Asia
Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week). EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA. As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts. Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy. Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9 Footnotes 1 Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion. It is available at ces.bcaresearch.com. 2 Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3 Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion. It is available at ces.bcaresearch.com. 4 We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5 Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6 Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7 Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8 Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
China's H-share market lagged its A-share counterpart in most of 2019 and 2020. While A shares benefited more directly from China’s domestic liquidity and monetary easing in the past two years, H-shares were hammered by political turmoil in Hong Kong (SAR)…
BCA Research’s China Investment Strategy service concludes that an underweight position in Chinese stocks is warranted for the next six months. Historically, China’s credit formation has consistently led economic activity by about six to nine months. A…
Highlights Clients countered our opinion that China’s economy has reached its cyclical peak. However, we have already incorporated the supporting facts into our analysis so they will not alter our cyclical outlook for the economy. The favorable external backdrop is a potential downside risk to China’s domestic economy, because the country’s pain threshold for reform is often positively correlated with global growth. We agree that an acceleration in local governments’ special-purpose bond issuance could boost infrastructure investment in the next six months, but we are skeptical about the magnitude of such support. China’s onshore and offshore stock markets remain firmly in a risk-off mode. For now, we recommend investors stay on the sidelines until some of the early indicators turn more bullish. Feature We spent the past week hosting virtual meetings with BCA’s clients in Europe and Asia. We presented our view that China’s economic recovery has likely peaked and escalating risks of a policy overtightening warrant an underweight position on Chinese stocks for the next six months. Most clients shared our concern that policymakers may keep financial and industry regulations more restrictive than the market is currently pricing in, leading to more downside surprises to risk asset prices. Clients also brought up a few opposing views which challenged our analytical framework. In this and next week’s reports we will highlight some of the counterpoints we discussed in these meetings. Interestingly, most of our clients - even ones who are more sanguine about China’s economic outlook - prefer to wait on the sidelines before jumping back into China’s equity market. They foresee sustained volatility in the coming months as the market continues to struggle between digesting high valuations and adjusting expectations for future earnings growth. Has China’s Economic Recovery Reached An Apex? The primary discussion centered around whether the strength in China’s economy has reached a cyclical peak. Q1 GDP points to slower sequential economic momentum from Q4 last year (Chart 1). Some of the high-frequency economic data also indicate that economic activity peaked in Q4 last year (Chart 2). Chart 1Q1 Sequential Growth Was The Slowest In A Decade Chart 2Has Economic Activity Peaked? Chart 3Our Framework Suggests A Slower Growth Momentum Ahead The view fits perfectly into our analytical framework, which has worked well in the past decade. Historically, China’s credit formation has consistently led economic activity by about six to nine months. A turning point in the credit impulse occurred last October, which suggests that economic activity should start to slow in Q2 this year (Chart 3). However, our clients countered with the following arguments, which support a notion that sequential economic growth rate can still trend higher in the next six months: Aggregate demand in Europe and the US continues to improve, while the COVID-19 resurgence in major emerging economies, such as India and Brazil, has forced their production recoveries to pause. Thus, China’s exports will remain robust and should continue to make substantial contributions to the economy (Chart 4). Infrastructure spending could get a meaningful boost when local governments speed up issuing special-purpose bonds (SPB) in Q2 and Q3. Infrastructure investment growth was relatively weak in Q1, probably the result of a slower pace in credit growth and government expenditures (Chart 5). However, a delay in local government SPB issuance in Q1 this year means more support for infrastructure investment in the rest of the year (Chart 6). Chart 4Counterpoint #1: Chinese Exports Will Stay Strong Chart 5Slower Credit Growth Led To A Subdued Q1 Infrastructure Investment Growth Travel restrictions imposed during the Chinese New Year weighed heavily on the service sector in Q1 (Chart 7). If China’s domestic COVID-19 cases remain well controlled, then the trend could reverse and the pent-up demand for service consumption may usher in a significant improvement in Q2 when three major public holidays occur. The service sector accounts for more than half of China’s GDP, therefore, an improvement in this sector should significantly bolster future GDP growth. Chart 6Counterpoint #2: More LG SPBs, More Spending On Infrastructure Chart 7Counterpoint #3: Service Sector Activities Will Pick Up Our Analytical Framework The viewpoints expressed by clients have not changed our cyclical view of China’s economy, since our broad analysis of Chinese business cycle already incorporates the main points that clients raised. Additionally, data such as GDP growth figures are coincident and lagging indicators, and do not explain the direction of forward-looking financial markets. The authorities will shift their policy trajectories only if the data significantly deviate from expectations. We view Q1 GDP and underlying data broadly in line with Chinese leadership’s short- and medium-term economic growth targets and, therefore, will not lead to any policy adjustment. Chart 8If Demand For Chinese Exports Stays Strong, Reform Efforts Will Intensify To our clients’ point that strong exports ahead will support China’s overall GDP growth, we regard a favorable external backdrop as a potential downside risk to the domestic economy. The willingness of Chinese authorities to pursue painful reforms is often positively correlated with global growth (Chart 8). BCA has written extensively about how China has taken advantage of a stronger export sector by increasing the pace of domestic reforms and in the past has embarked on a multi-year reform plan that weighed on growth. At the beginning of this year, Chinese policymakers were set out to “keep credit growth in line with nominal GDP growth in 2021.” Nonetheless, policymakers’ targets for credit and nominal GDP growth rates could change during the year, contingent on their perception of the broad growth outlook and unemployment. Chart 9Both Credit And Economic Growth Rates Are Moving Targets And Subject To Policy Finetuning Even if policymakers keep the country’s leverage ratio steady in 2021, which is our base case view and assuming China’s nominal GDP grows by 11%, then the credit impulse (measured by the 12-month difference in total social financing as a percentage of GDP) will likely fall to about 28% of GDP, down from 32% of GDP in 2020 (Chart 9). The rate of credit formation increased by 13.6% in the first three months from Q1 last year, above government’s target. We expect a further pullback in credit growth in the rest of the year, to bring the annual pace at or below 12%. Construction capex, which is sensitive to both credit creation and tightening regulations in the housing sector, will likely experience a slowdown. At more than 90% of GDP, China’s economy is mainly driven by domestic demand and a weakening in the domestic economy can more than offset positive contributions from a robust export sector. Infrastructure And Services We expect infrastructure investment will grow by 4-5% this year, which is in line with its rate of expansion in 2020. However, the sequential growth in the sector in Q2 – Q4 this year will be slower than during the same period in 2020 (Chart 10). We agree that a more concentrated issuance of local government SPBs in Q2 and Q3 could help to buttress infrastructure investment. However, SPBs made up only about 15% of overall infrastructure spending in the past three years, so we are dubious that SPBs can provide the crucial support. The rest of the gap for local governments to finance their spending on infrastructure projects will need to be filled through public-private partnerships (PPP) financing, government-managed funds’ (GMFs) revenues, government budgets and bank loans. Note that only non-household medium- and long-term (MLT) bank lending showed a positive impulse so far (Chart 11). While not all of MLT loans are used for infrastructure, they have a positive correlation with investments in infrastructure projects which are generally long term in nature. Chart 10Sequential Growth In Infrastructure Investment Will Be Slower Than In Q2 – Q4 Last Year Chart 11MLT Bank Loans Have Been Supportive To Infrastructure Spending... On the other hand, the contribution of PPPs to total infrastructure spending has been plunging in recent years due to tighter regulations aimed at controlling increased risks related to local government debt (Chart 12). Depressed revenues from land sales and extended corporate tax cuts this year will also curb the ability of local governments to finance infrastructure projects (Chart 13). Chart 12...But Public-Private Partnerships Have Become Too Small To Fill The Financing Gap Chart 13Government-Managed Funds Also Face Headwinds From Falling Land Sales Finally, although the service sector accounts for 54% of China’s GDP (2019 statistic), transport, retail and accommodation, which were hardest hit by COVID-19, accounted for less than 30% of China’s tertiary GDP. This compares with a slightly larger share of tertiary GDP from finance- and housing-related sectors (financial intermediation, leasing & business services, and real estate) –the sectors that have been thriving since the second half of last year when both the equity and housing markets boomed (Chart 14). Nonetheless, it is unreasonable to expect these areas to strengthen even more in an environment where the policy has shifted to contain risks in the financial and housing arenas. The net result to tertiary GDP growth is that the deterioration in finance- and real estate-related segments will likely offset an improvement in transport, retail and accommodation. Chart 14More Than 70% Of China’s Services Sector Is Finance And Real Estate Related Investment Conclusions The ultimate question we got from almost every client meeting was: What would make us turn bullish on Chinese stocks in the next 6 to 12 months? Chart 15Changes In Domestic Policy Dominate Chinese Stock Performance Since most monthly and quarterly economic data do not provide enough market-moving catalysts, we rely on our assessment of the changes in policy direction, such as interbank liquidity conditions and excess reserves, in addition to overall credit growth (Chart 15). We will also continue to watch for the following signs before upgrading our tactical and cyclical calls from underweight to overweight: Chart 16 shows that cyclical stocks remain depressed relative to defensives in both onshore and offshore markets, underscoring investors’ concerns about China’s economy. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards policy support and economic growth. A technical breakdown in the performance of healthcare and utility stocks relative to investable stocks would be another bullish indicator (Chart 17). These equities have historically led China’s economic activity, core inflation and stock prices by one to three months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a meaningful economic upturn in China. Chart 16Waiting For A Telltale Sign... Chart 17...Before Upgrading Chinese Stocks Given that the above mentioned indicators remain firmly in a risk-off mode, we maintain our view that China’s economy has reached its peak, and policy has tightened meaningfully. Our cyclical underweight position on Chinese stocks, in both absolute terms and within a global portfolio, is warranted. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14 Footnotes 1 Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020. It is available at ces.bcaresearch.com. 2 Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021. The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3 Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Surging Covid-19 cases to unprecedented levels have unsettled India’s equity and currency markets. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential ongoing super-spreader events. Yet, the country’s medium- and longer-term outlooks remain positive. Asset allocators with less tolerance for volatility may tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Feature New COVID-19 cases in India have skyrocketed in the past few weeks – far surpassing previous peaks. The country now accounts for 40% of daily new cases globally (Charts 1 and 2). This has raised the possibility of fresh lockdowns and, as a result, Indian stocks and the currency have begun to sell off. Chart 1Daily COVID-19 Cases Have Lately Skyrocketed In India … Chart 2… Accounting For 40% Of Global Cases And 20% Of Deaths … We have been overweight India in an EM equity portfolio because of the country’s positive cyclical and structural outlook. Even though our views have not changed, we believe the parabolic surge in COVID-19 cases is likely to cause near-term volatility in Indian equity and currency markets. As such, we recommend that asset allocators who have less tolerance for volatility tactically downgrade Indian equities to neutral for the next couple of months. Below we elaborate the reasons for this near-term downgrade, as well as the reasons for our more upbeat view over the medium to long term. New Cases Might Stay High Chart 3… And Raising The Specter Of Another Stringent Lockdown Being a densely populated country with less than ideal living conditions, the attempts to control the spread of COVID-19 via social distancing measures is extremely difficult in India. Yet, the authorities tried to do exactly that last spring by imposing the most stringent lockdown measures anywhere in the world (Chart 3). The result was a complete collapse in economic activity: year-over-year industrial production fell by a half, and GDP contracted by 22% in the second quarter of 2020 from a year ago. Now facing an unprecedented surge in new cases, markets are apprehensive that even a partial lockdown will scuttle the nascent recovery in the economy. Worryingly, the number of new cases in India might stay exceptionally high for a while. The reason is that there are several potential super-spreader events going on. The country is undergoing state-level elections in five states where the candidates are canvassing in front of gatherings of tens of thousands of people. Currently, there is also a religious congregation taking place where up to three million pilgrims have assembled. Chart 4Should Morbidity And Mortality Rates Rise, A Harsh Lockdown May Become Inevitable The morbidity and mortality rates have not yet risen (Chart 4). This is a key metric and will likely determine the stringency of the authorities’ lockdown measures. Even though the Prime Minister has declared that stern lockdowns would be last-resort measures, the possibility cannot be excluded if hospitalization and mortality rates begin to rise. The following has also added to investor concerns: The fact that equity valuations are much higher now than they were last spring makes the market even more prone to a setback (Chart 5). Indian stocks have benefitted from a record amount of foreign portfolio inflows over the past 12 months – totaling $ 34 billion. The risk is therefore high that some of these flows might reverse in the near term if the threat of renewed lockdowns is realized. That will be a headwind for both stock market and the rupee (Chart 6). Finally, a rising US dollar, and a likely general underperformance of EM stocks over the next several months, will also encourage outflows from India. Chart 5Elevated Valuations Have Added To The Vulnerability Of Indian Stocks Chart 6A Reversal In Foreign Portfolio Inflows Will Cause Both Stocks And The Rupee To Fall Cyclical Outlook Remains Positive Beyond the near-term jitters, India’s cyclical outlook remains positive. The recovery has been solid as indicated by the following metrics: The number of E-way bills issued (a barometer of business activity) as part of the Goods & Services Tax (GST) collection mechanism keeps rising steadily. GST collection itself has also been strong – validating the same message (Chart 7). Manufacturing and Services PMIs printed over 55 in March – indicating robust expansion of activity. Order books of companies, as indicated by both RBI and Dun & Bradstreet surveys, look strong. These indicators herald an improvement in industrial production going forward (Chart 8). Chart 7Underlying Economic Recovery In India Has Been Robust So Far … Chart 8… Supported By Strong Order Books … In short, all of the above points to an ameliorating top lines (sales) for the corporates in the coming months, barring stringent lockdowns. Meanwhile, firms’ profits margins have also recovered meaningfully. An RBI survey of over 2600 companies shows that both gross and net profit margins had risen to above pre-pandemic levels by December 2020 (Chart 9). Given the wide margins, a recovery in sales levels will lead to accelerating profits in the quarters ahead. In a sign that profit re-acceleration is not far off, firms have begun to invest in new plants and machinery. Capital spending had already turned positive during the last quarter of 2020 versus the same period of 2019. Imports of capital goods have also begun to rise – corroborating new capex plans of the firms (Chart 10). Chart 9… And Healthy Profit Margins … Chart 10… Which Have Encouraged Firms To Resume Capital Spending New capital expenditure is undertaken only when firms are confident of strengthening demand. Besides, capex usually comes on the heels of rising profits. Higher capital goods imports and capital spending therefore indicate that the companies are optimistic of both sales and profits going forward. On its part, the central bank has ensured that the liquidity in the banking system remains abundant by engaging in plenty of open market operations. Bank credit growth, at 6.3%, is still low, but appears to have bottomed. Excluding the credit to large corporations – who have in recent years been replacing bank credit by local currency debt issuances – the credit growth rate is 9% (Chart 11). Odds are that beyond the near-term jitters due to rising COVID-19 cases, credit will accelerate in line with recovering economic activity. That will be bullish for bank stocks. Incidentally, banks make up the largest chunk of Indian equity index. Finally, Indian small caps continue to outperform their large cap counterparts (Chart 12). Smaller firms in India are much more vulnerable to a slowdown in growth and tighter credit conditions. The fact that they keep outperforming suggests that investors do not expect a major or lasting impact of the latest pandemic outbreak on the economy. Chart 11Bank Credit Will Rise As The Expansion Continues Chart 12Small Caps Outperformance Suggest Investors Are Sanguine About Growth And Credit Conditions Beyond the cyclical recovery, we are bullish on India’s longer-term outlook as well. The reason for that is India is one of the rare EM countries undertaking meaningful structural reforms. The country’s demographics are also highly favorable. We will elaborate on these and other structural issues in greater detail in our future reports. Investment Conclusions Indian stocks and the currency have entered a period of turbulence as surging COVID-19 cases prompt profit taking/selling. EM equity portfolios with low tolerance for volatility should therefore consider tactically downgrading this bourse to neutral for a couple of months. Absolute return investors (in US$ terms) should also brace for near-term volatility in Indian share prices. Over the medium-to-long term however, Indian stocks will likely outperform their EM peers as well as rally in absolute terms (Chart 13). Indian bank stocks are also suffering from the ongoing volatility. However, given Indian private banks’ higher efficiency and better balance sheets vis-à-vis banks elsewhere in the EM, long-term investors should continue to stick with our recommended trade of long Indian banks/ short EM banks (Chart 14). Chart 13Beyond The Near-Term Volatility, Indian Stocks Will Outperform Their EM Peers … Chart 14… So Will Indian Bank Stocks Vis-à-vis EM Banks Fixed income investors should continue receiving 10-year swap rates in India. With the abundant rainfall, food prices will decline. This will keep inflation under check. The rising COVID-19 cases and a potential lockdown are disinflationary in nature and will push down swap rates. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com
South Korea’s exports suggest that the global trade recovery is intact. Exports surged 45.4% y/y for the first 20 days in April following a 12.5% y/y increase in March. On an average working day basis, export increased by 36% y/y increase. The y/y…
China’s GDP release shows the economy growing by a colossal 18.3% y/y in Q1. However, this figure is highly distorted by the pandemic-induced economic collapse last year. Instead, the quarter-on-quarter comparison reveals a sharp deceleration in activity last…
Highlights Geopolitical risk is rising once again after a big drop-off in risk during the pandemic and snapback. The Biden administration faces three critical foreign policy tests: China/Taiwan, Russia/Ukraine, and Israel/Iran. Russia could stage a military incursion into Ukraine that would cause a risk-off event. However, global markets would get over it relatively quickly since a total invasion of all Ukraine is unlikely. Iran is nearing the “breakout” threshold of uranium enrichment which will prompt more Israeli demonstrations of its red line against nuclear weaponization. Iran will retaliate. So far our view is on track that tensions will escalate prior to the resolution of a US-Iran deal by August. Taiwan is the most market relevant of all geopolitical risks – but the South China Sea is another scene of US-China saber-rattling. A crisis here is most important if connected to Taiwan. Go long CAD-RUB and CHF-GBP. Feature Chart 1Traffic In The World’s Most Dire Straits British Prime Minister Harold Macmillan, quoting Sir Winston Churchill, once said, “Jaw-jaw is better than war-war.”1 President Joe Biden would undoubtedly prefer jaw-jaw as he faces three imminent foreign policy tests that raise tail-risks of war: Chinese military intimidation of Taiwan, a Russian military build-up on the Ukrainian border, and Iranian acceleration of its nuclear program. All of these areas are heating up simultaneously and a crisis incident could easily occur, causing a pullback in bond yields and equity markets. One way of illustrating the seriousness of these conflicts is to look at the volume of global trade that goes through the relevant geographic chokepoints: the Taiwan Strait, the Strait of Malacca, the Strait of Hormuz, and the Bosphorus Strait (Chart 1). Oil and petroleum products serve as a proxy for overall traffic. The recent, short-lived blockage of the Suez Canal provides an inkling of the magnitude of disruption that is possible if conflict erupts in one of these global bottlenecks. In this report we review recent developments in Biden’s foreign policy tests. Our views are mostly on track. Investors should prepare tactically for more geopolitical risk to be priced into global financial markets, motivating safe-haven flows and potentially a general equity pullback. Cyclically the bull market will continue, barring the worst-case scenarios. Biden’s Three Foreign Policy Tests Biden’s three foreign policy tests are all intensifying as we go to press: China/Taiwan: China is continuing a high-intensity pace of “combat drills” and live-fire drills around the island of Taiwan.2 The US is sending a diplomatic delegation to Taiwan against Beijing’s wishes and is set to deliver a relatively large arms sale to the island. Yet Washington has sent John Kerry, its “climate czar,” to Beijing to set up a bilateral summit between Presidents Biden and Xi Jinping for Earth Day, in a bid to find common ground. Biden’s overarching review of US China policy is due sometime in May. Russia/Ukraine: Russia has amassed more than 85,000 troops on its border with Ukraine and in Crimea, the largest build-up since it invaded Ukraine in 2014-15. Russia has withdrawn its ambassador to Washington and warned that it will retaliate if the US imposes any new sanctions. The US is doing just that, with new sanctions leveled in response to Russian cyberattacks and election interference, including a block on sales of Russian ruble-denominated sovereign bonds from June. Hence Russian retaliation is looming. Israel/Iran: Shortly after the March 23 election, Israel sabotaged the underground Natanz Fuel Enrichment Plant in Iran, prompting the Iranians to declare that they will retaliate on Israeli soil. They also claim they will now enrich uranium to a 60% level, which pushes them close to the 90%-plus levels needed to make a nuclear device. American and Israeli officials had previously signaled that Iran would reach “breakout” levels of weapons-grade uranium between April and August. Negotiations are underway but the process will be beset by attacks. We have written extensively on the Taiwan dynamic this year as it is the most relevant for global investors. In this report we will update the Russian and Iranian situations first and then proceed to China. Bottom Line: Geopolitical risk is back after a reprieve during the pandemic. The new US administration faces three serious foreign policy tests at once. Financial markets have mostly ignored the rise in tensions but we expect safe-haven assets to catch a bid in the near term. However, we have not yet altered our bullish cyclical view. So far we are still in the realm of “jaw-jaw” rather than “war-war,” as we explain in the rest of this report. Stay Short Russia And EM Europe The return of the Democratic Party to power in Washington has led to an immediate increase in US-Russian tensions. The Biden administration is eschewing a diplomatic reset and instead pursuing great power competition. The US is increasing its arms sales and NATO military drills with Ukraine. It is imposing sanctions over Russian cyberattacks and election interference, including taking a long-awaited step against the purchase of ruble bonds. Washington could also force Germany to cancel the Nord Stream II pipeline. However, there are also mitigating signs. President Biden has offered to hold a bilateral summit with President Vladimir Putin in a third country and the two may meet at his Earth Day summit. The US Navy also called back the USS Donald Cook and USS Roosevelt destroyers from going into the Black Sea, after Moscow warned that any American warships in that sea would be in danger, especially if they go near Crimea. Washington’s new volley of sanctions are not truly tantamount to Russian interference in American elections and they do not include new measures on Nord Stream II. An American move to insist that Germany cancel Nord Stream before construction ends would provoke Russia to retaliate. The purpose of Nord Stream is to bypass Ukraine and cement direct economic ties between Russia and Germany. Germany’s government continues to support the project despite Russia’s build-up on the border with Ukraine and suppression of political dissidents. If the US vetoes the pipeline then it is denying Russia access to legitimate trade and restricting Russia’s export options to the Ukrainian route. If the US simultaneously increases military cooperation with Ukraine then it is implicitly trying to control Russia’s energy access to Europe. Russia will likely retaliate by punishing Ukraine. Russia could take aggressive action in Ukraine or elsewhere regardless of what the US does on Nord Stream or in its Ukraine outreach. Russia is struggling with a weak domestic economy and social unrest. Moscow has a record of foreign adventurism when popular support wanes. Moreover legislative elections loom in September. Thus Russia may have an independent reason to stir up conflict in Ukraine, at least for the next half year, that cannot be deterred. Judging by capabilities, Russia has deployed enough troops to stage a military incursion into the breakaway Donbass region of Ukraine. The Russian army build-up on the border is the largest since 2014 – large enough to put most of Russian-speaking Ukraine at risk. A full-scale Russian invasion of all of Ukraine is unlikely but not impossible. It would be extremely costly both in blood and treasure – not only in occupying a hostile Ukraine but also in unifying the West against Russia, the opposite of what Moscow is trying to accomplish (Chart 2). Moscow will want to avoid this outcome unless the US shuts down Nord Stream or tries to bring Ukraine into NATO. Chart 2Russia’s Constraints Over Ukraine From the market’s point of view, intensified fighting in Ukraine between the government and Russian-backed rebels is status quo. This is inevitable and will not have a major impact on global equities. The invasion of Crimea in 2014 led to a maximum 2% drawdown in the S&P 500. It was the shooting down of Malaysian Airline 17, not Russia’s invasion of Ukraine, that shook up financial markets in 2014. Global equities fell by 2.7%, Eurostoxx 500 by 6.2% and Russian equities by 10.7%. Note that the Russian military did ultimately participate in the fighting in 2014-15, it was not only Russian-backed separatists, so global financial markets can stomach that kind of conflict fairly well as long as it is limited to Ukraine, especially disputed regions, and as long as the US and NATO do not get involved. They are disinclined to fight for Ukraine, leaving it vulnerable. A larger flight to safety would occur if Russia pursued the total conquest of all of Ukraine. This is small probability but high impact. It would cause a major global risk-off because it would raise the risk of a larger war on the continent for the first time since World War II. Russia is obsessed with Ukraine from the point of view of grand strategy and national security and will take at least some military action if it deems it necessary. Investors should be prepared for escalation – though neither Washington nor Moscow has yet taken a fatal step. It is important to watch for any aggressive Ukrainian actions but Ukraine is not the main driver of action. The current situation is reminiscent of that in the Republic of Georgia in 2008, when Russia provoked President Mikhail Saakashvili into taking action against separatists that Russia then used as a pretext for intervening and breaking away Abkhazia and South Ossetia. While Ukrainian President Volodymyr Zelenskiy could be baited into a conflict, it is also true that fear of getting baited could result in hesitation that allows Russia to seize the initiative, as occurred in Ukraine in 2014. So for the Ukrainians it is “damned if you do, damned if you don’t.” Russia’s actions will largely depend on its own interests. So far Russian equities have lagged other emerging market equities and the commodity rally, which may partly reflect elevated political and geopolitical risk (Chart 3). The trend for Russian equities can easily get worse from here. Given Russia’s interest in conflict with the West ahead of the September elections, Russian-Ukrainian tensions could persist for most of this year. A major military campaign becomes more probable after mid-May when the weather improves. Russian currency and assets will remain under pressure. We recommend going long the Canadian dollar relative to the Russian ruble. The ruble will underperform commodity currencies as a whole, including the Mexican peso, if Russia intervenes militarily, judging by the Crimea conflict in 2014 (Chart 4). Meanwhile Canadian and Mexican currencies should benefit from the fact that the US economy is hyper-stimulated and rapidly vaccinating. Chart 3Russia Lagged Commodity Rally Chart 4Favor Loonie And Peso Over Ruble Chart 5Long DM Europe / Short EM Europe We continue to overweight developed Europe and underweight emerging Europe (Chart 5). Poland, Hungary, the Czech Republic, Romania, and the Baltic states will see a risk premium due to current tensions. The Czech Republic faces considerable political uncertainty surrounding its legislative election in October, an opportunity for Russia to interfere or for anti-establishment (albeit pro-EU) parties to rise to power. What would it take for Biden and Putin to de-escalate? The US and NATO could diminish Ukraine relations, downgrade democracy promotion and psychological counter-warfare, and allow Nord Stream to be completed. Russia could reduce its troop presence on the border and lend a helping hand on the Iranian nuclear deal and Afghanistan withdrawal. This is a risk to our view. Bottom Line: Russia and emerging European markets are some of the few truly cheap markets in the emerging market equity universe (Table 1). Yet the current geopolitical context looks to keep them cheap. For now investors should be prepared for the West’s conflict with Russia to escalate in a major way. At minimum we need to know whether the US will halt Nord Stream II’s construction before taking a more bullish view on EM Europe. Table 1Geopolitical Risk Helps Keep Russia And EM Europe Cheap The worst-case scenario of a full-blown Russian conquest of Ukraine has a small probability but cannot be ruled out. Iran Negotiations: First Explosions, Then A Nuclear Deal Israel has not put together a government after its March 23 election, although Prime Minister Benjamin Netanyahu has the opportunity to lead a government again which means no change in national policy so far. Moreover the Israeli public and political establishment are unified in their opposition to Iran’s regional and nuclear ambitions. Immediately after the Iranians inaugurated new centrifuges at the Natanz nuclear facility, on April 11, the Israelis allegedly sabotaged the facility underground facility in an attack that was supposedly not limited to cyber means and that deactivated a range of centrifuges. An Iranian scientist fell into a crater and hurt himself. The Iranians have vowed retaliation on Israeli soil. More fundamentally their politics are shifting in a hardline direction, to be confirmed with the election of a hawkish president in June, which will exacerbate the mutual antagonism. This power transition is a major reason we have identified the inauguration in August as a key deadline for the US to rejoin the 2015 nuclear deal (the Joint Comprehensive Plan of Action). If the Biden administration cannot get it done by that time then a much more dangerous, multi-year negotiation will get underway. The Israeli attack has not stopped negotiations in the short term, however. The second round of talks begins in Vienna as we go to press. The US has also confirmed it will withdraw from Afghanistan on September 11, which says to Iran that Biden is determined to reduce the US’s strategic footprint in the region, reinforcing the US desire for a deal. The Israelis will continue to underscore their red line against the Iranian nuclear and missile programs in the coming months through clandestine attacks. However, they were not able to stop the US from signing a nuclear deal with Iran in 2015 and they are not likely to stop the US today. They are still bound by a fundamental constraint. Israel needs to maintain its alliance with the United States, which ensures its long-term security against both Iran and the Middle East’s general instability (Chart 6). The Iranians will retaliate against Israel, making it likely that this summer will feature tit-for-tat attacks. These could include critical infrastructure. Iran may also continue its campaign against enemies in Iraq and Saudi Arabia, thus triggering unplanned oil outages and pushing up the oil price. A glance at Israeli, Saudi Arabian, and UAE stock markets suggests that global investors have largely ignored the geopolitical risks so far but may be starting to respond to the likely escalation in conflict prior to any US-Iran deal (Chart 7). Chart 6Israel’s Constraints Over Iran The US, Germany, France, Russia, and China are all officially on board with getting the Iranians back into compliance with the deal. A return to compliance would need to be phased with US sanctions relief. The Iranians demand that the US ease sanctions first, since it was the US that unilaterally walked away from the deal and re-imposed sanctions in 2018. Chart 7Saudi, UAE, Israeli Stocks Signal Danger Ultimately Biden is capable of making the first move since the American public shows very little concern about Iran. Biden himself is acting on behalf of a strong consensus in Washington that an Iranian deal is necessary to stabilize the region and enable the US to devote more strategic attention to Asia Pacific. Will Russia and China support the Iranian deal, given their simultaneous conflicts with the United States? As long as the US and Iran are satisfied with returning to the existing deal – which begins to expire in 2025 – there is little need for Russia or China to do anything. However, if Washington wants a better deal, then it will have to make major concessions to Moscow and Beijing. A new and better deal would require years to negotiate. Chart 8Russo-Chinese Cooperation Grows Russia and China supported the original nuclear deal because they saw an opportunity to limit the proliferation of nuclear weapons, which dilutes their own power. A Middle Eastern nuclear arms race is not in their interest. Iran is also a useful strategic partner for Russia and China in the Middle East and they are not averse to seeing Iran’s economy grow stronger in order to perpetuate its regime. They are wagering that liberalization of the Iranian economy will not result in liberalization of its politics – it certainly did not in the case of Russia or China – and therefore they will still have an ally but it will be more economically sound and influential. The Russo-Chinese strategic partnership has grown dramatically over the past decade. Both countries share an interest in undermining US global leadership and stoking American internal divisions. Both share an interest in reducing the US military presence near their borders, particularly in strategic territories and seas that they consider essential to their security and political legitimacy. Russia increasingly depends on Chinese demand for its exports and Chinese investment for developing its resources. Neither country trusts the other’s currency for trade but both have a shared interest in diversifying away from the US dollar (Chart 8). Chart 9China Offers Helping Hand On Iran? In cooperating with the US on Iran, Russia and China will expect the US to respect their demands on strategic areas much closer to their core interests. If the Biden administration continues to upgrade its trade and defense relations with Ukraine and Taiwan then Moscow and Beijing will push back aggressively and could at that point prevent or undermine any deal with Iran. China is at least officially enforce sanctions on Iran (Chart 9). Its strategic partnership with Iran is constantly in a state of negotiation – until the US clarifies its sanctions regime. Clearly China hopes to extract concessions from the Americans for cooperation on nuclear threats. This is also the case with North Korea, where a missile crisis would be useful for China’s purposes in creating the need for Chinese arbitration. China sees a chance to persuade Biden to remove restrictions imposed by President Trump. If the Biden administration’s hawkishness on China is confirmed in the coming months, then China’s willingness to cooperate will presumably change. Bottom Line: Israel is underscoring its red lines against Iranian nuclear weaponization and this will cause an increase in conflict this spring and summer. But it is not yet preventing the US and Iran from renegotiating the 2015 nuclear deal. We still expect Biden to agree to a deal by August. Taiwan And The South China Sea For global financial markets the most important test facing Biden lies in the US-China relationship and tensions over the Taiwan Strait. We will not rehash our recent research and arguments on this issue. Suffice it to say that we see a 60% chance of some kind of crisis over the next 12-24 months, including a 5% chance of full-scale war. The odds of total war can rise rapidly in the event of domestic Chinese instability, a game-changing US arms sale, or a Taiwanese declaration of independence. The greatest deterrent to a full Chinese attack on Taiwan – the reason for our current 5% odds – is that it would result in a devastating blowback against the Chinese economy. China’s trade with the developed world, in addition to Taiwan, makes up 63% of exports, or 11% of GDP (Chart 10). Beijing is ultimately willing to pay this price – or any price – to “unify” the country. But it will not do so frivolously. Each passing year gives China greater global economic leverage and greater military capability over Taiwan. Chart 10China’s Constraints Over Taiwan China is increasing its purchases of US treasuries, which waned during the trade war (Chart 11). China often increases purchases when interest rates rise and markets have seen a rapid increase in treasury yields since the vaccine discovery in November. There is no indication from this point of view that China is preparing for outright war with the United States, although this is admittedly a limited measure that could be misleading. What about a crisis other than war? What do we mean when we say “some kind of crisis” over Taiwan? A major gray zone would be economic sanctions or an economic embargo. While China cut back on tourism after Taiwan’s nominally pro-independence party won the election in 2016, and all tourism ground to a halt with COVID-19, there is no evidence of a broader embargo so far (Chart 12). This could change overnight. While US law forbids an embargo on Taiwan, this is precisely an area where Beijing might wish to test the US’s commitment. Chart 11China Buys More US Treasuries The current high pressure on Taiwan stems in large part from the confluence of new US export controls and the global semiconductor shortage. China cannot yet meet its domestic demand for semiconductors and it cannot develop advanced computer chips fast enough without the US and its allies (Chart 13). Chart 12No Embargo On Taiwan (Yet) If the Biden administration pursues a full technological blockade then China may be forced to take tougher action on Taiwan. But if Biden pursues a more defensive strategy then a new equilibrium will develop that spares China the risks of war. Chart 13China's Demand For Semiconductors The US and China are simultaneously escalating their naval confrontation in the South China Sea, particularly around the Philippines. US and Chinese aircraft carrier groups and other ships have been circling each other as Beijing attempts to intimidate the Philippines and shake its trust in the defense treaty with the US. China claims the South China Sea as its own – and its efforts to deny the US access will be met with US assertions of freedom of navigation, which could lead to sunken ships. The strategic importance of the South China Sea is similar to that of the Taiwan Strait: Chinese control of these bodies of water would threaten Taiwan’s, Japan’s, and South Korea’s supply security while weakening America’s strategic position in the region. We have long highlighted the elevated risks of proxy war for Vietnam and the Philippines but these are hardly issues of global concern compared with Northeast Asia’s security. While Taiwan is far more relevant to global investors, due to the semiconductor issue, there are ample opportunities for a crisis to erupt in the South China Sea. A crisis in this sea cannot be dismissed as marginal because it could involve direct US-China conflict or, worst case, it could be a prelude to action on Taiwan, as China would seek to control the approaches to the island. The final risk in this region is that North Korea has restarted ballistic missile tests. As stated above, a crisis would be well-timed from China’s point of view. For investors, however, North Korea is largely a distraction from the critical Taiwan Strait. It could feed into any risk-off sentiment. Bottom Line: US-China relations are still unsettled and a clash could emerge over the South China Sea and Korean peninsula just as it could emerge over the Taiwan Strait. The Taiwan Strait remains the most significant geography. A direct US-China clash in the South China Sea could cause a global selloff but the markets would recover quickly, unless it is linked to a conflict over Taiwan. Investment Takeaways Geopolitical risk is reviving after a reprieve during the COVID-19 pandemic. That does not mean that frictions will lead straight into war. Diplomacy is possible. If the US, China, Russia, and Iran choose “jaw-jaw” over “war-war” then the global equity rally will see another leg up. From a tactical point of view, however, our arguments above should demonstrate that at least one of Biden’s early foreign policy tests is likely to escalate into a geopolitical incident that prompts negative impacts either in regional or global equity markets. Markets are not prepared for these risks to materialize. Standard measures of global policy uncertainty have fallen sharply for most countries. It is notable that two of the few countries in the world seeing rising policy uncertainty are China and Russia. The latter is likely due to domestic instability – which is a major motivator for an aggressive foreign policy (Chart 14). Chart 14AGlobal Policy Uncertainty Will Revive Chart 14BGlobal Policy Uncertainty Will Revive Global fiscal stimulus remains exceedingly strong – it is likely to peak this year. Chart 15 shows the latest update in fiscal stimulus for select countries, comparing the COVID-19 crisis to the 2008 financial crisis. There are some notable changes to previous versions of this chart, mostly due to revisions in GDP after last year’s shock, revisions in tax revenues due to the rapid economic snapback, and revisions to the timing and size of stimulus packages. The Biden administration’s $2.3 trillion infrastructure plan is obviously not included. The second panel of Chart 15 shows the changes in the IMF’s estimates from October 2020 to April 2021. Essentially the fiscal stimulus in 2020 was overestimated, as many measures did not kick in and the economic snapback was better than expected, whereas the 2021 stimulus is larger than expected. Russia and China are notable for tightening policy sooner than others – leading to a reduction in IMF estimates of fiscal stimulus for both years. Chart 15Revising Our Global Fiscal Stimulus Chart Commodities have been a major beneficiary of the global recovery (Chart 16). Chinese growth is likely to decelerate this year which will spark a pullback, even aside from geopolitical crises. However, from a cyclical perspective commodities, especially industrial metals, should benefit from limited supply and surging demand. Geopolitical crises and even wars would first be negative but then positive for metals. Chart 16Commodities To Benefit From Geopolitical Conflict Notably the US is embracing industrial policy alongside China and the EU. In particular the US is joining the green energy race with Biden’s $2.3 trillion American Jobs Plan containing about $370 billion in green initiatives and likely to pass Congress later this year. Symbolically Biden will emphasize the US’s attempt to catch up with Chinese and European green initiatives via his hosting of a global summit on April 22-23 for Earth Day. A brief word on the British pound. We took a tactical pause on our cyclically bullish view of the pound in February in anticipation of the Scottish parliamentary election on May 6. A strong showing by the Scottish National Party could lead to a second independence referendum. This party is flagging in the polls but independence sentiment has ticked back up, reinforcing our point that a nationalist surprise could take place at the ballot box (Chart 17). Once we have clarity on the prospect of a second referendum we will have a clearer view on the pound over the medium term. Chart 17Pound Sees Short-Term Risk From Scots Election Chart 18Long CHF-GBP For A Tactical Trade In the near term, we continue to pursue tactical safe-haven trades and hedges. Our tactical long Swiss franc trade was stopped out at 5% on March 25. But our Foreign Exchange Strategist Chester Ntonifor has since highlighted that the franc is excessively cheap (Chart 18). This time we recommend a tactical long CHF-GBP, which has an attractive profile in the context of geopolitical risk, taken together with the British political risk highlighted above. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 “Jaw-Jaw Is Best, Macmillan Finds,” New York Times, January 30, 1958, nytimes.com. 2 Taiwan – Province of China.