version of the same TASS story (http://www.tradearabia.com/news/OGN_317517.html). Concerns re possible tax increases next year, which will force production lower, appear in the second-to-last paragraph. 7 Please see pp. 22 - 23 of "From Boom to Gloom: Energy States After the Oil Bust," presented by Mine Yucel, Senior Vice President and Director of Research at the Federal Reserve Bank of Dallas, July 12, 2016, for a discussion of shale breakevens. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades
Highlights Dear Client, This issue of BCA's Commodity & Energy Strategy features our 2017 Outlook for Bulks and Base Metals. The evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced. That said, the potential for price spikes - e.g., copper, where spare capacity is shrinking - and for monetary and fiscal policy errors to spill into these markets keeps downside price risk elevated. Next week, we will publish our 2017 Outlook for Energy Markets, with special attention to the oil market. As expected, OPEC and Russia agreed to cut production. As we went to press, WTI and Brent crude oil prices were up ~ 8.5% on the news. We will take profits today on our Long February 2017 Brent $50/bbl Calls vs. Short February 2017 $55/bbl Calls, which was up 73.6% basis Wednesday's close when we went to press. We remain long August 2017 WTI vs. Short November 2017 WTI futures in anticipation of a backwardated forward curve in 2017H2; as of Wednesday's close, this position returned 76.39% since November 3, when we recommended the exposure. Our 2017 Precious Metals and Agricultural outlooks will be published in the following weeks. We will finish with an outlook for commodities as an asset class in 2017 at year-end. We trust you will find these reports informative and useful for your investing and year-ahead planning. Kindest regards, Robert P. Ryan, Senior Vice President The monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. While we expect "reflationary" policies to continue going into the Communist Party Congress next fall, when new leadership roles will be announced, we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. We are downgrading our tactically bullish view on iron ore to neutral. Our out-of-consensus bullish call was proven correct with a 43% rally in iron ore prices within the past eight weeks.1 Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector should eventually knock down prices in 2017H2. We remain neutral copper going into 2017, expecting Chinese reflationary stimulus to continue along with a concerted effort to slow the housing boom in that country. This will still support real demand for copper, but will reduce demand from new construction. Manufacturing will play a larger role on the demand side next year, while a stronger USD could limit price appreciation. We still believe nickel will outperform zinc over a one-year time horizon. We are bullish nickel prices, both tactically and strategically, as we expect a supply deficit to widen on rising stainless steel demand and falling nickel ore supply in 2017. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. For the global aluminum market, we remain tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. We have three investment strategies, including long iron ore/short steel futures, long nickel/short zinc futures, and buying aluminum on weaknesses. Feature Iron Ore & Steel: Limited Upside In 2017 A Quick Recap Back in early October, we wrote an in-depth report on global iron ore and steel markets in which we made an out-of-consensus tactically bullish call on iron ore, expecting the price to reach the April high of $68.70/MT in 2016Q4. Our prediction was realized, with iron ore prices surging 43% to a two-year high of $79.81/MT on November 11 (Chart 1, panel 1). Although the steel market has been much stronger than the assessment driving our tactically neutral stance indicated earlier in the quarter, our call that iron ore would outperform steel in the near term was correct: Steel prices rose 21% during the same period of time - only half of the iron ore price rally (Chart 1, panel 1). Over the past two months, the rally occurred in both futures and spot markets, and in the markets globally (Chart 1, panels 2 and 3). Chart 1Iron Ore: Downgrade To Tactically Neutral Chart 2Steel: Remain Tactically Neutral The 2017 Outlook First, we downgrade our tactically bullish view on iron ore to neutral, as China likely will import less iron ore in 2017Q1 (Chart 2, panel 1). China has imposed stricter environmental regulations on its domestic metals industry since 2014 to control pollution. The government currently is sending environmental inspection teams to major steel-producing provinces to check how well the steel producers are complying with state environment rules. Many steel-producing factories were closed this year, due to environmental violations. This will constrain growth in Chinese steel output in the near term (Chart 2, panel 2). Between 2011 - 15, the state-owned Xinhua news agency states Chinese steel capacity has been reduced by 90 million MT; authorities want to cut as much as 150 million MT by 2020, including 45 million MT this year.2 Chinese steel production generally falls in January and February as workers are celebrating the Chinese Spring Festival - the most important festival for the Chinese. Iron ore inventories at major Chinese ports are still high (Chart 2, panel 3). Given iron ore prices have already rallied more than 100% since last December and steel demand outlook remains uncertain next year, most steel producers likely will choose to push off purchases into 2017Q2 or later. While China may slow its iron ore purchases next year, global iron ore supply is set to increase in 2017 as many projects will come on stream. The world's biggest iron ore project, Vale's S11D, which has a capacity of 90 million metric tons (mmt) per year, is expected to ship its first ore in January 2017. Moreover, with iron ore prices above $70/MT, global top iron ore companies with low production costs can be expected to sell as much as they can to maximize their profit, given their all-in production costs for high-quality iron ore (62% Fe) typically are between $30 and $35/MT.3 That said, we are not bearish on iron ore prices in the near term. We prefer to be neutral. Iron ore prices will have pullbacks, but the downside may be also limited in 2017H1. Chinese domestic iron ore production is still in a deep contraction (Chart 2, panel 4). Plus, most steel producing companies prefer high-quality ore from overseas over the domestic low-quality ore. In addition, almost all steel companies in China are profitable at present, which means Chinese steel production will rise after the Spring Festival holidays. All of these factors will support iron ore prices. Chart 3Iron Ore & Steel: Strategically Bearish Second, we retain our tactically neutral view on steel. Chinese steel demand was lifted by China's expansionary monetary and fiscal policies this year - which we have dubbed China's "reflationary" policy - which included reductions in its central bank's policy rate and reserve requirement ratio, and implementation of additional infrastructure projects (Chart 3). This was the driving force for the sharp steel price rally this year. The big question is how sustainable Chinese steel demand growth will be? This will be highly dependent on the Chinese government's decisions and actions. More than a third of steel demand is accounted for by the property market, of which some 70% is residential property.4 Mortgages accounted for approximately 71% of all new loans in August of this year, down from 90% in July, according to Reuters.5 This loan growth powered the iron ore and steel markets this past 12 - 18 months and China's credit-to-GDP ratio to extremely high levels. The OECD recently observed, "The high pace of debt accumulation was sustained despite weaker domestic demand growth. This raises concerns about the underlying quality of new credit, disorderly corporate defaults and the possible extent to which it has been used to support financial asset prices. Residential property prices in some of the largest cities have risen by over 30% year-on-year, although price growth in smaller cities has been much more modest. The price gains have been partly driven by loose monetary policy and ample credit availability as well as reduced land supply."6 Based on our calculations, Chinese steel demand started showing positive yoy growth in July and, so far, had posted four consecutive months of positive yoy growth from July to October. In September and October, the growth was accelerated to 8.3% and 6.6%, respectively, a clear improvement from the 0.8% yoy growth registered in July. The growth may last another three to six months but could peak sooner, if there are no new stimulus plans announced by the government. In addition to the housing sector, China's auto industry also saw significant demand growth. As China cut the sale taxes on small passenger vehicles from 10% to 5% this year, Chinese car sales jumped 13.6% yoy for the first 10 months of 2016, a significant improvement from a 5.7% yoy contraction in the same period of last year. If the government lets the tax cut expire at year-end, Chinese auto production may decline in 2017, which will weaken Chinese steel demand. In the meantime, Chinese steel producers will keep boosting production next year, which likely will limit the upside for steel prices. That said, current steel inventories in China are still low. According to the China Iron and Steel Association (CISA), steel inventories at large and medium steel enterprises fell 9% from mid-September to late October. This probably will limit the downside for steel prices. Third, we retain a strategic bearish view on both iron ore and steel. If there is no additional reflationary stimulus deployed in 2017, we expect Chinese steel demand to weaken. In the meantime, Chinese steel producers will keep boosting their production. Let these two factors run nine to 12 months, and we believe they will be sufficient to knock down both steel and iron ore prices. Our research last year concluded the Chinese property sector is structurally down-trending.7 Given that the property market is the biggest end user of steel in China, accounting for about 35% of total steel demand, we are strategically bearish on steel and iron ore prices. How To Make Money In The Iron Ore & Steel Market? Chart 4Take Profit On Long ##br##Iron Ore/ShortSteel Rebar Trade We went long May/17 iron ore futures in Dalian Futures Exchange in China and short May/17 steel rebar futures in Shanghai Futures Exchange on October 6 (Chart 4). Both contracts are denominated in RMB. The relative trade gives us a return of 18.1% in two months. We are taking profits with this publication, but we may re-initiate this pair trade on pullbacks. Risks If China deploys additional fiscal and monetary stimulus next year, similar in scope to this year's stimulus, we will re-evaluate our view accordingly. If global iron ore production is less than the market expects we could see further rallies in iron ore prices. Should this occur, we will re-examine our market call, as well. Copper: Market Is Balanced; Little Flex On Supply Side The reflationary stimulus that powered China's property markets - and drove demand for iron ore and steel higher - also propelled copper prices to dizzying heights in 2016H2. We do not expect this juggernaut to continue, and instead expect copper to trade sideways next year as global supply and demand stay relatively balanced (Chart 5). China accounts for roughly half of global refined copper demand (Chart 6). Manufacturing activity has the greatest impact on prices: A 1% increase in China's PMI translates to a 1.8% increase in LME copper prices (Chart 7). Chart 5Copper Market Is In Balance Chart 6World Copper Markets Are Balanced Chart 7China Demand Will Remain Key For Copper China's property market accounts for about a third of global copper demand in used in construction, according to the CME Group, which trades copper on its COMEX exchange. A 1% increase floor-space started in China leads to a 0.3% increase in LME copper prices (Chart 8). The surge in demand from the housing market lifted China's copper demand over the past 12 - 18 months, as credit creation in the form of home-mortgage loans expanded at a rapid clip (Chart 9). We expect the Chinese government to continue to try to rein in a booming property market, which has seen mortgage-loan growth of 90% p.a. recently. If the government is successful, this will limit price gains for copper next year. If not, the bubble will continue to expand in large tier-1 and -2 cities in China, making the copper rally's fundamental support tenous to say the least. Chart 8China PMIs and USD TWI Drive LME Prices Chart 9Mortgage Growth Likely Slows in 2017 This drives our expectation that the real economic activity in China - chiefly manufacturing - will be the dominant fundamental on the demand side for copper next year. On the supply side, we expect 2.65% yoy growth in refined copper production, just slightly above the International Copper Study Group's 2% estimate. Company and press reports cite a reduced mine capacity additions, lower ore content in mined output, and labor unrest as reasons supply side growth is slowing. Our balances reflect a convergence of supply and demand for next year, and also highlight the reduced flexibility in the system to respond to unplanned outages. For this reason, the global copper market could be prone to upside price risk in the event of a major unplanned production outage. Watch Out For USD Strength Copper, like all of the base metals, is sensitive to the path taken by the USD. We continue to expect the Fed to lift rates next month and a couple of times next year. This most likely will lift the USD 10% or so over the next 12 months. This would be bearish for base metals, particularly copper, since 92% of global demand for the red metal occurs outside the U.S. Our modeling indicates a 1% increase in the broad USD trade-weighted index leads to a 3.5% decrease in LME copper prices. A stronger USD will raise the local-currency cost of commodities ex-U.S. EM demand would suffer, which would slow the principal source of growth for base metals. Metals producers' ex-U.S. with little or no exposure to USD debt-service obligations would see local-currency operating costs fall. At the margin, this will lead to increased supply. These effects would combine to push commodity prices lower, producing a deflationary blowback to the U.S. Nickel & Zinc: Going Different Ways In 2017? Zinc has outperformed nickel significantly for the past six years. This year alone, zinc prices have shot up over 90% since January, almost doubling the 50% rally in nickel prices for the same period of time (Chart 10, panel 1). The nickel/zinc price ratio has declined to its lowest level since 1998 (Chart 10, panel 2). Will nickel continue underperforming zinc into 2017? Or will the trend reverse next year? We believe the latter has a higher probability. Tactically, we are bullish nickel and neutral zinc. Strategically, we are bullish nickel and bearish zinc.8 Zinc's bull story has been well-known for the past several years, and nickel's oversupplied bear story also has been commented on in the news. However, both markets' fundamentals are changing. Based on World Bureau of Metal Statistics (WBMS) data, for the first nine months of this year, the supply deficit in the global nickel market was at its highest level since 1996. Meanwhile, the global zinc market was already in balance (Chart 10, panels 3 and 4). Chart 10Nickel Likely To Outperform Zinc In 2017 Chart 11Nickel Has More Positive Fundamentals Than Zinc Both nickel and zinc markets are experiencing ore shortages (Chart 11, panels 1 and 2). For the nickel market, the ore shortage was mainly due to the Indonesian ore export ban, and Philippines' suspension of nickel miners for violating that country's environmental laws. For the zinc market, the ore shortage arose because of several big mines' depletion, years of underinvestment, and mine suspensions due to low prices late last year. The nickel ore shortage will become acute as the Indonesian ban remains in place and the Philippines' government becomes stricter on domestic mining operations. However, for zinc, most of the output loss occurred last year, and actually may be restored to the market in the near future. Zinc prices reached $2,811/MT last year as the market was adjusting to lost supply - the highest level since March 2008. In terms of demand, nickel exhibits much stronger demand growth versus zinc (Chart 11, panels 3 and 4). In addition, China's auto sales tax-cut policy will expire at year-end, which may cause Chinese auto production to fall in 2017. This will affect zinc much more than nickel, as less galvanized steel will be needed next year if Chinese car production falls. Investment Strategies We sold Dec/17 zinc at $2,400/MT on November 3, and the trade was stopped out at $2,500/MT with a 4% loss (Chart 12, panel 1). Zinc prices jumped 11.5% in four trading days in late November, which we believe was mainly driven by speculative buying. Nonetheless, in the near term, global zinc supply is still on the tight side, and zinc inventories are low (Chart 12, panel 2). Zinc prices could rally more in the near term. We were looking to go Long Dec/17 LME nickel vs. Short Dec/17 LME zinc if the ratio drops to 4.3 since mid-November (Chart 13, panel 1). We also suggested that if the order gets filled, put a stop-loss for the ratio at 4.15. Chart 12Zinc: Stay Tactically Neutral Chart 13Risks To Long Nickel/Short Zinc On November 25, the order was filled at the closing price ratio of 4.17. But unfortunately the ratio declined to 4.08 on the next trading day (November 28), based on the closing price ratio, which triggered our predefined stop-loss level with a 2.2% loss. The ratio was trading at 4.17 again as of November 29. As the market is so volatile, we recommend initiating this relative trade if it drops below 4.05 to compensate the risk. If the order gets filled, we suggest putting a 5% stop-loss level for the relative trade. After all, nickel prices could still have pullbacks, as global nickel inventories still are elevated (Chart 13, panel 2). Risks Our strategically bearish view on zinc will be wrong if global zinc ore supply does not increase as much as we expect, or global zinc demand still has robust growth in 2017. Our strategically bullish view on nickel will be wrong if Indonesian refined nickel output increases quickly, resulting in a smaller supply deficit than the market expects. However, due to power shortages, poor infrastructure and funding problems, development on many of the smelters and stainless steel plants once envisioned for the nickel market have been delayed. We believe these problems will continue to be headwinds for Indonesian nickel output growth, and will continue to restrict supply growth going forward. Aluminum: Cautiously Bullish In 2017 Chart 14Aluminum: Remain Tactically Bullish ##br## And Strategically Neutral Sharp supply cuts combined with tight inventories have pushed aluminum prices higher this year. Prices in China have rallied more than 50% so far this year, which was more than double the 20% rise in the global aluminum market (Chart 14, panel 1). This probably indicates a tighter Chinese domestic market than the global (ex-China) market. Looking forward, we remain tactically bullish on LME aluminum prices and neutral on SHFE aluminum prices.9 The supply shortage will likely persist ex-China over next three to six months. Global aluminum production has declined faster than demand so far this year. Based on the WBMS data, global aluminum output was still in a deep contraction in September (Chart 14, panel 2). Even though China's operating capacity has been rising every month so far this year, Chinese total aluminum output for the first 10 months was still 1.1% less than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Extremely tight domestic inventories should limit the downside of SHFE aluminum prices (Chart 14, panel 3) as the market adjusts on the supply side. We think there is more upside for LME aluminum prices, as the supply shortage will likely persist ex-China over next three to six months. Currently, Chinese aluminum prices are about 18% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of world. Strategically, we are neutral LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is making money. With new low-cost capacity and more idled capacity coming back on line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term like nine months to one year, should eventually spill over to the global market. Investment strategy Chart 15Still Look To Buy Aluminum We recommended buying the Mar/17 LME aluminum contract (Chart 15) if it falls to $1,640/MT (current: $1,721/MT). We expect the contract price to rise to $1,900/MT over the next three to five months. If our order is filled, we suggest a 5% stop-loss. Risks Prices at both the SHFE and LME may come under intense pressure if aluminum producers in China increases their output quickly, even at a small loss, in order to create jobs and revenue for local governments. If global aluminum demand falters in 2017 while supply is rising, we will revisit our strategically neutral view on LME aluminum prices. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see Commodity & Energy Strategy Special Report for iron ore and steel "Global Iron Ore And Steel Markets: Is The Rally Over?," dated October 6, 2016, available at ces.bcaresearch.com. In this report, we are using Metal Bulletin iron ore price delivered to Qingdao port in China as our iron ore reference price. 2 Please see "N. China city cuts 32 mln tonnes of steel capacity" published October 30, 2016, by Xinhua's online service, xinhuanet.com. 3 Please see "CHART: The breakeven iron ore prices for major miners in 2016," published June 7, 2016, by Business Insider Australia. 4 Please see "China Resources Quarterly, Southern spring ~ Northern autumn 2016," published by the Australian Department of Industry, Innovation and Science and Westpac, particularly this discussion on p. 4, "The real estate sector." 5 Please see "China August new loans well above expectations on mortgage boom," published by Reuters September 14, 2016. 6 Please see the OECD Economic Outlook, Volume 2016 Issue 2, Chapter 1, entitled "General Assessment of the Macroeconomic Situation," p. 44, under the sub-head "Rapid debt accumulation risks instability in EMEs." The IMF also expressed concern over rising debt levels supporting the real-estate boom in China, particularly in the larger cities, noting, "Credit and financial sector leverage continue to rise faster than GDP, and state-owned enterprises in sectors with excess capacity and real estate continue to absorb a major share of credit flow. The deviation of credit growth from its long-term trend, the so-called credit overhang--a key cross-country indicator of potential crisis--is estimated somewhere in the range of 22-27 percent of GDP..., which is very high by international comparison." Please see the IMF's Global Financial Stability Report for October 2016, "Fostering Stability in a Low-Growth, Low-Rate Era," p. 35, under the sub-heading "China: Growing Credit and Complexities." 7 Please see Commodity & Energy Strategy Special Report "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015 and "China Property Market Q&As," dated July 2, 2015, available at ces.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report "Oil Production Cut, Trump Election Will Stoke Inflation Expectations," dated November 17, 2016 and "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com 9 Please see Commodity & Energy Strategy Weekly Report "Market Saturation Likely In Asia, If KSA - Russia Fail To Curb Oil Production," dated November 10, 2016, available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades
Whether OPEC's announcement of its intention to curtail production actually feeds through into meaningfully lower output next year remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expect the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. On the downside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent. That is a strain on refining margins. Our model warns that there is little profit upside ahead. Instead, our preference is to maintain outsized exposure to the oil field services group. Increased E&P confidence that underlying commodity prices could drift toward the top end of their trading should boost drilling activity. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the former. We are underweight refiners, overweight oil field services, and neutral on the broad sector.
Highlights Despite the static headline GDP figures, most of our indicators suggest Chinese growth momentum has improved since the second quarter, particularly in the industrial sector. A dollar overshoot, domestic housing policy tightening and potential policy mistakes by the Chinese authorities need to be monitored for potential growth disappointments. The rally in commodity prices reflects improving Chinese demand, but it has ignored the surging dollar. Chinese H shares are a safer play on Chinese reflation and growth improvement. Feature Our recent conversations with clients suggest that global investors' concerns over China have slightly abated, as various economic numbers have shown improvement. Nonetheless, investors remain highly sceptical about China's macro situation, raising questions ranging from "traditional" distrust of China's economic data to the latest worries of a "trade war" with the U.S. under President Donald Trump. We dedicate this week's report to addressing some common issues that we have been discussing with clients of late. What Is The Actual GDP Growth In China? In Recent Quarters, It Seems To Be Holding In A "Too-Good-To-Be-True" Tight Range? Chinese real GDP growth has been 6.7% for the past three consecutive quarters, right in the middle of the government's official target of 6.5-7%. This seemingly incredible stability has stoked long-held suspicions among investors about the reliability of Chinese economic data. While we do not claim to have the ultimate insider story on official Chinese statistics, and it is certainly possible that the macro numbers are "smoothed out" to hide otherwise greater volatility in economic reality, it is also possible that stable headline numbers overshadow bigger underlying fluctuations among different sectors (Chart 1). Chart 1Greater Volatility Underneath ##br##Stable GDP For example, while real GDP growth has stayed at 6.7% since Q1 this year, there has been some fluctuations in both the industrial and service sectors. Within the service sector, the financial industry has had a major downturn, with nominal growth falling from 10.9% in Q1 to 8.2% in the last quarter, partly due to last year's base effect of the stock market boom-bust. The real estate sector, on the other hand, has been on the mend, with growth strengthening from 14% in Q1 to 16.3%. Regardless, the exact GDP growth figures rarely matter from an investor's perspective. What is more important is the growth trajectory and policy implications. On this front, most of our indicators suggest growth momentum has improved since the second quarter of the year, particularly in the industrial sector. A strong recovery in manufacturing-sensitive indicators such as railway freight, heavy machine sales and electricity consumption (Chart 2). Continued acceleration in profit growth, in both the overall industrial sector and among listed firms.1 Further improvement in pricing power and producer prices. Producer price deflation that lasted for over four years ended in September, compared with 5.3% deflation in January. Looking forward, we expect the economy to continue to improve, even though some of the high-flying variables may begin to moderate. On the policy front, the authorities will likely enter a wait-and-see mode, especially on interest rates. Our model signals that the central bank's interest rate cuts have likely come to an end, unless the economy relapses again (Chart 3). This is also reflected in the pickup in interest rates in the bond market. We will further explore China's growth outlook, policy orientation and investment implications for the New Year in the first week of 2017. Chart 2Broad Improvement In##br## Industrial Indicators Chart 3No More Rate Cuts, ##br##For Now There Appears To Be Growing Acceptance In The Market That China Will Not Suffer A Hard Landing. What Are You Monitoring To Gauge The Growth Risk? We have not been in the "hard landing" camp, and have been anticipating a "rocky bottoming" process in Chinese growth for the year.2 Despite enormous financial volatility in January associated with the domestic stock market and the RMB, growth has largely played out as we anticipated. We expect the economy to remain resilient, but are watching some pressure points that could lead to disappointments. The first is the RMB, which has been depreciating notably against the dollar in recent weeks, as the dollar uptrend has resumed with vigour. In our view, a strong dollar is one of the key risks, as it not only generates downward pressure on the CNY/USD cross rate, on which the market tends to focus closely, but also halts the "stealth" depreciation of the RMB in trade-weighted terms, which reduces the reflationary benefits of a weaker exchange rate on the Chinese economy (Chart 4). In other words, a weak CNY/USD and a strong trade-weighted RMB is a poor combination for both financial markets and the macro economy.3 So far, the CNY/USD decline appears orderly, and we doubt the greenback will massively overshoot against all major currencies within a short period without causing growth difficulties in the U.S. However, the situation should be closely monitored and continuously assessed. The second is housing policy tightening, which the authorities have re-imposed since October to check rapid gains in home prices. So far, the tightening measures have not led to a significant slowdown in home sales in major cities: Daily home sales in the major cities that we track have broken out to new record highs (Chart 5). However, new housing supply has already been very weak, which together with robust sales could lead to even lower housing inventory and a further spike in home prices. We maintain guarded optimism on China's housing construction, as we discussed in detail in our previous report.4 The risk is that unyielding home price gains will force the Chinese authorities to up the ante on tightening, which could lead to a sudden deterioration in housing activity. In this vein, price moderation should be good news from policymakers' perspectives, as well as for the overall economy. Chart 4The RMB: Weak Or Strong? Chart 5Monitor Housing Activity Finally, as we have argued repeatedly, China's growth difficulties in recent years have had a lot to do with the excessively tight policy environment post the global financial crisis - a policy mistake that compounded deflationary pressures in the economy, which had already been suffering from weak external demand. Despite budding improvement in the economy, China's overall macro environment remains highly challenging, and policy mistakes that undermine aggregate demand will prove extremely costly. In this vein, any broader attempt to tighten policies, hasten administrative enforcement to de-lever or prematurely withdraw fiscal support on infrastructure construction will prove counterproductive. A more recent risk is how China deals with the potential protectionist threat from the U.S. under President Donald Trump.5 Our view is that China should avoid escalating trade tensions with tic-for-tac retaliations that could further complicate the growth outlook. As far as the markets are concerned, Chinese equities appear to have begun to price in a lower "China risk premium." Forward P/E ratios for both A shares and H shares have been rising since early this year, likely a reflection of investors' easing anxiety on China's macro conditions (Chart 6). Nonetheless, Chinese stocks' forward P/E ratios remain well below other major markets and the global average, and the risk premium in Chinese equities is still substantially higher than historical norms. Beyond near-term volatility, we expect the risk premium in Chinese stocks to continue to revert to the mean, leading to multiples expansion and further price gains. At minimum, Chinese equities should outpace global and EM benchmarks. There Has Been A Massive Rally In Some Industrial Commodity Prices In China. Is This Driven By Speculative Frenzy? How Much Does The Commodities Rally Reflect Chinese Demand? Industrial commodity prices have rebounded sharply in both the Chinese domestic spot markets and various derivatives exchanges. For some products, prices have gone parabolic, and there is little doubt that these extreme moves cannot be fully explained by fundamental factors (Chart 7). Nonetheless, it is also well known that commodities in general are subject to volatile price fluctuations, as they are extremely sensitive to marginal shifts in the supply-demand balance due to very low price elasticity among both producers and end users. Therefore, it is impossible, and rather meaningless, to precisely detangle speculative forces and fundamental factors. Chart 6Risk Premium Will Continue ##br##To Mean Revert Chart 7No Clear Evidence Of Commodity ##br## Speculative Frenzy That said, from a macro perspective, a few observations are in order: There does not appear to be a particularly high level of over-trading and speculative activity involved this time around compared with historical norms. Futures transactions this year have been hovering at close to record low levels, despite sharp prices gains in numerous products. Even if prices decline sharply, the impact on the financial system should be negligible because of very low investor participation. Broad-based improvement in numerous industry-sensitive indicators shown in Chart 2 on page 2 suggest the gains in commodity prices are at least partially attributable to improving demand rather than purely driven by speculative frenzy. In fact, improving Chinese demand is also reflected in a firmer global shipping rate. The Baltic Dry Index has almost quadrupled since its February lows, which hardly has anything to do with Chinese retail speculators (Chart 8, top panel). Massive price gains in some commodities such as steel and coal have been partially driven by the Chinese authorities' attempts early this year to "de-capacity" the two sectors, with aggressive efforts to cut idle capacity and reduce domestic production. The self-imposed restrictions together with improving demand have led to sharp price gains and a significant rebound in imports of related products (Chart 8, bottom panel). This confirms our view that the overcapacity issue in the Chinese industrial sector has been overestimated.6 Moreover, regulators' control on domestic supply has been relaxed, which will likely lead to rising domestic production in due course - this bodes well for Chinese domestic business activity, but poorly for the prices of related products. Historically, commodity prices have been positively correlated with China's growth trajectory, and negatively correlated with the trade-weighted dollar (Chart 9). Currently, the commodities rally clearly reflects regained strength in Chinese industrial activity, but has ignored the recent strength of the greenback, leading to a glaring divergence that has been very rare in recent history. Chart 8More Signs Of ##br## Improving Demand Chart 9Macro Drivers And Commodity Prices: ##br##Mind The Gap It remains to be seen how such a divergence will eventually converge. Our hunch is that the dollar will likely continue to rally in the near term, which means commodity prices could converge to the downside. Our commodities team has upgraded base metals from underweight earlier this year on China's reflation efforts, and is currently neutral on the asset class. What is more certain, however, is that China's reflation efforts and growth improvement should also lift Chinese H shares, but the price gains of H shares so far have been much more muted. Earlier this year we recommended going long Chinese H shares against the CRB index, which so far has been flat. We are still comfortable holding this position. The bottom line is that we do not advocate chasing the current rally in base metals. Chinese H shares are a safer play on Chinese reflation and growth improvement. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming", dated January 6, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?", dated November 24, 2016; and "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com 6 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity", dated October 6, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights U.S. bond yields and the U.S. dollar will rise further. Consistently, EM currencies and local bonds will continue selling off. There is meaningful downside in EM exchange rates. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KOR, MYR, IDR, TRY, ZAR, BRL, COP and CLP. Within domestic bond portfolios, overweight low-beta defensive markets as well as Russia and Mexico. Our underweights are Turkey, South Africa, Malaysia and Indonesia. The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy. Feature Emerging market (EM) risk assets will likely continue to be driven by both rising U.S. bond yields and a strong U.S. dollar over the next two months or so. Beyond the next couple of months, the focus of the markets will likely switch to China: renewed weakness in growth and possible instability in its financial markets, with negative implications for China plays globally and for commodities prices in particular. The combination of these two negative forces will lead to a considerable drop in EM currencies in the next six months or so. In turn, EM currency depreciation will trigger broad liquidation of EM risk assets. BCA's Emerging Markets Strategy service believes that EM risk assets will continue to sell off in absolute terms, and underperform their DM/U.S. peers. EM Local Bonds The total return (including carry) index of JPM GBI-EM1 local currency bonds in U.S. dollar terms has rolled over at a critical resistance level (Chart I-1). The total return index of EM local bonds has also relapsed relative to the total return of 5-year U.S. Treasurys, failing to break above its long-term moving average (Chart I-1, bottom panel). Consistently, domestic bond yields have troughed at important technical levels in several key countries such as Brazil, Turkey, Colombia, Russia, South Africa and Malaysia (Chart I-2A and Chart I-2B). Chart I-1EM Local Bonds' Total ##br##Return In US$: Failed Breakout Chart I-2AHave EM Domestic ##br##Bond Yields Bottomed? Chart I-2BHave EM Domestic ##br##Bond Yields Bottomed? In short, EM local bonds are exhibiting negative technical dynamics that corroborate our downbeat fundamental analysis. Consequently, we believe the total return JPM GBI-EM index in U.S. dollar terms will drop to new lows for the following reasons: Currency swings are responsible for most of the fluctuations in EM local bond total returns. As we have elaborated numerous times and re-assert in this report, the outlook for EM exchange rates remains gloomy. Foreign holdings of EM local currency bonds are substantial (Table I-1). Even though there have been improvements in a few countries, current account and fiscal deficits generally remain wide in the majority of developing nations (Chart I-3A and Chart I-3B). In other words, a number of EM economies are still at risk from a slowdown in foreign funding. Table I-1Foreign Holdings Of EM Local Bonds Chart I-3ACurrent Accounts And Fiscal Deficits Chart I-3BCurrent Accounts And Fiscal Deficits Chart I-4U.S. And EM Local Yields Notably, the bar for exchange rate depreciation is very low in EM economies with current account deficits. It takes only a reduction in net capital and financial inflows - i.e., net outflows are not necessary - for these countries' currencies to depreciate significantly. As net foreign funding diminishes, exchange rates of countries with current account deficits should weaken and interest rates should rise in order to compress domestic demand, which in turn would equalize the current account deficit to net inflows in capital and financial accounts. Finally, the spread of EM local bonds (the yield for GBI-EM global diversified index) over duration-matched (5-year) U.S. Treasury yields has not risen much (Chart I-4). Heightened risks in EM currencies warrant higher local bond yield spreads over U.S. Treasurys. Bottom Line: Absolute return investors should stay away from EM local currency bonds. U.S. Bond Yields And The Dollar: More Upside We expect U.S./DM bond yields to keep rising as re-pricing in global fixed income markets continues. The decline in DM bond yields in recent years until the latest selloff was enormous, and some sort of mean reversion should not come as a surprise. Our bias is that this selloff will likely continue until sometime in January, when U.S. President-elect Donald Trump takes office. This riot in the bond market could, in retrospect, resemble a typical "sell the rumor, buy the news" pattern. In other words, by the time President-elect Trump takes office, a lot of bad news will already be priced into the U.S. bond markets, creating a buying opportunity. In our July 13 Weekly Report,2 we argued that: "In the U.S., the combination of a healthy labor market and a heavily overbought fixed-income market have created the backdrop for a material rise in U.S. interest rate expectations/bond yields. As U.S. rate expectations climb, the U.S. dollar should gain support. This in turn will create headwinds for EM currencies and other EM risk assets." Then, we reiterated this view in our July 27 Weekly Report: "Nowadays, there is little talk in the investment community about a bond bubble and the potential for much higher bond yields. Indeed, "lower for longer" has begun to dominate the investor lexicon. This is a sign that many G7 bond bears have likely capitulated. Investor consensus on bonds has become quite bullish, and many investors are long duration. When many bears capitulate, the odds of a market selloff inevitably rise. "Importantly, the increase in G7 bond yields might not be gradual as many expect because of the following: with yields at such low levels, bonds' duration is high and price changes become very sensitive to changes in yield... Such (large) price changes (drops) would amount to large losses for bond investors, and forced selling could intensify. As a result, the unwinding of long positions could be abrupt and volatile." For now, odds are that U.S. bond yields will rise further. Given global bond funds have seen massive inflows in recent years, the latest drop in prices of various bonds has been substantial and will likely trigger withdrawals and redemptions from bond funds, prompting forced selling. This is true for all types of bond portfolios, including DM government and corporates, EM credit (U.S. dollar bonds) and EM local currency bonds. U.S. bond yields are still low, even from the perspective of the past several years, and the market-implied terminal fed funds rate is still 80 basis points below the median projection of the Federal Open Market Committee's longer-run rate (Chart I-5). Given that U.S. interest rate expectations are not high at all, they will rise further (Chart I-6) as the uptrend in U.S. wages persists - driven by an already reasonably tight labor market (Chart I-7). Chart I-5U.S. Interest Rate Expectations Are Still Low Chart I-6U.S. Wage Growth Is Accelerating Chart I-7More Upside In U.S. Treasurys Yields Finally, the U.S. dollar will continue to be buoyed by rising U.S. interest rate expectations. Our composite momentum indicator for the broad trade-weighted U.S. dollar has bounced off the zero line (Chart I-8). This constitutes a strong technical confirmation of the durable bullish market trend in the dollar. Bottom Line: Odds are that the rise in U.S. bond yields is not over. As U.S. bond yields rise further, EM currencies and bonds will sell off. Long-Term EM Currency Trends We have several observations on the long-term performance of EM currencies and financial markets: In the long run, there is no guarantee that the majority of EM currencies will appreciate in real terms (adjusted for inflation differentials). In fact, even countries such as Korea and Taiwan - which have been very successful in their economic development and have tremendously grown their income per capita - have seen their real (inflation-adjusted) exchange rates depreciate over the past several decades (Chart I-9). The case for long-term appreciation in real terms is even weaker for exchange rates in countries that exhibit chronically high inflation rates and/or current account deficits. This has been true for many non-Asian EM currencies (Chart I-10). Chart I-8The U.S. Dollar Is ##br##In A Genuine Bull Market Chart I-9Long-Term Currency ##br##Downtrends In Korea And Taiwan Chart I-10EM Currency Trends: ##br##A Long-Term Perspective Importantly, most losses to foreign investors in EM financial markets often occur via currency depreciation. This is even truer in the current bear market downtrend. The JPM ELMI+ currency total return index (including cost of carry) seems to be about to break down (Chart I-11). In EM ex-China, the real effective exchange rate is still elevated (Chart I-12). Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Chart I-11EM Currency Return With Cost ##br##Of Carry Versus U.S. Dollar Chart I-12Weak Productivity Means ##br##Further Currency Depreciation To limit the upside in domestic interest rates - both in bond yields and interbank rates - many developing nations' central banks will inject more local currency liquidity into their respective systems.3 This might help cap local interest rates, but is bearish for their currencies. The Turkish central bank has been among the most aggressive in this disguised money printing, and not surprisingly the value of its currency has collapsed (Chart I-13). There is no long-term history for EM currencies, as before 1998 most developing nations' exchange rates were pegged. Yet when one examines EM equities' relative performance against the S&P 500, it emerges that there is no single EM bourse that has outperformed U.S. stocks on a consistent basis in the very long run. Chart I-14A and Chart I-14B demonstrate that among 11 EM equity markets that have a long-term history, none have outperformed the S&P 500 over the past 30-35 years. Chart I-13Turkey's Central Bank Has Been ##br##Pumping Local Currency Into The System Chart I-14AEM Equities Versus The S&P 500: ##br##A Long-Term Perspective Chart I-14BEM Equities Versus The S&P 500: ##br##A Long-Term Perspective This goes to reveal that the starting point of underdevelopment and the mark "emerging" does not guarantee consistent outperformance even in the long run. In fact, EM's relative performance against the U.S. has followed multi-year cycles, and we believe the current bear market and underperformance is not yet over. While EM underperformance is long in duration, economic and financial adjustments remain incomplete. DM QE programs and China's still-growing credit bubble have delayed the adjustment. As a rule, the longer a financial or economic imbalance/excess lingers, the more protracted the adjustment will be. Bottom Line: EM exchange rates will continue depreciating. We recommend short positions in the following basket of EM currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP. For a complete list of our open currency and fixed-income trades please refer to page 18. Country Allocation For EM Local Bond Portfolios Chart I-15 demonstrates the relationship between developing countries' foreign funding requirements and their real (inflation-adjusted) local bond yields. The foreign funding requirement is calculated as the sum of the current account deficit and foreign debt service obligations over the next 12 months. We use inflation-linked (real) bond yields for markets where they are available. In other cases, we subtract the headline inflation rate from nominal bond yields to derive the real one. Chart I-15Real Bond Yields And Foreign Funding Requirements: A Cross Country Comparison The higher the foreign funding requirement, the higher the real yield must be to attract foreign capital, all else equal. On this diagram, the value pockets are Brazil (its real yield of 6.3% offers the best value by far), Indonesia, Russia and India. Domestic real yields in these countries are relatively high compared to their foreign funding requirements, which is a proxy for exchange rate risk. In contrast, Turkey, Chile, Colombia, Hungary and Malaysia have low real yields relative to their large foreign funding requirements. However, there are other factors that are shaping local yields. For example, Brazilian real yields look very attractive on this matrix because the latter does not account for public debt dynamics. The fiscal dynamics in Brazil are dreadful.4 On the contrary, Chilean local bonds appear expensive, but the country's fiscal outlook is very healthy. After considering all factors that affect local bond yields as well as incorporating the currency outlook, we recommend the following allocations: Overweight Korea, Thailand, Poland, Hungary, the Czech Republic, Russia and Mexico (Chart I-16). For investors who can invest in Chinese, Taiwanese and Indian local bonds, we also recommend overweighting these markets within an EM domestic bond portfolio. Underweight Turkish, South African, Malaysian and Indonesian local currency bonds (Chart I-17). We will publish our analysis on Indonesia soon. Stay neutral on domestic bonds' total return in U.S. dollar terms in Brazil (with a negative bias because of the considerable currency risk), Chile and Colombia (Chart I-18). Chart I-16Our Recommended ##br##Overweights In Local Bonds Chart I-17Our Recommended ##br##Underweights In Local Bonds Chart I-18Local Bonds ##br##Warranting A Neutral Allocation A Word On China's Commodities Frenzy Speculative fever is running high in Chinese commodities exchanges. Frenetic commodities trading in China has seen prices skyrocket of late (Chart I-19). Prices often rise a limit during a day. We have the following observations: This stampede into commodities is a reflection of rotating bubbles in China. Mania forces rotated from property to stocks, then to corporate bonds, and then back to housing, again. It seems to be shifting into commodities now. While the mainland's industrial sector and real demand for commodities have registered gradual improvement in recent months, the sharp spike in commodities prices largely reflects speculative activity much more than real demand. In fact, net imports of base metals have been flat for the past six years (zero growth in six years), and all swings have most likely been related to inventory cycles (Chart I-20). Chart I-19The Spike In Commodities ##br##Prices Trading In China Chart I-20China: Net Import Of Base Metals Like any speculative frenzy, this is momentum-driven and will one day crash. Timing the reversal is impossible. A lot depends on policymakers' willingness to confront this speculative bubble and investor psychology. Notably, onshore corporate bond yields and swap rates have recently begun rising. As in DM bonds, the rise in yields from very low levels is causing large price drops. As and if yields rise further, losses in corporate bonds will become considerable and investors (especially ones managing retail investors' money) will head for the exits, triggering liquidation. This, along with the eventual unraveling of commodities speculation poses substantial potential risk to global, or at least EM, financial markets. Bottom Line: The latest exponential rise in commodities prices on Chinese exchanges is an unsustainable speculative frenzy that will end badly. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments. 2 Please see Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016. 3 Please see "EM: Is The Liquidity Upturn Genuine And Sustainable?" Parts I & II, dated November 25, 2015 and December 2, 2015, respectively. 4 Please refer to the Emerging Markets Strategy Special Report, "Brazil: The Honeymoon Is Over," dated August 3, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally Chart I-42005: Commodity##br## Rally Was An Oil Rally Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Chart I-6China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds Chart I-8DM Hurting EM EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth Chart I-10The Liquidity ##br##Channel Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. Chart I-15Favorable Supply/Demand Backdrop For Oil Chart I-16A Good Entry Point For Shorting AUD/CAD Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight Chart I-18A Countertrend Move In USD/JPY Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades