Bear/Bull Market
Highlights Entering 2H21, oil and metals' price volatility will rise as inventories are drawn down to cover physical supply deficits brought about by the re-opening of major economies ex-China. As demand increases and oil and metals supply become more inelastic, forward curves will backwardate further. This will weaken commodity-price correlations with the USD and boost commodity-index returns. Going into next week's OPEC 2.0 meeting, the Kingdom of Saudi Arabia (KSA) and Russia likely will hold off on further production increases, until greater clarity around US-Iran negotiations and the return of Iran as a bona fide exporter is available. Chinese authorities will release 100k MT of copper, aluminum and zinc into tight domestic markets in July. A two-day rally followed the news. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, following the ~ 230% move in crude oil and the ~ 100% rise copper prices. Higher volatility will present buying opportunities for these ETFs (Chart of the Week). We remain long commodity index exposure – S&P GSCI and COMT ETF – expecting steeper backwardations. We will go long the PICK ETF at tonight's close again, after being stopped out last week with a 23.9% return. Feature Heading into 2H21, industrial commodity markets will continue to tighten. In the case of oil, this is caused by OPEC 2.0's production-management strategy – i.e., keeping supply below demand – and capital discipline among producers in the price-taking cohort.1 Base metals, on the other hand, are tightening because demand is recovering much faster than supply.2 Re-opening of major economies will boost refined-product demand in oil markets – e.g., gasoline and jet fuel – which will leave refiners little choice but to continue drawing on inventories to cover supply shortfalls in the near term (Chart 2). Chart of the WeekResources ETFs Follow Prices Higher Chart 2Refiners Will Continue Drawing Crude Investments Base metals – particularly copper and aluminum – will remain well bid in the face of constrained supply and higher consumption ex-China. Despite China's widely anticipated decision to release strategic stockpiles of copper, aluminum and zinc next month into a tight domestic market – which we flagged last month – continued inventory draws will be required to cover physical deficits in these markets, particularly in copper (Chart 3).3 Chart 3Copper Inventories Will Draw As Demand Ex-China Rises Chart 4Steeper Backwardation, Higher Volatility Higher Vol On The Way As demand for industrial commodities increases and inventories continue to draw, forward curves will become more backwardated – i.e., material delivered promptly (next day or next week) will command a higher price than commodities delivered next month or next year: Consumers value current supply above deferred supply, and producers and merchants have to charge more to cover inventory replacement costs, which increase when prompt demand outstrips supply. The steepening of forward curves for industrial commodities will lead to higher price volatility in oil and metals markets, particularly copper: Demand will confront increasingly inelastic supply. In this evolution, prices will be forced to allocate inelastic supply as demand increases. Sometimes-sharp changes in price are required to equilibrate available supply with demand when this happens. This can be seen clearly in oil markets, but it holds true for all storable commodities (Chart 4).4 Investment Implications Industrial commodity markets are entering a more volatile phase, which will be characterized by sharp price movements up and down over the short term, as demand continues to outpace supply. Our analysis suggests this is the beginning of a more volatile phase in industrial commodity markets. The balance of risk in industrial commodity prices will remain to the upside as volatility increases. In the short term, fundamental imbalances can be addressed over a relatively short months-long horizon – i.e., OPEC 2.0 can release spare capacity over a 3-4 month interval to accommodate rising demand – so that price increases do not destroy demand as oil-exporters are rebuilding their fiscal balance sheets. Base metals markets will have a tougher time in the short run finding the supply to meet surging demand, but it can be done over the next year or so without prices getting to the point where demand-destruction sets in. Over the medium to long term, investor-owned oil and gas producers literally are being directed by policymakers, shareholders and courts toward an extended wind-down of production and investment in future production. Markets have been pricing through just such a situation in the post-COVID-19 world, with OPEC 2.0 managing supply against falling demand and still managing to reduce inventories significantly. If the world follows the IEA's pathway to a decarbonized future – in which no investment in new oil or gas production is required after 2025 – this will become the status quo for these markets going forward.5 Metals producers, on the other hand, are being encouraged to increase marketable supply at a rapid pace to accommodate demand driven by the build-out of renewable energy – chiefly wind and solar – and the grids that will be required to move this energy. Producers, however, remain reluctant to do so, fearing their capex investment to build out supply will produce physical surpluses that depress returns, similar to the last China-led commodity super-cycle. Supplying the necessary base metals to make this happen will be difficult at best, according to Ivan Glasenberg, CEO at Glencore. At this week's Qatar Economic Forum, he said copper supply will have to double between now and 2050 to meet expected demand for this critical metal. “Today, the world consumes 30 million tonnes of copper per year and by the year 2050, following this trajectory, we’ve got to produce 60 million tonnes of copper per year,” he said. “If you look at the historical past 10 years, we’ve only added 500,000 tonnes per year … Do we have the projects? I don’t think so. I think it will be extremely difficult.”6 The volatility we are expecting in oil, gas and base metals prices, will present buy-the-dip opportunities in related equities vehicles. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, matching the ~ 230% move in crude oil and the ~ 100% rise in copper prices. We remain long commodity index exposure – S&P GSCI, which is up 5.9% and the COMT ETF, which is up 7.6% – expecting steeper backwardations. The trailing stop on our MSCI Global Metals & Mining Producers ETF (PICK) position recommended 10 December 2020 was elected, which stopped us out with a gain of 23.9%. We are getting long the PICK again at tonight's close. 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 Commercial crude oil stocks in the US (ex-SPR barrels) fell 7.6mm barrels w/w in the week ended 18 June 2021, according to the US EIA. Including products, US crude and product inventories were down 5.8mm barrels. US domestic crude oil production was down 100k b/d, ending the week at 11.1mm b/d. Overall product supplied, the EIA's proxy for refined-product demand, was up 180k b/d at 20.75mm b/d, which is 129k b/d below 2019 demand for the same period. At 9.44mm b/d, gasoline demand was just below comparable 2019 consumption of 9.47mm b/d, while jet-fuel demand remains severely depressed vs. comparable 2019 consumption at 1.58mm b/d (vs. 1.92mm b/d). Distillate demand (e.g., diesel fuel) for the week ended 18 June 2021 was 3.95mm b/d vs. 3.97mm b/d for the comparable 2019 period. Base Metals: Bullish Benchmark spot iron ore (62% Fe) prices are holding above $210/MT in trading this week, as demand for the steel input remains strong in China (Chart 5). The Chinese Communist Party (CCP) increased its level of intervention in the iron ore market this week, launching investigations into “malicious speculation,” vowing to “severely punish” anyone found to be engaged in such behavior, according to ft.com.7 Benchmark iron ore prices hit $230/MT in May. We continue to expect exports from Brazil to pick up in 2H21, which will push prices lower in 2H21. Precious Metals: Bullish In the aftermath of last Wednesday’s FOMC meeting gold prices lost nearly $86/oz (Chart 6). Our colleagues at BCA Research's USBS believe markets are paying too much attention to the Fed’s dot plots, and not to the central bank’s verbal guidance.8 Originally, the Fed stated that it will only start raising interest rates once a checklist of three conditions have been met. This checklist includes guidance on actual and expected inflation rates and the labor market. Gold prices did not react to Chair Powell's testimony before the House Select Subcommittee on the Coronavirus Crisis. Ags/Softs: Neutral US spring wheat prices are rallying on the back of dry weather in the northern Plains, while forecasts for benign crop weather in the Midwest pressured soybeans lower this week, according to successfulfarming.com. Chart 5 Chart 6 Footnotes 1 Please see our most recent oil price forecasts published last week in Balance Of Risks Tilts To Higher Oil Prices. It is available at ces.bcaresearch.com. 2 Please see A Perfect Energy Storm On The Way published on June 3, 2021 for further discussion. 3 Please see Less Metal, More Jawboning published on May 27, 2021, which flagged China's likely decision to release strategic stockpiles of base metals. 4 Chart 4 shows implied volatility as a function of the slope of the forward curve, i.e., the difference between the 1st- and 13th-nearby futures divided by the 1st-nearby future vs implied volatilities for Brent and WTI options. This modeling extends Kogan et al (2009), mapping realized volatilities calculated using historical settlements of crude oil futures against the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009), "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64:3, pp. 1345-1375. 5 Please see fn 2's discussion of the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector beginning on p. 5 under The Case For A Carbon Tax. 6 Please see Copper supply needs to double by 2050, Glencore CEO says published on June 23, 2021 by reuters.com. Of course, being a copper producer with large-scale base-metals projects due to come on line in the next year or so, Mr. Glasenberg could be talking his book, but as Chart 3 shows, copper has been and likely will be in physical deficits for years. 7 Please see China cracks down on iron ore market, published by ft.com on June 21, 2021. 8 Please see How To Re-Shape The Yield Curve Without Really Trying, published on June 22, 2021. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Oil demand expectations remain high. Realized demand continues to disappoint. This means OPEC 2.0's production-management strategy – i.e., keeping the level of supply below demand – will continue to dictate oil-price levels. US producers will remain focused on consolidation via M&A and on returning capital to shareholders, in line with the Kingdom of Saudi Arabia's (KSA) expectation. Going forward, shale producers will focus on protecting and growing profit margins. The durability of OPEC 2.0's tactical advantage arising from its enormous spare capacity – ~ 7mm b/d – is difficult to gauge: Tightening global oil markets now in anticipation of Iran's return as a bona fide exporter benefits producers globally, and could accelerate the return of US shales if that return is delayed or re-opening boosts demand more than expected. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. Feature While the forecasted rebound in global oil demand continues to drive expectations for higher prices, it is the production discipline of OPEC 2.0 and capital discipline imposed on US shale producers that has and will continue to super-charge the recovery of prices. Continued monetary accommodation and fiscal stimulus notwithstanding, realized global oil demand has mostly flatlined at ~ 96mm b/d following its surge in February, as uncertainty over COVID-19 containment keeps governments hesitant about reopening their economies too quickly. Stronger demand in Asia, led by China, has been offset by weaker demand in India and Japan, where COVID-19 remains a deterrent to re-opening and recovery. The recovery in DM demand generally stalled over this period even as vaccine availability increased (Chart 2). Chart of the WeekOPEC 2.0 Comfortable With Higher Prices Chart 2Global Demand Recovery Stalled That likely will change in 2H21, but it is not a given: The UK, which has been among the world leaders in COVID-19 containment and vaccinations, delayed its full reopening by a month – to July 19 – in an effort to gain more time to bolster its efforts against the Delta variant first identified in India. In the US, New York state lifted all COVID-19-induced restrictions and fully re-opened this week. Still, even in the US, unintended inventory accumulation in the gasoline market – just as the summer driving season should be kicking into high gear – suggests consumers remain cautious (Chart 3). Chart 3Unintended Inventory Accumulation in US Gasoline Market We continue to expect the re-opening of the US and Europe (including the UK) will boost DM demand in 2H21, and wider vaccine availability will boost EM oil demand later in the year and in 2022. For all of 2021, we have lifted our demand-growth estimate slightly to 5.3mm b/d from 5.2mm b/d last month. We expect global demand to grow 4.1mm b/d next year and 1.6mm b/d in 2023. Our 2021 estimates are in line with those of the US EIA and the IEA. OPEC is more bullish on demand recovery this year, expecting growth of 6mm b/d. We continue to believe the risk on the demand side remains to the upside; however, given continued uncertainty around global COVID-19 containment, we remain circumspect. Supply-Side Discipline Drives Oil Prices OPEC 2.0 remains committed to its production-management strategy that is keeping the level of supply below demand. Compliance with production cuts in May reportedly was at 115%, following a 114% rate in April.1 Core OPEC 2.0 – i.e., states with the capacity to increase production – is holding ~ 7mm b/d of spare capacity, according to the IEA, which will allow it to continue to perform its role as the dominant supplier in our modeling (Chart 4). Earlier this year, KSA's Energy Minister Abdulaziz bin Salman correctly recognized the turn in the market that likely ensures OPEC 2.0's dominance for the foreseeable future – i.e., the shift in focus of the US shale-oil producers from production for the sake of production to profitability.2 This is a trend that has been apparent for years as capital markets all but abandoned US shale-oil producers. Chart 4OPEC 2.0 Remains Dominant Producers outside OPEC 2.0 – what we refer to as the "price-taking cohort" – have prioritized shareholder interests as a result of this market pressure, and remain focused on sometimes-forced consolidation via M&A, which we have been expecting.3 The significance of this evolution of shale-oil production is difficult to overstate, particularly as the survivors of this consolidation will be firms with strong balance sheets and a focus on profitability, as is the case with any well-run manufacturing firm. We also expect large producers to opportunistically shed production assets to reduce their carbon footprints, so as to come into compliance with court-ordered emission reductions and shareholder demands to reduce pollution.4 With the oil majors like Shell, Equinor and Oxy divesting themselves of shale properties, production increasingly will be in the hands of firms driven by profitability.5 We expect US shale-oil production to end the year at 9.86mm b/d and to average 9.57mm b/d next year; however, as the shales become the marginal global supply, production could become more volatile (Chart 5). The consolidation of US production also will alter the profitability of firms continuing to operate in the shales. We expect breakeven costs to fall as acquired production by stronger firms results in high-grading of assets – only the most profitable will be produced given market-pricing dynamics – while less profitable acreage will be mothballed until prices support development(Chart 6). Chart 5US Producers Focus On Profitability Chart 6Shale Breakevens Likely Fall As Consolidation Picks Up Supply-Demand Balances Tightening The current round of M&A consolidation and OPEC 2.0's continued discipline lead us to expect continued tightening of global oil supply-demand balances this year and next (Chart 7). This will allow inventories to continue to draw, which will keep forward oil curves backwardated (Chart 8). Chart 7Supply-Demand Balances Will Continue To Tighten Chart 8Tighter Markets, Lower Stocks The critical factor here will be OPEC 2.0's continued calibration of supply in line with realized demand and the return of Iran as a bona fide exporter, which we expect later this year. OPEC 2.0's restoration of ~ 2mm b/d of supply will be done by the beginning of 3Q21, when we expect Iran to begin restoring production and visible exports (i.e., in addition to its under-the-radar sales presently). The return of Iranian supply – and a possible increase in Libyan output – will present some timing difficulties for OPEC 2.0's overall strategy, but they will be short-lived. We continue to monitor output to assess the evolution of balances (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Investment Implications Oil demand will increase over the course of 2H21, as vaccines become more widely distributed globally, and the massive fiscal and monetary stimulus deployed worldwide kicks economic activity into high gear. On the supply side, markets will tighten on the back of continued restraint until Iranian barrels return to the market. The balance of risk is to the upside, particularly if the US and Iran are unable to agree terms that restore Iran as a bona fide exporter. In that case, the market tightening now under way will result in sharply higher prices. That said, realized demand growth has stalled over the past three months, which can be seen in unintended inventory accumulation in the US gasoline markets just as the summer driving season opens. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly as well to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. The big risk, as highlighted above, remains an acceleration of COVID-19 infections, hospitalizations and deaths, which force governments to delay re-opening or impose localized lockdowns once again. In this regard, KSA's strategy of calibrating its output to realized – vice forecasted – demand likely will remain in place. 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 China's refinery throughput surged 4.4% to 14.3mm b/d in May, a record high that surpassed November 2020's previous record of 14.26mm b/d, according to S&P Platts Global. The increased runs were not unexpected, and were largely accounted for by state-owned refiners, which operated at 80% of capacity after coming out of turnaround season. Turnarounds will fully end in July. In addition, taxes on niche refined-product imports are due to increase, which will bolster refinery margins as inventories are worked down. China's domestic crude oil production was just slightly more than 4mm b/d. Base Metals: Bullish China's Standing Committee approved the release an undisclosed amount of its copper, aluminum and zinc stockpiles via an auction process in the near future, according to reuters.com. The government disclosed its intent on the website of National Food and Strategic Reserves Administration on Wednesday; however, specifics of the auction – volumes and auction schedule, in particular – were not disclosed. Prices had fallen ~ 9% from recent record highs in the lead-up to the announcement, which we flagged last month.6 Prices rallied from lows close to $4.34/lb on the COMEX Wednesday (Chart 9). Precious Metals: Bullish After a worse-than-expected US employment report, we do not expect the Federal Reserve to lift nominal interest rates in Wednesday’s Federal Open Market Committee (FOMC) meeting. The Fed will only raise rates once the US economy reaches a level consistent with its definition of "maximum employment." Wednesday’s interest rate decision will be crucial to gold prices. If the Fed does not mention asset tapering or an interest-rate hike, citing current inflation as a transitory phenomenon, gold demand and prices will rise. On the other hand, if the Fed indicates an interest rate hike sooner than the previously stated 2024, this will weigh on gold prices (Chart 10). Ags/Softs: Neutral As of June 13, 96% of the US corn crop had emerged vs. the five-year average of 91%, according to the USDA. 68% of the crop was rated in good to excellent condition, slightly below the five-year average. In the bean market, 94% of the crop was planted as of 13 June, vs. the five-year average of 88%. The Department reported 86% of the crop had emerged vs. the five-year average of 74%. According to the USDA, 52% of the bean crop was in good-to-excellent condition vs the five-year average of 72%. Chart 9 Chart 10 Footnotes 1 Please see OPEC+ complies with 115% of agreed oil curbs in May - source published by reuters.com on June 11, 2021. 2 Please see Saudis raise U.S. and Asian crude prices for April delivery published by worldoil.com on March 8, 2021. 3 Please see US shale consolidation continues as Independence scoops up Contango Oil & Gas published by S&P Global Platts on June 8, 2021. 4 We discuss this in A Perfect Energy Storm On The Way, published on June 3, 2021. Climate activism will become increasingly important to the evolution of oil and natural gas production, and likely will lead to greater concentration of supply in the hands of OPEC 2.0 and privately held producers that do not answer to shareholders. 5 Please see Interest in Shell's Permian assets seen as a bellwether for shale demand published by reuters.com on June 15, 2021. 6 Please see Less Metal, More Jawboning, which we published on May 27, 2021. It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply. Higher commodity prices will ensue, and feed through to realized and expected inflation. Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred. Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year. We are upgrading silver to a strategic position, expecting a $30/oz price by year-end. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Chart 2Global Manufacturers' Prices Moving Higher These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View Chart 8Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Chart 10Wider Vaccine Distribution Will Support Gold Demand Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10). 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 The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Chart 12 Footnotes 1 Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2 In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination. 3 For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week. It is available at ces.bcareserch.com. 4 Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights China's high-profile jawboning draws attention to tightness in metals markets, and raises the odds the State Reserve Board (SRB) will release some of its massive copper and aluminum stockpiles in the near future. Over the medium- to long-term, the lack of major new greenfield capex raises red flags for the IEA's ambitious low-carbon pathway released last week, which foresees the need for a dramatic increase in renewable energy output and a halt in future oil and gas investment to achieve net-zero emissions by 2050. Copper demand is expected to exceed mined supply by 2028, according to an analysis by S&P, which, in line with our view, also sees refined-copper consumption exceeding production this year (Chart of the Week). A constitution re-write in Chile and elections in Peru threaten to usher in higher taxes and royalties on mining in these metals producers, placing future capex at risk. Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk. We remain bullish copper and look to get long on politically induced sell-offs as the USD weakens. Feature Politicians are inserting themselves in the metals markets' supply-demand evolutions to a greater degree than in the past, which is complicating the short- and medium-term analysis of prices. This adds to an already-difficult process of assessing markets, given the opacity of metals fundamentals – particularly inventories, which are notoriously difficult to assess. Chinese Communist Party (CCP) jawboning of market participants in iron ore, steel, copper and aluminum markets over the past two weeks has weakened prices, but, with the exception of steel rebar futures in Shanghai – down ~ 17% from recent highs, and now trading at ~ 4911 RMB/MT – the other markets remain close to records. Benchmark 62% Fe iron ore at the port of Tianjin was trading ~ 4% lower at $211/MT, while copper and aluminum were trading ~ 5.5% and 6.5% off their recent records at $4.535/lb and $2,350/MT, respectively. In addition to copper, aluminum markets are particularly tight (Chart 2). Jawboning aside, if fundamentals continue to keep prices elevated – or if we see a new leg up – China's high-profile jawboning could presage a release by the State Reserve Board (SRB) of some of its massive copper and aluminum stockpiles in the near term. In the case of copper, market guesses on the size of this stockpile are ~ 2mm to 2.7mm MT. On the aluminum side, Bloomberg reported CCP officials were considering the release of 500k MT to quell the market's demand for the metal. Chart of the WeekContinue Tightening In Copper Expected Chart 2Aluminum Remains Tight Brownfield Development Not Sufficient Our balances assessments continue to indicate key base metals markets are tight and will remain so over the short term (2-3 years). Economies ex-China are entering their post-COVID-19 recovery phase. This will be followed by higher demand from renewable generation and grid build-outs that will put them in direct competition with China for scarce metals supplies for decades to come. Markets will continue to tighten. In the bellwether copper market, we expect this tightness to remain a persistent feature of the market over the medium term – 3 to 5 years out – given the dearth of new supply coming to market. Copper prices are highly correlated with the other base metals (Chart 3) – the coefficient of correlation with the other base metals making up the LME's metals index is ~ 0.86 post-GFC – and provide a useful indicator of systematic trends in these markets. Chart 3Copper Correlation With LME Index Ex-Copper Copper ore quality has been falling for years, as miners focused on brownfield development to extend the life of mines (Chart 4). In Chart 5, we show the ratio of capex (in billion USD) to ore quality increases when capex growth is expanding faster than ore quality, and decreases when capex weakens and/or ore quality degradation is increasing. Chart 4Copper Capex, Ore Quality Declines Chart 5Capex-to-Ore-Quality Decline Set Market Up For Higher Prices Falling prices over the 2012-19 interval coincide with copper ore quality remaining on a downward trend, likely the result of previous higher prices that set off the capex boom pre-GFC. The lower prices favored brownfield over greenfield development. Goehring and Rozencwajg found in their analysis of 24 mines, about 80% of gross new reserves booked between 2001-2014 were due not to new mine discoveries but to companies reclassifying what was once considered to be waste-rock into minable reserves, lowering the cut-off grade for development.1 This is consistent with the most recent datapoints in Chart 5, due to falling ore grade values, as companies inject less capex into their operations and use it to expand on brownfield projects. Higher prices will be needed to incentivize more greenfield projects. A new report from S&P Global Market Intelligence shows copper reserves in the ground are falling along with new discoveries.2 According to the S&P analysts, copper demand is expected to exceed mined supply by 2028, which, in line with our view, sees refined-copper consumption exceeding production this year. Renewables Push At Risk Just last week, the IEA produced an ambitious and narrow path for governments to collectively reach a net-zero emissions (NZE) goal by 2050.3 Among its many recommendations, the IEA singled out the overhaul of the global electric grid, which will be required to accommodate the massive renewable-generation buildout the agency forecasts will be needed to achieve its NZE goals. The IEA forecasts annual investment in transmission and distribution grids will need to increase from $260 billion to $820 billion p.a. by 2030. This is easier said than done. Consider the build-out of China's grid, which is the largest grid in the world. To become carbon neutral by 2060, per its stated goals, investment in China’s grid and associated infrastructure is expected to approach ~ $900 billion, maybe more, over the next 5 years.4 The world’s largest fossil-fuel importer is looking to pivot away from coal and plans to more than double solar and wind power capacity to 1200 GW by 2030. Weening China off coal and rebuilding its grid to achieve these goals will be a herculean lift. It comes as no surprise that IEA member states have pushed back on the agency's NZE-by-2050 plan. This primarily is because of its requirement to completely halt fossil-fuel exploration and spending on new projects. Japan and Australia have pushed back against this plan, citing energy security concerns. Officials from both countries have stated that they will continue developing fossil fuel projects, as a back-up to renewables. Japan has been falling behind on renewable electricity generation (Chart 6). Expensive renewables and the unpopularity of nuclear fuel could make it harder for the world’s fifth largest fossil fuels consumer to move away from fossil fuels. Around the same time the IEA released its report, Australia committed $464 million to build a new gas-fired power station as a backup to renewables. Chart 6Japan Will Continue Building Fossil-Fuel Back-Up Generation Just days after the IEA report was published, the G7 nations agreed to stop overseas coal financing. This could have devastating effects for emerging and developing nations‘ electricity grids which are highly dependent on coal. In 2020 70% and 60% of India and China’s electricity respectively were produced by coal (Chart 7).5 Chart 7EM Economies Remain Reliant On Coal-Fired Generation Near-Term Copper Supply Risks Rise Even though inventories appear to be rebuilding, mounting political risks keep us bullish copper (Chart 8). Lawmakers in Chile and Peru are in the process of re-writing their constitutions to, among other things, raise royalties and taxes on mining activities in their respective countries. This could usher in higher taxes and royalties on mining for these metals producers, placing future capex at risk. In addition, Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk.6 None of these events is certain to occur. Peruvian elections, for one thing, are too close to call at this point, and Chile has a history of pro-business government. However, these are non-trivial odds – i.e., greater than Russian roulette odds of 1:6 – and if any or all of these outcomes are realized, higher costs in copper and lithium prices would result, and miners would have to pass those costs on to buyers. Bottom Line: We remain bullish base metals, especially copper. Another leg up in copper would pull base metals higher with it. We would look to get long on politically induced sell-offs, particularly with the USD weakening, as expected Chart 8Global Copper Inventories Rebuilding But Still Down Y/Y 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 Next Tuesday's OPEC 2.0 meeting appears to be a fairly staid affair, with little of the drama attending previous gatherings. Russian minister Novak observed the coalition would be jointly "calculating the balances" when it meets, taking into account the likely official return of Iran as an exporter, according to reuters.com. We expect a mid-year deal on allowing Iran to return to resume exports under the nuclear deal abrogated by the Trump administration in 2019, and reckon Iran has ~ 1.5mm b/d of production it can bring back on line, which likely would return its crude oil production to something above 3.8mm b/d by year-end. We are maintaining our forecast for Brent to average $64.45/bbl in 2H21; $75 and $78/bbl, in 2022 and 2023, respectively. By end 2023, prices trade to $80/bbl. Our forecast is premised on a wider global recovery going into 2H21, and continued production discipline from OPEC 2.0 (Chart 9). Base Metals: Bullish Our stop-losses was elected on our long Dec21 copper position on May 21, which means we closed the position with 48.2% return. The stop loss on our long 2022 vs short 2023 COMEX copper futures backwardation recommendation also was elected on May 20, leaving us with a return of 305%. We will be looking for an opportunity to re-establish these positions. Precious Metals: Bullish We expect the collapse in bitcoin prices, the US Fed’s decision to not raise interest rates, and a weakening US dollar to keep gold prices well bid (Chart 10). China’s ban on cryptocurrency services and Musk’s acknowledgment of the energy intensity of Bitcoin mining sent Bitcoin prices crashing. The Fed’s decision to keep interest rates constant, despite rising inflation and inflation expectations will reduce the opportunity cost of holding gold. According to our colleagues at USBS, the Fed will make its first interest rate hike only after the US economy has reached "maximum employment". The Job Openings and Labor Turnover Survey reported that job openings rose nearly 8% in March to 8.1 million jobs, however, overall hiring was little changed, rising by less than 4% to 6 million. As prices in the US rise and the dollar depreciates, gold will be favored as a store of value. On the back of these factors, we expect gold to hit $2,000/oz. Ags/Softs: Neutral Corn futures were trading close to 20% below recent highs earlier in the week at ~ $6.27/bu, on the back of much faster-than-expected plantings. Chart 9 Chart 10 Footnotes 1 Please refer to Goehring & Rozencwajg’s Q1 2021 market commentary. 2 Please see Copper cupboard remains bare as discoveries dwindle — S&P study published by mining.com 20 May 2021. 3 Please see Net Zero by 2050 – A Roadmap for the Global Energy Sector, published by the IEA. 4 Please see China’s climate goal: Overhauling its electricity grid, published by Aljazeera. 5 We discuss this in detail in Surging Metals Prices And The Case For Carbon-Capture published 13 May 2021, and Renewables ESG Risks Grow With Demand, which was published 29 April 2021. Both are available at ces.bcaresearch.com. 6 Please see A game of chicken is clouding tax debate in top copper nation, Fujimori looks to speed up projects to tap copper riches in Peru and Codelco says 40% of its copper output at risk if glacier bill passes published by mining.com 24, 23 and 20 May 2021, respectively. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand. This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption. We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year. This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023. Chart 3US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Chart 7Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond. 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 The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 Chart 11 Footnotes 1 Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Over the 2021-22 period, renewable capacity will account for 90% of global electricity-generation additions, per the IEA's latest forecast. This will follow the 45% surge (y/y) in renewable generation capacity added last year, which occurred despite the COVID-19 pandemic (Chart of the Week). Continued investment in renewables and EVs – along with a global economic rebound – are pushing forecasts at banks and trading companies to a $13k - $20k/MT range for copper, vs. ~ $10.6k/Mt (~ $4.80/lb) at present. Should these stronger metals forecasts prove out, investments that extend low-carbon use of fossil fuels via carbon-capture and circular-use technologies will become more attractive. Investment in these technologies has been limited because there is no explicit global reference price to assess investments against. A carbon market or tax would provide such a bogey and accelerate investment. It could be monitored via a Carbon Market Club, which would limit trade to states posting and collecting the tax.1 Feature At almost 280GW, renewable energy capacity additions last year increased 45% y/y, the most since 1999, according to the IEA's most recent update on renewable energy.2 For this year and next, renewables are expected to account for 90% of capacity additions, led by solar PV investment increasing ~ 50% to 162GW. Wind capacity grew 90% last year, increasing to 114GW, and is expected to increase ~ 50% to end-2022. As renewables generation – and EV investment – continues to grow, demand for bulks (steel and iron ore) and base metals, led by copper, will pull prices higher. This is occurring against a backdrop of flat supply growth and physical deficits over the four years ended 2020 (Chart 2). According to the IEA, a 40% increase in steel and copper prices over the September 2020 to March 2021 period played a role in higher solar PV module prices. Chart of the WeekRenewables Capacity Surges The supply side of the copper market will remain in deficit this year and next, in our assessment, and may continue on that trajectory if, as Wood Mackenzie expects, demand grows at a 2% p.a. rate over the next 20 years and miners remain reluctant to commit to the capex required to keep up with demand.3 Chart 2Physical Deficits Will Draw Copper Stocks... ESG risk for copper – and other metals required to build the generation and infrastructure required in the renewables buildout – will increase as prices rise, which also will add to cost.4 Cost increases coupled with increasing ESG risks in this buildout will increase the attractiveness of carbon-capture and circular-economy technology investment, in our view. This would extend the use of low-carbon fossil fuels if the technology can move the world closer to a net-zero carbon future. However, unless and until policy catalyzes this investment, – e.g., via a global carbon trading price or tax – investment in these technologies likely will continue to languish. Carbon-Capture Tech's Unfulfilled Promise The history of Carbon Capture, Utilization and Storage (CCUS) has been one of high hopes and unmet expectations. It is generally recognized as a route to mitigate climate change; however, its deployment has been slower than expected. Low-carbon technology requires more critical metals than its fossil-fuel counterpart (Chart 3). Apart from the issue of cost, the ESG risks of mining metals for the renewable energy transition will increase as more metals are demanded, which we discussed in previous research.5 According to Wood Mackenzie, mining companies will need to invest nearly $1.7 trillion in the next 15 years to help supply enough metals to transition to a low carbon world.6 Chart 3Low-Carbon Tech Is Metals Intensive Given these looming physical requirements for metals, fossil fuels most likely will need to be used for longer than markets currently anticipate, as a bridge to the low-carbon future, or as part of that future, depending on how successfully carbon is removed from the hydrocarbons used to power modern society. If so, using fossil fuels while mitigating their environmental impact will require highly focused technology to lower CO2 and other green-house gas (GHG) emissions during the transition to a low-carbon future. Enter CCUS technology: This technology traps CO2 from sources that use fossil fuels or biomass to make the energy required to run modern societies. In the current iterations of this technology, CO2 can either be compressed and transported, or stored in geological or oceanic reservoirs. This can then be used for Enhanced Oil Recovery (EOR) to extract harder-to-reach oil by injecting CO2 into the reservoirs holding the hydrocarbons.7 The Scope For CCUS Investment CCUS investment spending is increasing, as are the number of planned facilities using or demonstrating this technology. In the 2020 edition of its Energy Technology Perspectives, the IEA noted 30 new integrated CCUS facilities have been announced since 2017, mostly in advanced economies such as US and Europe, but also in some EM nations. As of 2020, projects at advanced stages of planning represented a total of $27 billion, more than double the investment planned in 2017 (Chart 4). Among its many goals, the Paris Agreement seeks a balance between emissions by man-made sources and removal by greenhouse gas (GHGs) sinks (absorption of the gases) in the second half of the 21st century. Practically, many countries – especially EM economies – will still need to use fossil fuels to develop during this period (Chart 5).8 Chart 4Carbon-Capture Projects To Date Chart 5EM Development Will Require Fossil-Fuel Energy CCUS In The Energy Sector As a fuel that emits fewer GHGs than coal – i.e., half the CO2 of coal – natural gas can be used effectively as a bridge to green-power generation (Chart 6). Chart 6Natural Gas Will Remain Attractive As A Bridge Fuel The CO2 in natgas needs to be removed before dry gas is sold as pipeline-quality gas or LNG. This CO2 is normally vented to the atmosphere; however, by using CCUS technology, it can be reinjected into geological formations and used for EOR. For this reason, LNG companies in the US, the world’s largest LNG exporter, have been looking into investing in CCUS technology in a bid to become greener.9 CCUS can also be used to produce low-cost hydrogen – so-called blue hydrogen – using natural gas and coal, as opposed to the more expensive electrolysis process, which uses renewables-based electricity to produce "green" hydrogen. The lower blue-hydrogen costs will make clean hydrogen more accessible to emerging nations, opening new avenues for the world to use the energy carrier in its decarbonization effort. The Value Of Ccus In Other Industries CCUS technology can be retrofitted to existing power and industrial plants, which, according to the IEA, could otherwise still emit 8 billion tons of CO2 in 2050, around one-quarter of annual energy-sector emissions in 2020. Of the fossil fuel generators, coal-fired power generation presents the biggest CO2 challenge, with most of the emissions coming from China and other EM Asia nations, where the average plant age is less than 20 years. Since the average age of a coal fired power plant is 40 years, according to the US National Association of Regulatory Commissioners, this implies that these plants have a long remaining life and could still be operating until 2050. CCUS is the only alternative to retiring or repurposing existing power and industrial plants. The IEA believes that CCUS is imperative to reach net-zero carbon emissions. In its Sustainable Development Scenario - in which global CO2 emissions from the energy sector decline to net-zero by 2070 – CCUS accounts for 15% of the cumulative reduction in emissions. If the world needs to reach net-zero by 2050 instead, it will need almost 50% more CCUS deployment.10 Properly implemented and scaled, CCUS can allow industries to continue using oil, gas and coal and to attain net-zero carbon emission targets, boosting demand for fossil fuels in the medium term. This is especially important to EM development. Why Aren’t We Further Along In CCUS? What Can Be Done? The main reason CCUS isn’t used more widely is because of its cost. Currently, the cost of capturing carbon varies, based on the amount of CO2 concentration, with Direct Air Capture being most expensive (Chart 7). Given the prohibitive costs, CCUS has not been commercially viable. However, the same argument could have been used against implementing renewable sources of energy. While at one point the Levelized Cost of Energy from renewable sources was high, as these sources have been scaled up – aided in no small part by government subsidies – costs have fallen, following something akin to a Moore’s Law cost-decay curve. A Levelized Cost of Energy for solar generation reported by Lazard Ltd., which allows for comparisons across technologies (e.g., fossil-fuel vs renewable), shows generation costs fell by 89% to $40/MWh from $359/MWh from 2009-2019 (Chart 8). This learning curve was able to take place because of government subsidies, which promoted the deployment of solar technology. Chart 7CCUS Can Be Expensive Chart 8Subsides Could Support CCUS, Just As Was Done For Solar The cost of CCUS technology is falling. For example, in 2019 the Global CCS Institute reported it cost $100/ton to capture carbon from the Canada-based Boundary Dam using a CCS unit built in 2014. The cost of carbon captured at the US-based Petra Nova plant – built three years later – using improved technology was $65/ton. Both are coal-powered electricity plants. The report also noted coal-fired power plants planning to commence operations in 2024-28 using the same CCS technology as those at Boundary Dam and Petra Nova expect carbon costs to be ~ $43/ton, due to steeper learning curves, research, lower capital costs due to economies of scale, and digitalization. One commonality amongst these sources of cost reductions is that companies need to invest more into CCUS and familiarize themselves with this technology. As was the case with renewables, government subsidies would reduce the prohibitive costs of operating CCUS technology, and draw more participation to refining this technology. Early, first-of-its-kind CCUS will be expensive, however subsidies in the form of capital support or tax credits will increase CCUS implementation and research. Boundary Dam and Petra Nova are examples of facilities that benefitted from government subsidies. The facilities received $170 million and $200 million respectively from Canadian and US Government agencies at the time of the CCS units’ construction. The US has also implemented a 45Q tax credit system which pays facilities $50/ton of CO2 stored and $35/ton of CO2 if it is used in applications like Enhanced Oil Recovery. According to the Global CCS Institute, in late-2019, of the eight new CCUS projects that were added in the US, four cited the presence of 45Q as the key driver. Putting Carbon Markets And Taxes To Work The EU’s Emissions Trading System (ETS) market, which was implemented in 2005, is an example of innovative policy which incentivizes companies to curb emissions, using market forces. The price of carbon measured in these markets puts a tangible value on a negative externality, which before this went unrecorded. The downside of this ETS is its reliance on the EU's environmental policy implementation, which is subject to policy changes that complicate supply-demand analysis for longer-term planning – e.g., the recent increase in its emissions target to a minimum of 55% net reduction in GHG emissions by 2030. An alternative to policy-driven trading of emissions rights is a per-ton tax on emissions, which governments would impose and collect. This would raise costs of technologies using fossil fuels – including those used in the mining industry to increase supply of critical bulks and base metals needed for the renewables transition. At the same time, such a tax would give firms supplying and using technologies that raise CO2 levels an incentive to lower CO2 output using CCUS technologies. ETS markets and governments imposing CO2 taxes could form Carbon Market Clubs – a technology developed by William Nordhaus, the 2018 Nobel Laureate in Economics – that restrict trading to states that can demonstrate their participation and support of actual carbon-reduction detailed in the Paris Agreement via trading or tax schemes.11 As the green energy transition gains traction and governments implement more net-zero emissions policies, the price of carbon will rise. As the price of carbon rises, the price tag associated with companies’ carbon emissions will increase with it. With market participants expecting the price of carbon to continue to rise after hitting record values, the incentive for companies operating in the EU to use CCUS technology will rise, as would the incentive for firms facing a carbon tax.12 Bottom Line: Given the meteoric price rise of green metals, underfunded capex, and the ESG risks associated with mining metals for the low carbon future, we expect fossil fuels to play a larger role in the transition to a low-carbon society than markets are currently expecting. For countries to be able to use fossil fuels while ensuring they achieve their climate goals, the use of CCUS technology is important. To increase CCUS uptake, governments will need to subsidize this technology until demand for it gains traction, just like in the case of renewables. Encouraging ETS and carbon-tax schemes also will be required to catalyze action. 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 Brent prices were knocking against the $70/bbl door going to press, following the IEA's assessment of a robust demand recovery in 2H21 (Chart 9). The IEA took its 1H21 demand growth down 270k b/d, owing to COVID-19-induced demand destruction in India, OECD Americas and Europe, but left its 2H21 estimate intact, making overall demand growth for this year 5.4mm b/d. The EIA also expects 5.4mm b/d demand growth for this year, and growth of 3.7mm b/d next year. OPEC left its full-year 2021 demand growth estimate at 6mm b/d. OPEC 2.0 meets again on June 1 and will look to return more of its sidelined production to the market, in our estimation. We will be updating our supply-demand balances and price forecasts in next week's report. Base Metals: Bullish Spot copper prices traded on either side of $4.80/lb on the CME/COMEX market this week as we went to press. Threats of a tax increase in Chile, where a bill calling for such a measure is making its way through Congress; a potential strike by mine workers; and a shortage of sulfuric acid used in the extraction of ore brought about, according to Bloomberg, by reduced global sulfur supplies due to lower refinery runs during the pandemic all are keeping copper well bid. Our target for Dec21 COMEX copper remains $5/lb (~ $11k/ton on the LME). We remain long calendar 2022 COMEX copper vs short 2023 COMEX copper expecting physical supply deficits to continue to force storage draws, which will backwardate the metal's forward curve. Precious Metals: Bullish US CPI data on Wednesday showed that headline inflation rose by 4.2% for the month of April compared to the previous year. While this increase is the highest since 2008, this jump could also be fueled by a low base effect – Inflation levels were falling this time last year as the pandemic picked up. While rising prices increases demand for gold as an inflation hedge, if the Federal Reserve increases interest rates on the back of this data, the US dollar will rise, negatively affecting gold prices (Chart 10). However, we do not expect the Fed to abruptly change its guidance on this report, and therefore expect the central bank will treat this blip as transitory. As of yesterday’s close, COMEX gold was trading at $1,835.9/oz. Ags/Softs: Neutral Going to press, the Chicago soybean market was surging ahead of the scheduled World Agriculture Supply and Demand Estimates (WASDE) report due out later Wednesday. Front-month beans were trading ~ $16.70/bu, up 2% on the day. This month's WASDE will contain the USDA's first estimate for demand in ag markets for the 2021/22 crop year. Markets are expecting supplies to tighten as demand strengthens. Chart 9 Chart 10 Footnotes 1 Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016. The intellectual and computational framework for such technology was developed by William Nordhaus, the 2018 Nobel Laureate in Economics. 2 Please see Renewable Energy Market Update, Outlook for 2021 and 2022.pdf, published by the IEA this week. 3 WoodMac notes, "without additional substantial investment, production will decline from 2024 onwards. Coupled with demand growth, this decline in output will lead to a theoretical shortfall of around 16 Mt by 2040." The consultancy estimates an additional $325 - $500+ billion will be needed to meet copper demand over this period. Please see Will a lack of supply growth come back to bite the copper industry? Published 23 March 2021 by woodmac.com. 4 Please see Renewables ESG Risks Grow With Demand, which we published 29 April 2021. It is available at ces.bcaresearch.com. 5 Refer to footnote 4. 6 Please see Low carbon world needs $1.7 trillion in mining investment, published by Reuters. 7 This method is used to increase oil production. It changes the properties of the hydrocarbons, restores formation pressure and enhances oil displacement in the reservoir. Using EOR, oil companies can recover 30% to 60% of the original oil level in the reservoir. Please see Enhanced Oil Recovery published by the US Department of Energy. 8 Please see the Reuter’s column CO2 emission limits and economic development. 9 Please see World Oil’s U.S. LNG players tout carbon capture in bid to boost green image. 10 Please see IEA’s Special Report on Carbon Capture Utilisation and Storage, published as a part of the Energy Technology Perspective 2020. 11 See footnote 1 above. 12 Please see Cost of polluting in EU soars as carbon price hits record €50 by the Financial Times. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
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
Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks... But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021 II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.
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