HOUSE_OVERSIGHT_014775.jpg

Tail risk 3: China-led commodity weakness Commodity collapse hedge: buy AUD/USD 6m 0.67 digital put Metal and bulk commodity prices have skyrocketed in anticipation of infrastructure spending in the US, We are wary of this rally: tax cuts are likely to be the first line of fiscal stimulus and potentially easier to get through Congress than sizeable infrastructure spending, which in any case will take a longer time to impact commodity demand (allowing for supply adjustments). Perhaps most importantly, China is still the swing factor for global commodity prices and the risks here remain to the downside. The recent dramatic rise for China-linked bulk commodity prices, especially coal, has been driven by a combination of supply and demand imbalances (China floods, pit closures and inventory shortages) and an apparent rise in speculative activity in futures markets that has already drawn attention from regulators (Chart 76). Our resource analysts have raised forecasts but still see moderation over 2017 (Chart 77). The futures forward curve has already moved into backwardation. We see iron ore prices back at USD50/t in 2017 compared to a current spot price of USD74. While global reflation might be positive for commodities, there are reasons for caution: « We expect Chinese property investment, the most commodity-intensive sector of the economy, to slow in 2017. * Sizeable RMB depreciation would be an additional deflationary impulse for industrial commodities. « There will be a supply response as current prices bring uneconomic producers back on line, admittedly with a lag. ¢ There is potential for trade friction to impact regional trade while higher US rates are already impacting regional EM currencies. Australia is especially exposed to intra-regional trade and resource demand from the region. Persistent supply/demand imbalances ahead of Chinese New Year might delay commodity weakness until after 1Q17, especially for coking coal due to a preference for thermal coal supplies over the Chinese winter. However, the risk of a sharp reversal beyond is worth hedging against given the demand dynamics in China, most obviously through the AUD. While short-dated implied volatility rose following the US election, the risk-reversal skew remains high as a percentage of implied volatility relative to G10 pairs. This suggests hedging via AUD/USD digital puts is appropriate, in our view. Trade recommendation: Buy 6m AUD/USD 0.67 digital put, entry: 10% (spot reference: 0.7550). Risk is global demand recovery provides support to commodity prices. Chart 76: Bulk commodity spot prices Chart 77: China Coking coal futures and BAML forecasts Our 2017 forecasts for Liulin No.4 Coking coal are averages for 1H and 2H USDit 400 F RMB/t Iron Ore (china) 1600 3200 a6 300 ——— Aus Thermal Coal 4400 o Sa%e8 2800 fae 2400 Hardcoal (Coking) spot e a . 2000 200 ° 1000 1600 100 | 800 Coking Coal Future (Ihs) 4200 —e«—Futures Curve 800 800 —*—BAML Forecast 0 Volume (rhs, 000s contracts) 400 11 12 13 14 15 16 17 400 0 Source: Bof A Merrill Lynch Global Research, Bloomberg Jan-16 May-16 — Sep-16 Jan-17 May-17 Sep-17 Jan-18 Source: Bof A Merrill Lynch Global Research, Bloomberg Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 45 HOUSE_OVERSIGHT_014775