Commodities & Energy Sector
Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year. Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral. This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. Feature Chart of the WeekUSD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Chart 8Grains Rallied During Pandemic tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Chart 10 Footnotes 1 The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2 Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks. The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm. 3 Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
The UN IPCC Report on Climate Change – the agency’s first comprehensive assessment since 2013 – delivered a bleak message. Under the best-case scenario of rapid emissions cuts, temperatures would rise by 1.5C by 2040 and 1.6C by 2060. The high emissions…
Increasing COVID-19 infection and death rates, particularly in Asia; heightened regulatory crackdowns in China leading to equity sell-offs; and the all-too-familiar policy cacophony from the Fed are contributing to rising global uncertainty and keeping the…
Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights The rapid spread of the COVID-19 delta variant in Asia will re-focus precious metals markets anew on the possibility of another round of lockdowns and the implications for demand, particularly in Greater China and India, which account for 33% and 12% of global physical demand for gold (Chart of the Week).1 Regulatory crackdowns across various sectors in China will continue to roil markets over coming months. Policy uncertainty around these crackdowns is elevated in local financial markets, and could spill into global markets. This will support the USD at the margin, which creates a headwind for gold and silver prices. Ambiguous and contradictory signaling from Fed officials following the July FOMC meeting re its $120-billion-per-month bond-buying program also adds uncertainty to precious-metals and general commodity forecasts. Despite this uncertainty, we remain bullish gold and silver. More efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies. In DM economies, vaccination uptake likely increases as risks become more apparent. We continue to expect gold to trade to $2,000/oz and silver to trade to $30/oz this year. Feature Markets once again are focused on the possibility lockdowns will follow rising COVID-19 infections and deaths, as the delta variant – the most contagious variant to date – spreads through Asia and elsewhere. Chart of the WeekCOVID-19 Delta Variant Rampages Chart 2COVID-19 Infections, Deaths Rising Infection and death rates are moving higher globally (Chart 2). COVID-19 infections are still rising in 78 countries. Based on the latest 7-day-average data, the countries reporting the most new infections daily are the US, India, Indonesia, Brazil, and Iran. The countries reporting the most deaths each day are Indonesia, Brazil, Russia, India, and Mexico. Globally, more than 42% of infections were in Asia and the Middle East, where ~ 1mm new infections are reported every 4 days. We expect more efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies. In DM economies, vaccination uptake likely increases as risks become more apparent. China's Regulatory Crackdown Markets also are contending with a regulatory crackdowns across multiple sectors in China, which is part of a years-long reform process initiated by the Politburo.2 Industries ranging from internet, property, education, healthcare to capital markets will have new rules imposed on them under China's 14th Five-Year Plan as part of this process. Our colleagues in BCA's China Investment Service note the pace of regulatory tightening will not moderate in the near term, as policymakers transition from an annual planning cycle focused on setting economic growth targets to a multi-year planning horizon. "This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits," according to our colleagues. The overarching goal of this reform process is to introduce more social equality in the society. Of immediate import for precious metals markets is the potential for spillover effects outside China arising from the policy uncertainty that already is emanating from that market. Uncertainty boosts the USD and gold. This makes its effect uncertain. In our most recent modeling of gold prices, we have found strong two-way feedback between US and Chinese policy uncertainty.3 We also find that broad real foreign exchange rates for the USD and RMB exert a negative influence on gold prices, while higher economic uncertainty pushes gold prices higher (Chart 3). In addition, across markets – Chinese and US economic policy uncertainty – have similar effects, suggesting economic uncertainty across these markets has a similar effect as domestic uncertainty at home (Chart 4).4 Chart 3Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Chart 4...As Do Cross-Border Uncertainty, Real FX Rates This is yet another reason to pay close attention to PBOC and Fed policy innovations and surprises: they affect each other in similar ways within and across borders. Fed Officials Add Uncertainty Following the FOMC meeting at that end of last month, various Fed officials expressed their views of Chair Jerome Powell's post-meeting remarks, or again resumed their campaigns to begin tapering the US central bank's bond-buying program. Chair Powell's remarks reinforced the data-dependency of the Fed in directing its bond buying and monetary accommodation. He emphasized the need to see solid improvement in the jobs picture in the US before considering any lift-off of rates. As to the Fed's bond-buying program, this, too, will depend on progress on reducing unemployment in the US. Powell also reiterated the Fed views the current inflation in the US as transitory, a point that was emphasised by Fed Governor Lael Brainard two days after Powell's presser. Some very important Fed officials, most notably Fed Vice Chair Richard Clarida, are staking out an early position on what will get them to consider reducing the Fed's current accommodative policies, chiefly an "overshoot" of PCE inflation, the Fed's favored gauge, above 3%. Other Fed officials are urging strong action now: St. Louis Fed President James Bullard is adamant that tapering of the Fed's bond-buying program needed to begin in the Autumn and should be done early next year. Bullard is supported by Governor Christopher Waller. The Fed's bond-buying program is more than a year old. Beginning in July 2020, the Fed started buying $80 billion of Treasurys and $40 billion of mortgage-backed securities every month, or ~ $1.6 trillion so far. This lifted the Fed's balance sheet to ~ $8.3 trillion. Thinking about this as a commodity, that's a lot of asset supply removed from the Treasury and MBS market, which likely explains the high cost of the underlying debt instruments (i.e., their low interest rates). It is understandable why the gold market would get twitchy whenever Fed officials insist the winddown of this program must begin forthwith and be done in relatively short order. The loss of that steady stream of buying could send interest rates higher quickly, possibly raising nominal and real interest rates in the process, which, given the sensitivity of gold prices to US real rates would be bearish (Chart 5). While it is impossible to know when the tapering of the Fed's asset-purchase program will end, these occasional choruses of its imminent inauguration add to uncertainty in the US, which also depresses precious metals prices, as Chart 5 indicates. A larger issue attends this topic: economic policy uncertainty is not contained within national borders. Above, we noted there is a two-way feedback between US and China economic policy uncertainty. There also is a long-term relationship in levels of economic policy uncertainty re China and Europe, which makes sense given the trading relationship between these states. Changes in the two measures of economic policy uncertainty exhibit strong co-movement (Chart 6). Chart 5Taper Talk Makes Precious Metals Markets Twitchy Chart 6Economic Policy Uncertainty Goes Across National Borders Investment Implications The increase in COVID-19 infection and re-infection rates, and death rates, is forcing commodity markets to reevaluate demand projections and the likelihood of continued monetary accommodation globally. This ultimately affects the prospects for commodity prices. Conflicting interpretations of the state of local and the global economies increases uncertainty across markets, especially precious metals, which are exquisitely sensitive to even a hint of a change in policy. This uncertainty is compounded when top officials at systematically important central banks provide sometimes-contradictory interpretations of the state of their economies. Despite this uncertainty we remain bullish gold and silver, expecting efficacious vaccines to become more widely available, which will allow the global recovery to regain its footing. We are less sanguine about the prospects for the winding down of the massive monetary accommodation globally, particularly that of the US, where data-dependent policymakers still feel compelled to provide almost-certain policy prescriptions in an increasingly uncertain world.This is a fundamental factor driving global uncertainty. We remain long gold expecting it to trade to $2,000/oz this year, and long silver, expecting it to hit $30/oz. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish While US crude oil inventories rose 3.6mm barrels in the week ended 30 July 2021 gasoline stocks fell 5.3mm barrels, contributing to an overall decline in crude and product inventories in the US of 1.2mm barrels, according to the US EIA's latest tally (Chart 7). US crude and product stocks have been falling throughout the COVID-19 pandemic, and now stand ~ 13% below year earlier levels at 1.7 billion barrels. Crude oil stocks, at 439mm barrels, are just over 15% below year-ago levels. This reflects the decline in US domestic production, which is down 7.1% y/y and now stands at 11.2mm b/d. US refined-product demand, however, is up close to 9% over the January-July period y/y, and stands at 21.2mm b/d. Base Metals: Bullish Workers at the world's largest copper mine, Escondida in Chile, are in government-mediated talks with management that end on Saturday to see if they can avert a strike. There is a chance talks could be extended five days beyond that date, under Chilean law. The mine is majority owned by BHP. Workers at a Codelco-owned mine also voted to strike and will enter government-mediated talks as well. These potential strikes most likely explain why copper prices have been holding relatively steady as other commodities have come under pressure, as markets reassess the odds of a demand slowdown brought about by surging COVID-19 infections, which are hitting Asian markets particularly hard (Chart 8). Chart 7 Chart 8 Footnotes 1 We flagged this risk in our July 8, 2021 report entitled Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. 2 Please see Pricing A Tighter Regulatory Grip published on August 4, 2021 by our China Investment Strategy. It is available at cis.bcaresearch.com. 3 We measure this using Granger-Causality tests. 4 These broad real FX rates are handy explanatory variables, in that they combine two very important factors affecting gold prices – inflation and broad FX trade-weighted indexes. Additional modelling also suggests these broad real FX rates for the USD and RMB coupled with US real 2- and 5-year rates also provide good explanatory models for gold prices. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Advances in tennis, swimming and the high jump came from challenging the ‘best practices’, and finding better ways of doing these things. The pandemic has challenged the best practices on how we should work, do business, and shop, catalysing better ways of doing these things. The productivity boom could be a super-boom because the current disruption is not in just one sector but across the entire economy. A productivity super-boom means that the economy will take longer to reabsorb the unemployed, and that structural inflation will stay depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal analysis: stocks versus bonds remains fragile, and the rally in tin is very fragile. Feature Chart of the WeekThe Pandemic Has Catalysed A Productivity Boom “I believe that the (Fosbury) flop was a natural style and I was just the first to find it” – Dick Fosbury, on how he revolutionised the high jump Watching the Tokyo Olympics, the flurry of new world records reassures us that human athletic productivity continues to advance. It does so in three ways: better biology, better technology, and better ways of doing the same thing. Better biology comes from advances in nutrition and healthcare – at least, for those that embrace the advances. Better technology means better equipment. For example, more ergonomic bikes, sharkskin-like swimwear that minimises water resistance, and running shoes that re-channel energy back into the legs. Albeit this raises the contentious issue that technological advances are giving some athletes an unfair and unnatural advantage. Case in point, World Athletics (and the Tokyo Olympics) have banned prototype versions of Nike’s Vaporfly running shoe that was used by Eliud Kipchoge to run the first sub-two hour marathon. The banned prototype shoe, containing triple carbon plates inside thick ultra-compressed foam, is claimed to improve running economy by up to four percent. But if technological advances are giving some athletes an advantage, it follows that they must also be giving some firms and economies an advantage. While this is unfair in sporting competition, it is fair in economic competition. An important implication is that firms and economies that embrace disruptive technologies and innovations – such as working from home – are likely to generate superior long-term productivity growth than firms and economies that do not. Productivity Growth Comes From Finding Better Ways Of Doing The Same Thing Yet, looking at the longer-term ‘productivity growth’ in sport, many of the greatest advances have come not from better biology or better technology, but just from finding better ways of doing the same thing. Tennis, swimming, and athletics provide three excellent examples of such innovation. A tennis ball weighs just 50 grams, so anybody can hit a tennis ball hard. The difficult part is hitting the ball hard and landing it within the 78 foot court. In the 1970s, Bjorn Borg revolutionised tennis by hitting with aggressive topspin on both the forehand and backhand as well as the serve. Meaning that rather than having to approach the net as was the ‘best practice’, Borg could win matches from the baseline. All it required was a different way of holding the racket and using his arms (Figure I-1). Figure I-1Challenging The Best Practice In Tennis Boosted Its Productivity Borg’s revolution has a fascinating backstory. Borg’s father, a table tennis champion, won a tennis racket in a table tennis tournament and gave it to the 9-year old Bjorn. Familiar with table tennis and now armed with a tennis racket, the young Borg’s revolution was to play tennis as if it were table tennis – with its trademark topspin on both wings as well as the serve – albeit on a much bigger ‘table.’ And with a racket that was far too heavy for him that he held with both hands. (He eventually switched to a one-handed forehand but kept his two-handed backhand.) Go back a hundred years, and swimming experienced a similar revolution. Until the 1870s, the best practice for European swimmers was the highly inefficient breaststroke. But in 1873, John Arthur Trudgen emulated the technique used by Native Americans whereby the arms moved in a crawl. Later, the Australian Fred Cavill also emulated the Natives’ flutter kick, and thus made mainstream the front crawl, which has significantly increased swimming speed, or swimming ‘productivity.’ All it required was a different way of moving our arms and legs. But probably the greatest example of athletic innovation came in the 1968 Mexico Olympics, when Dick Fosbury turned the standard high jumping technique on its head – or, more precisely, on its back – to win the gold medal and smash the world record. Prior to the 1968 Games, the best practice high jump technique had been the ‘straddle’ which involved jumping forward, twisting the body to navigate the bar, and then landing on your feet. Fosbury changed all that forever. He jumped backwards off the wrong foot, arched his back over the bar, and landed on his back (Figure I-2). Figure I-2Challenging The Best Practice In The High Jump Boosted Its Productivity Just like the tennis topspin and swimming’s front crawl, high jump’s ‘Fosbury flop’ has become the mainstream technique in the sport, taking performance and ‘productivity’ literally to new highs. And just like the tennis topspin and swimming’s front crawl, all it required was a different way of using our existing resources – in this case, jumping backwards rather than forwards. Yet in the case of the innovative Fosbury flop, something else also played an important role – a new environment. Until the 1960s, high jumpers cleared the bar and landed on sawdust, sand, or thin mats. Hence, any innovation in high jump techniques was constrained by having to land on your feet. This changed when Fosbury’s high school became one of the first to install deep foam matting for high jump landing. The Fosbury flop could not have been innovated before the introduction of deep foam matting, because jumping backwards and landing on your back depended on the existence of a soft foam mat for a safe landing. The crucial lesson is that a new environment gives us a chance to challenge beliefs on ‘how things should be done’, a chance to discover new ways of doing the same thing differently, and better. To challenge beliefs on how things should be done, what bigger change in the environment can there be than a global pandemic? The Pandemic Has Catalysed Better Ways Of Doing The Same Thing Just like athletic productivity growth, economic productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways of doing the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways of doing the same thing, gets a massive boost from disruptive changes in the environment such as recessions (Chart of the Week and Chart I-2). Chart I-2Productivity Surges After Recessions In this regard, any technology that is required already generally exists, but the recession is the necessary catalyst for its wholesale adoption. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression was the catalyst for its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession was what finally killed the office typing pool. In the same way, the technology for online shopping and remote meetings has been around for years, but it is the pandemic that has catalysed its wholesale adoption (Chart I-3). Chart I-3The Pandemic Has Accelerated The Shift To Online As Fosbury said, he was just the first to find a more natural style of high jumping, yet it required a change of environment to challenge the best practice. Similarly, it has taken a global pandemic for us to challenge the best practice on how we should work, do business, shop, and interact (Chart I-4). Chart I-4The Pandemic Has Accelerated The Shift To Online It is sub-optimal to work in the office or to shop in-person all the time. It is also sub-optimal to do these things remotely all the time. The optimal way is some hybrid of in-person and remote interactions, which will clearly differ for each person. But the pandemic has given us the opportunity to find this more natural and better way, and thereby to give our productivity a massive boost (Chart I-5). Chart I-5The Pandemic Has Challenged The Best Practice On How To Work The productivity boom could be a super-boom because the current disruption has forced us all to find better ways of doing things. This differentiates the current episode from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is penetrating the entire economy. The Investment Conclusion A productivity super-boom carries two important implications for policymakers. It will take longer for the economy to reabsorb the unemployed, and it will keep structural inflation depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing (Chart I-6 and Chart I-7). Chart I-6Rate Hikes Will Be Later Than The Market Is Pricing Chart I-7Rate Hikes Will Be Shallower Than The Market Is Pricing The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater potential upside. An alternative expression is to buy the 30-year T-bond, or to go long the 30-year T-bond versus the 30-year German bund. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal Analysis Update Global stocks versus bonds (MSCI All Country World versus 30-year T-bond) continue to exhibit the fragility on the 260-day fractal structure that started in mid-March. Since then, and consistent with this fragility, global stocks have underperformed bonds by 6 percent (Chart I-8). Chart I-8Stocks Versus Bonds Remains Fractally Fragile But fragility on a 260-day fractal structure implies elevated risk of a reversal through at least the following six months. On this basis, our recommendation is to remain, at most, neutral to global stocks versus bonds through the summer. Among recent trades, short corn versus wheat, and short marine transportation versus market achieved their profit targets of 12 percent and 16.5 percent respectively, but short Austria versus Chile, and short lead versus platinum hit their stop-losses of 7 percent and 6.4 percent respectively. The 6-month win ratio stands at a very pleasing 71 percent. This week’s recommended trade is to reinitiate the stopped-out metals pair-trade in a modified expression – short tin versus platinum – given the very fragile 130-day and 260-day fractal structure (Chart I-9). Set the profit target and symmetrical stop-loss at 16.5 percent. Chart I-9Tin Is Fractally Fragile Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Chinese President Xi Jinping’s de-carbonization drive is well telegraphed. Last year, he announced that carbon emissions will peak by 2030 and that carbon neutrality will be achieved by 2060. Unsurprisingly, the steel industry, which accounts for 15% of…
Highlights The dollar is fighting a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. The litmus test for determining which force will gain the upper hand is if the DXY fails to break above the 93-94 level that marked the March highs. So far that appears to be the case. In the interim, investors can capitalize on a few themes that will ultimately unfold: an end to the China slowdown, a bet on real rates staying low for longer, and a play on the Olympics. The expressions of these themes are long AUD/MXN, long silver and long the yen, respectively. Natural disasters are also rising in frequency globally. Historically, this has coincided with rising currency volatility. Long CHF/NZD positions can be a potent play on this trend. We ultimately expect the dollar lower 9-12 months from now. The best currencies to express this view today are NOK and SEK. Feature We are a month into the second half of year, and it is instructive to revisit the dollar view and our roadmap towards year-end. As a starting point, two key themes are propping the dollar on a tactical basis: The first is a global economic slowdown, one that could be exacerbated by increased infections of the COVID-19 Delta variant. The dollar tends to rise in an environment where global growth is weak. This is especially the case when US growth is relatively resilient, like now (Chart I-1). The second is the resilience of the US equity market, not only due to superior earnings, but also as regulatory crackdowns hit shares in China specifically, and emerging markets in general. Equity inflows into the US were a key reason the dollar did not collapse in 2020. Renewed inflows into US equities will be particularly beneficial for the dollar (Chart I-2). This will especially be the case if technology and healthcare earnings keep surprising to the upside. Chart I-1The Dollar And Relative Economic Momentum Chart I-2The US Is Leading The Earnings ##br##Cycle At the same time, real interest rates in the US are very depressed. In its latest meeting, the Federal Reserve reiterated that it will keep running the economy hot, a thesis central to our bearish dollar view. This puts the dollar in a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. Arbitrating The Tug Of War Historically, unless the world economy experiences a recession, the interest rate story has dominated currency market action. Our report last week showed that real interest rates matter for currencies both short term and longer term. Given our bias that global growth will moderate rather than contract, the future path of interest rates will once again become important for currency market action. In this light, lower real rates are negative for the US dollar. How long the outperformance of US equities will last is a tougher call. What we do know is that in a rising interest rate environment, the US equity market has tended to derate relative to the rest of the world. Our base case is that bond yields will be higher globally on a cyclical horizon, suggesting investors should fade the current outperformance of US equities. Scandinavian Currencies As A Strategic Dollar Play The best currencies to express a cyclically lower dollar are the NOK and SEK, for a few reasons other than the strong correlation with the DXY index (Chart I-3): Chart I-3NOK And SEK Are A Play On DXY Economic momentum in both Norway and Sweden is picking up steam. In Norway, high oil prices will be a cyclical boost to the currency, as has been the case historically. Meanwhile, Sweden is benefiting from a strong manufacturing landscape, especially in autos where pricing has skyrocketed due to shortages. While the Swedish manufacturing PMI has moderated recently, it still sits at 65.8, the highest level since the mid-1990s. Both currencies remain very cheap according to our models. Our favored PPP model shows that NOK and SEK are trading at a discount of 20% and 17% respectively, amongst the cheapest in the G10 (Chart I-4). Chart I-4The Dollar Is Expensive Norway, Sweden and Canada are among the countries whose output gaps are expected to close relatively fast (Chart I-5). In the case of Norway (and Canada), the central bank has been vocal about curtailing monetary accommodation, as market conditions improve. The upside surprise in Swedish GDP this week lowers the odds of more monetary accommodation from the Riksbank. This will boost real rates in these countries, supporting their currencies. Chart I-5Output Gaps Across The G10 In a nutshell, if the dollar heads lower 9-12 months from now, this will benefit most procyclical currencies, with the NOK and SEK as winners. The Yen As An Olympian Chart I-6Currencies And The Olympics We made the case last month that the yen was the most underappreciated G10 currency, and that certainly remains true. Since then, there has been improvement in the Japanese economy: The vaccination campaign is progressing smoothly, with 27% of the population having been inoculated from almost nil earlier this year. Meanwhile, about 38% have received at least one dose. This should curtail hospitalizations, despite the increase in new cases. Economic momentum remains tepid, but there are green shoots. Real cash earnings are inflecting higher, which is boosting household spending. There was also remarkable improvement in the Eco Watchers Survey, a sign of optimism among small and medium-sized businesses. Global trade remains strong, which is a boost to the Japanese external sector. While this may slow going forward, it will be a benign headwind. Japan is less exposed to China, a key market for exports, compared to its developed market peers like Australia and New Zealand. Meanwhile, China is already easing policy at the margin. The true catalyst for the yen could be the Olympics. Since the 1970s, the median performance of a currency hosting the Olympics is 4% over a year. The performance of the yen today falls well below the 25th percentile of this performance gap (Chart I-6). This year’s games have obviously been unique given the pandemic but given that the yen is the most shorted G10 currency, this is probably already in the price. It also it does raise the prospect that the yen rises from being an underdog to staging a powerful mean reversion rally. While Japan will not get a tourism boost this summer that will buffet discretionary spending, foreigners are likely to return as the pandemic is put behind us. It is remarkable that Japanese shares, even construction and material companies, that should have benefited from the leadup to the Olympics, have massively underperformed (Chart I-7). This suggests that at the margin, many investors have folded hands and sold Japanese equities indiscriminately. Chart I-7Japanese Shares Have Underperformed Finally, real rates in Japan are among the highest in the G10. This will not only prevent Japanese concerns from deploying yen cash on foreign paper, but could also lead to some repatriation of funds, boosting the yen. Low Real Rates: Buy Silver (And Platinum) The case for buying silver has become compelling, at least on a tactical basis. First, the runup in prices from under $12/oz in March to almost $30/oz in August ushered silver into a well-defined wedge formation, with a series of higher lows. We are now sitting close to the lower bound of this wedge. Given our expectation that any DXY rally will be capped at 93-94, this puts a solid floor under silver prices around the $22-$23/oz level (Chart I-8). This makes for an attractive risk/reward since silver could overtake its 2011 highs near $50/oz, once strong resistance at $30/oz is breached. Second, similar to gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for fiat money debasement. But unlike gold or even cryptocurrencies, physical use for silver is quite elevated. Silver fabrication demand benefits from electronic production (whereby there is a shortage, so it is bound to eventually increase), as well as new green industries such as solar power that are dominating the manufacturing landscape (Chart I-9). Meanwhile, our Commodity & Energy Strategists have flagged that the surplus of silver is expected to shrink significantly this year, driven by both industrial and investment demand (Chart I-10). Chart I-8Buy Some Silver Chart I-9Silver Demand Is Picking Up Chart I-10The Silver Surplus Is Shrinking Third, silver is also a more potent play on a lower dollar. This is because the silver market is thinner and more volatile, with futures open interest at about one-third that of gold. Put another way, volatility in silver has always been historically higher than gold, which is why silver tends to outperform gold when the dollar is falling (Chart I-11). Chart I-11Silver Is A More Potent Play On The Dollar It is worth pointing out that the velocity of money between the US and China is slowing again, suggesting growth is likely to start outperforming outside the US, beyond the current slowdown. The US benefits less from a pickup in Chinese growth, compared to other countries. This has generally pushed the dollar lower and set fire under the silver/gold ratio (Chart I-12). Finally, there is also a case to be made for platinum. It has lagged both gold and palladium prices (Chart I-13). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart I-12Money Velocity And The GSR Chart I-13Platinum And Silver Have Lagged Gold China Slowdown Almost Over: Buy AUD/MXN Soon We highlighted in February that a tactical opportunity had opened to go short the AUD/MXN cross. With the cross down 11% from its recent highs, an opportunity to go long will soon open up. China has started easing policy at the margin. The AUD/MXN cross correlates quite strongly with the Chinese credit cycle, as Australia is economically tied to China while Mexico depends more on the US (Chart I-14). The Australian PMI has remained quite firm, despite a slowdown in the Chinese credit impulse. Strong commodity prices have been a factor, but it also points to endogenous strength in the Aussie economy. Relative terms of trade favor the Aussie. We had expected terms of trade between Australia and Mexico to relapse on the basis of destocking in China, but that has not been the case (Chart I-15). With oil prices structurally challenged by EVs, while metal prices benefit from the buildout of green infrastructure, terms of trade will remain favorable for the cross longer term. Australian stocks have been underperforming the more defensive Mexican bourse (Chart I-16). This should reverse as cyclicals start to regain the upper hand. Chart I-14AUD/MXN Tracks Chinese Credit Chart I-15AUD/MXN And Terms Of Trade Chart I-16AUD/MXN And Relative Equity Prices The timing for a long position is tricky as Chinese economic activity is likely to slow in the coming months, and cyclical equities could remain under pressure. Meanwhile, as value investors, we are also uncomfortable with AUD/MXN valuations. This suggests that in the very near term, short positions still make sense. That said, the 13-14 zone should provide formidable support to go long, an opportunity likely to unfold in the next 3 months (Chart 17). Chart I-17AUD/MXN And Momentum A Final Thought On Rising Catastrophes We have been watching with obvious trepidation the rising incidence of catastrophes globally. The occurrence of weather events such as droughts, floods, storms, cyclones, and wildfires has been skyrocketing (Chart I-18). Chart I-18Disasters And Volatility The direct play is to buy global construction and machinery stocks that are likely to benefit from increased reconstruction activity. It also favors agricultural futures. As for currency markets, the one observation is rising volatility with the VIX having spiked significantly in the years with numerous weather events. We are already long CHF/NZD and the yen as a play on rising currency volatility, and we will be exploring this thesis more deeply in future publications. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the US this week was relatively robust: The Markit manufacturing PMI for July edged up from 62.1 to 63.1. That said, the services PMI fell from 64.6 to 59.8. Durable goods orders were rather weak, rising 0.8% year on year in June, versus a consensus of a 2.2% increase. Admittedly, the core non-defense measure, excluding aircraft and parts, rose by 0.5% from 0.1%. Consumer confidence remains resilient, rising from 127.3 to 129.1 in July, well above expectations. Q2 GDP came in at 6.5% quarter on quarter, versus an 8.4% consensus. The US dollar DXY index fell this week. The Fed meeting highlighted that the authorities are in no rush to tighten monetary policy, despite what has been a robust recovery in labor market conditions and inflation. The aftermath of the meeting saw a drop in US real yields and the dollar. The Fed’s dovish stance has been a central theme to our bearish dollar view. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of the eurozone this week softened: The manufacturing PMI fell to 62.6 in July from 63.4. The services PMI surprisingly improved, rising from 58.3 to 60.4 in July. Economic confidence rose from 117.9 to 119 in July. The German IFO survey was below consensus in July, but the expectations component did rise from 99.6 to 100.4. The euro rose by 1% this week. We went long the euro at 1.18 on expectations that at the margin, monetary policy in the euro area will shift in a more hawkish fashion. Since then, the ECB has adopted a symmetric inflation target, promising to keep interest rates low for longer. The euro’s indifference to this dovish development suggests a strong floor under the currency, and upside should euro area growth beat consensus. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data was rather mixed this week: The Jibun manufacturing PMI eased slightly in July, to 52.2 from 52.4. The services component also fell to 46.4. Department store sales came in at 3.7% year on year in June. We highlighted last week that supermarket sales also remain strong. The yen was up 0.4% against the dollar this week. In the history of the Olympics, the incumbent currency has tended to rise over the course of the year. Given the yen is the most shorted developed-market currency currently, this sets it up for a coiled spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There were some mixed data out of the UK this week: Retail sales in the UK were in line with expectations. The measure excluding automobiles and fuel rose by 7.4% year on year in June. The PMIs generally slowed from very strong levels. The manufacturing print for July was 60.4, while the services component came in at 57.8. House price inflation remains strong, with the nationwide measure coming in at 10.5% year on year in July. Mortgage approvals fell slightly in June but remain at a robust 81.3K. The pound rose by 1.5% this week. The big surprise in the UK has been a reversal in the COVID-19 infection rate, despite an economy that is reopening quite briskly. This sets cable up for a volatile few weeks and months, given a poor technical picture (speculations are cutting long positions from very aggressive levels). We like GBP long term but will stand aside for now. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The inflation report in Australia was in line with expectations for Q2: Headline CPI rose from 1.1% to 3.8%. The trimmed mean and median measure came in at 1.6% and 1.7% respectively. The AUD was flat this week, the worst performing G10 currency. The dominant story remains the renewed restrictions from a resurgence in COVID-19, particularly in Sydney. That said, weakness in AUD is starting to create an attractive reward/risk profile. Speculators are net short the Australian dollar, and our bias is that there has been spillover pressure from the recent turmoil in Asian/Chinese markets. In the end, this only makes for a coiled spring rebound in the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: The trade balance came in at NZ$261 million, even with stronger imports in June. The ANZ activity outlook index fell in July, to 26.3 from 31.6. The NZD was up 0.5% this week. The strong rally in NZD after a hawkish RBNZ a fortnight ago continues to fade. This week, we highlighted a new theme, which is the rising incidence of natural disasters. Historically, this has been great for agricultural prices, benefiting NZD. But it has also been accompanied by a tremendous rise in currency volatility, which hurts the NZD vis-à-vis safe-haven currencies. We are currently long CHF/NZD and will be exploring this theme in future publications. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been mixed: Retail sales fell month on month in May by 2.1% but this was above expectations. Inflation remains robust. Headline CPI was 3.1%, while the core trim, median and common measures came in at 2.6%, 2.4% and 1.7% respectively. The CAD rose by 0.8% this week. The backdrop for the loonie remains positive as the Bank of Canada is leaning against monetary accommodation by tapering asset purchases, and signaling interest rate increases, while the Fed remains on hold. These pin real interest rate differentials in favor of the loonie. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Investor confidence from the Credit Suisse survey fell in July, from 51.3 to 42.8. Total sight deposits were unchanged at CHF 712 bn for the week of July 23. The Swiss franc was up 1.3% this week. Incoming Swiss inflation data next week will dictate whether the SNB steps up the pace of FX intervention. So far, there have been no big moves in the CHF exchange rate to implore central bank attention. A rebound in global bond yields will be a welcome relief since the franc tends to weaken in that environment. For the time being, we believe volatility can continue to rise. As such, the franc will benefit, justifying long CHF/NZD bets. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: Retail sales were flat month on month in June. The NOK was up 1% this week. Our limit buy on Scandinavian currencies was triggered a fortnight ago, nudging us in the money with this week’s currency moves. We are not fighting the Norges Bank, which has signaled they will increase interest rates this year, ahead of both the Federal Reserve and the ECB. As such, we are short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been improving: The PPI for July came in at 9.6%, up from 7.9%. The June trade balance showed a healthy surplus of SEK 10.3 billion. The economic tendency survey for July came in at 122.4 from 119.8. Manufacturing confidence continues to inflect higher, rising from 125.2 to 129.2 in July. The SEK was the strongest performing G10 currency this week, rising 1.5%. Swedish Q2 GDP was a welcome positive surprise, up by 10.5% year on year and 0.9% quarter on quarter. This is paring back expectations of more stimulus from the Riksbank. We have been highlighting that SEK remains one of our most potent plays on a global growth recovery. As such, we are short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Coffee prices are on a rip. They are up nearly 30% over the past month, bringing the year-to-date increase to almost 60% and climbing to a 7-year high. Hostile weather in Brazil’s coffee growing region – which included a drought followed by two frosts – is…