Economy

Special Report

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Special Report

Highlights Both the massive inventory accumulation and robust underlying consumption have been driving Chinese crude imports in recent years. Chinese crude oil import growth will decelerate in 2021 due to a slower pace in the country’s oil inventory accumulation. The country’s underlying crude oil consumption growth will remain robust this year, which will support a still positive growth in Chinese crude oil imports this year. Strong Chinese crude oil imports are positive to global oil prices this year. Feature The gap between China’s total crude oil supply and its domestic crude oil consumption has been widening in recent years, due to a massive buildup in Chinese crude oil inventory (Chart 1A and 1B). In fact, China’s crude oil inventories have quadrupled in the past five years, exceeding two billion barrels as of November 2020 and are equal to about 70% of OECD total inventory (Chart 2). Chart 1AA Massive Buildup In Chinese Crude Oil Inventory Chart 1BChina: Total Crude Oil Supply Growth Has Exceeded Its Domestic Consumption Growth In addition, China’s crude oil import growth has been outpacing domestic oil consumption growth, while domestic production remains stagnant (Chart 3). Chart 2Crude Oil Inventories In China Have Quadrupled In The Past Five Years Chart 3China: Crude Oil Import Growth Has Been Stronger Than Its Domestic Consumption Growth Will China maintain its strong crude oil import growth this year? How will the interplay between domestic consumption and imports evolve in 2021? We expect China’s crude oil consumption growth to remain solid in 2021, growing at an annual rate of about 6-7% and up from the 4.5% growth rate reached in 2020. However, China’s crude oil imports are likely to increase by 4-6% in 2021 from the previous year, slower than the 7.2% growth seen in 2020. The moderation in Chinese oil imports in 2021 will mainly be due to a slower pace of crude oil inventory buildup. Understanding The Surge In Crude Oil Inventory Chart 4China's Crude Oil Inventory Buildup: One Major Driver Behind Its Strong Imports Since 2016 The massive buildup in domestic crude oil inventory has been one major driving force behind the strong growth in China's crude oil imports since 2016 (Chart 4). As oil prices continue to rebound, and given China’s existing large oil inventories, we think the pace of inventory accumulation in China will slow in 2021. Therefore, growth in Chinese oil imports this year will likely moderate. China’s crude oil imports currently account for about 75% of the country’s total crude oil supply. Since China’s domestic crude oil production has been stagnant in the last decade, the fluctuations in Chinese crude oil imports are largely driven by the change in the country’s total demand, which includes both domestic consumption and changes in inventories. China’s crude oil import growth has significantly outpaced domestic consumption growth in the past five years, leading to a buildup in inventory. China’s crude oil inventory includes Commercial Petroleum Reserves (CPR), which are held by refiners and traders; and Strategic Petroleum Reserves (SPR), which are held by the government. Our Chinese crude oil inventory proxy1 was constructed based on the crude oil flow diagram shown in Chart 5.  Chart 5How Did We Derive Our Chinese Crude Oil Inventory Proxy? Our research has suggested that since 2016, most of the buildup has occurred in CPR. This is due to the following: The government in 2015 required refiners to keep their inventory level at no less than their 15-days requirement for operation use. Chinese refinery capacity had been expanded at a compound annual growth rate (CAGR) of 2.8% during 2016-2019. These existing and new refineries have been building their inventories to meet government regulations in the past several years.  In addition, the government started to allow independent refineries to import crude oil by setting a quota in mid-2015, and the import quotas have been increased every year. In 2020, the quota reached 184.6 million tons, equaling to about 3,700 kbpd, nearly five times the quota in 2015. The total increase in imports of these independent refiners over the past five years was about 2,950 kbpd, accounting for 70% of the increase in the country’s total crude oil imports during the same period. Chart 6China: Rising Run Rates For Its Independent Refineries Independent refiners import crude oil for both refinery purposes and to meet the new inventory requirement. Over the last several years, the increased amount of quota has improved Chinese independent refiners’ profitability and refinery capacity run rate, as the import quota allows these private sector refiners to save operating costs by cutting out the “middleman” and by actively managing their own feedstocks. For example, Shandong has the largest number of independent refineries among all provinces. Chart 6 shows that the run rate of the region’s independent refineries has surged since 2016, from about 40% in that year to 75% this year. In addition, since 2016, the fluctuations in their run rates have become much more closely correlated with global oil prices.   Commercial crude oil users have much larger physical reserve space than the SPR. Notably, they tend to sharply increase their imports when crude oil prices are low.  In addition, inventory accumulation often occurs when credit/financing is available with low costs and refiners expect higher prices ahead. Meanwhile, our research shows the SPR development has been slowing considerably in recent years, resulting in little inventory buildup in SPR. The last time the National Bureau of Statistics (NBS) reported the SPR data was December 29, 2017. It showed the SPR was about 37.73 million tons by mid-2017, not far from the country’s target of 40 million tons for the first two phases2 of SPR. This suggests that the country was at least close to finishing its second phase of the SPR in 2017. Since then, there has been little information about the third phase of the SPR progress. We have only been able to find two pieces of news on that subject, and both suggest the construction of the third phase of SPR has been stagnant, and the planning of two sites only started in 2019. As the average construction time for projects in the second phase of SPR was about four years, we do not think these sites were completed in 2020. The NBS data shows that even during the period of mid-2015 and mid-2017, the SPR had only increased by 234 kbpd, about 117 kbpd per year. In comparison, the Chinese total crude oil inventory increased by 600-700 kbpd per year in 2016 and 2017. Clearly, SPR only accounted for a small share of the Chinese total crude oil inventory. Looking forward, we expect a much slower pace of crude oil inventory buildup in China in 2021. Our forecast is based on the following factors: Current Chinese crude oil inventories (CPR and SPR combined) are already in the upper range when comparing the OECD countries (Chart 7). Although the IEA data shows that Japan and Korea have oil stocks of 200 days and 193 days of their respective crude oil net imports, Chinese oil inventories are currently equivalent to 195 days of crude oil net imports and much higher than the 90 days the IEA requires OECD countries to hold. With Brent oil prices having risen by a lot from the April 2020 trough and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. In comparison, Chinese crude oil inventory accumulation growth slowed sharply in 2018 when Brent oil prices rose by 95% from their trough in mid-2017 (Chart 8), A significant portion of Chinese oil inventory buildup was accumulated over the past five years. At 1,170 kbpd, the largest annual accumulation was in 2020, higher than the 700-900 kbpd fill per year during 2017-2019. Chart 7China's Crude Oil Inventory: No Longer Low Chart 8China: Rising Oil Prices Will Likely Slow Down Its Pace Of Crude Oil Inventory Accumulation We do not expect the fast inventory accumulation of 2020 to repeat in 2021. Instead, a mean-reversal in the inventory accumulation pace will likely occur. Table 1Our Estimates Of The Scale Of Chinese Crude Oil Inventory In 2021 Our baseline estimate based on China’s 2021 import quota and refinery capacity3 is that Chinese crude oil inventory will increase to 207-210 days of Chinese crude oil imports by this year-end, up from 192 days at last year-end (Table 1). With already-elevated crude oil inventory, the pace of the inventory accumulation in China will be slower than last year. Bottom Line: After a massive buildup over recent years, the pace of inventory accumulation in China will slow in 2021 and probably onwards as well. As a result, Chinese oil import growth will converge with the pace of domestic consumption growth. China’s Robust Crude Oil Consumption Growth In 2021 Chart 9China: Resilient Domestic Crude Oil Consumption Growth In 2020 Despite the pandemic outbreak, last year’s underlying consumption of crude oil in China was resilient at a year-on-year growth of 4.5%, even though the rate was smaller than the average growth of 6-7% in 2018-2019 (Chart 9).  The growth in oil consumption last year was mainly from the non-transportation sector. The output of non-transportation fuels, including fuel oil, naphtha, petroleum coke, and petroleum pitch, are mostly having impressive growth, suggesting strong consumption in sectors like chemical products, steel sector and infrastructure (Chart 10). For example, naphtha is the primary feedstock for ethylene production. Ethylene is the building block for a vast range of chemicals from plastics to antifreeze solutions and solvents. Transportation fuel consumption was weak in 2020, with the output of major transportation fuels including gasoline, diesel oil and kerosene in contraction (Chart 11). Chart 10Strong Consumption In Non-Transportation Sectors in 2020 Last Year Chart 11Transportation Fuel Consumption Was Weak In 2020 In 2021, we expect the underlying consumption growth of crude oil in China to increase to 6-7% from last year’s 4.5%. This will be in line with its growth in both 2018 and 2019 (Chart 9 on page 7). First, the consumption of transportation fuels will likely recover this year. Transportation fuels are the largest consuming sector for Chinese petroleum products. Based on British Petroleum data, gasoline, diesel and kerosene accounted for 55% of total Chinese oil consumption in 2019. We expect the transportation fuel consumption growth to be stronger (i.e., 6-7%) than its five-year compounded annual growth rate (CAGR) of 4.1% during 2015-2019. Chart 12China's Automobile Sales Correlated Well With Its Crude Oil Imports Automobile sales in China correlated well with the country’s crude oil imports (Chart 12, top panel). Despite a year-on-year contraction of 2% for the whole year of 2020, automobile sales had been strong with a double-digit growth nearly every month since May. Only 5% of these automobiles are new energy vehicles (NEV). About 80% of them are gasoline cars and 15% are diesel automobiles. Annual total car sales still account for about 9% of total existing automobiles (Chart 12, bottom panel). This means a 6-7% growth in the transportation consumption of passenger cars and commercial cars is very possible in 2021. The number of airports and airplanes are still on the uptrend in China. The CAGR of Chinese kerosene consumption rose from 10.1% during 2010-2014 to 10.6% during 2015-2019. This suggests that the kerosene consumption growth in China could reach 11% in 2021. Domestic gasoline and diesel prices are near decade lows (Chart 13). This will encourage consumption of these fuels. Second, the oil consumption growth in the industry sector will likely be larger than the 5% in the recent years (Chart 14). Based on the NBS data, the industry sector accounts for about 36% of China’s petroleum product consumption. Chart 13Low Domestic Gasoline And Diesel Prices Encourage Fuel Consumption This Year Chart 14Robust Oil Consumption Growth In The Industry Sector In 2021 Third, infrastructure spending and property market construction will slow in 2H2021 given the credit, fiscal, and regulatory tightening that has been taking place. However, construction only accounts for about 6% of Chinese petroleum product consumption.  Given all of this, achieving a 6-7% underlying consumption growth of crude oil in China this year is possible. Taking into consideration the slower pace of inventory buildup, we expect China’s crude oil imports to increase by 4-6% in 2021 over the previous year, slower than last year’s 7.2% growth. Bottom Line: The underlying consumption growth of crude oil in China is likely to increase to 6-7% in 2021 from last year’s 4.5%, providing solid support to China’s crude oil imports. What About Other Factors Affecting Chinese Crude Oil Imports? Currently, both domestic crude oil production and net exports of Chinese petroleum products exports are small contributors to the growth of Chinese crude oil imports. However, as the Chinese petroleum export sector becomes more competitive in the global market, it will likely take a bigger share of China’s crude oil imports going forward. Chart 15Net Exports Of Chinese Petroleum Products Are On The Uptrend We expect domestic crude oil output to be stagnant in 2021. The breakeven prices for most domestic oil fields are US$50-60 per barrel. Without a considerable rally in oil prices, the total domestic crude oil output is unlikely to pick up. Moreover, due to the massive crude oil inventory buildup in recent years, Chinese oil producers may constrain their output. In this scenario, a reduction in domestic crude oil output by 1-2% in 2021 from 2020 is possible. Nonetheless, this will only increase China’s oil imports by a small amount of about 40-80 kbpd. The net exports of Chinese petroleum products are on the uptrend (Chart 15). Currently net exports of Chinese petroleum products account for only about 6% of Chinese crude oil imports.  However, Chinese refineries are increasingly competitive in global gasoline and diesel markets, since most of the new refineries in the country are high technology equipped and highly efficient. In addition, last July, China started issuing export licenses to private refiners, and we expect the trend to continue. According to Bloomberg, China is set to surpass the US to become the world’s largest oil refiner in 2021. As such, in the coming years we expect rising Chinese exports of petroleum products will demand more imports of crude oil.  We expect Chinese petroleum products net exports to rise by 100-150 kbpd in 2021 15-20% growth from last year), which may increase our estimate of China’s year-on-year crude oil import growth from 4-6% to 5-7% in 2021. However, increasing Chinese petroleum product exports does not increase global final demand for oil. It cannot be viewed as a fundamentally bullish factor for oil prices. Bottom Line: Stagnant domestic crude oil output and rising net exports of Chinese petroleum products will also lead to an increase of China’s crude oil imports.  Investment Implications Chart 16China: An Increasingly Important Factor For Global Oil Demand Strong crude oil imports by China have supported global oil prices in recent years. China has become an increasingly important driving force of global oil demand. Its oil imports currently make up about 12% of global oil demand, more than doubled from a decade ago (Chart 16). The country’s crude oil imports will continue expanding this year. Even at a slower rate, the robust oil consumption and imports from China will remain a positive factor for global oil prices in 2021. Beyond 2021, however, the country’s crude oil import growth outlook is facing increasing downside risks. Demand that is due to inventory accumulation is ultimately finite and non-recurring. Moreover, more oil accumulations in 2021 on top of China’s already elevated oil inventories may weigh on Chinese oil imports beyond 2021. In the meantime, US crude oil producers may benefit from continuing strong purchases from China. In 2020, China significantly ramped up its crude oil imports from the US, as the country has pledged to boost purchases of US energy products under the phase one trade deal signed with President Trump in January 2020. Chart 17Chinese Imports Of US Crude Oil May Continue To Rise In 2021 In 2020, Chinese imports of US crude oil in volume terms were 155% higher from a year before (Chart 17, top panel). Its share of total Chinese crude oil imports also spiked from 1-2% in late 2019 to 7-8% in the past several months (Chart 17, bottom panel). In the meantime, China’s share of US crude oil export also jumped from 4.6% in 2019 to 14.7% last year. In 2021, our baseline view is that China will want to show goodwill to the newly elected Biden administration by continuing to boost its crude oil purchase from the US. This will benefit US crude oil producers. However, if China buys more from the US, it may buy less from other countries.   Ellen JingYuan He  Associate Vice President ellenj@bcaresearch.com     Footnotes 1By deducting crude oil used in refineries and in direct final consumption from the total supply, we derived the flow of inventory and the level of changes in inventory. By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. We assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low at that time as well. In addition, based on the data from the National Bureau of Statistics, we found out that the direct final consumption of crude oil without any transformation only accounted for about 1-2% of total supply. 2 In 2004, the government planned three phases of SPR construction, targeting 10-12 million tons of crude oil SPR for the first phase, 28 million tons for the second phase, and another 28 million tons for the third phase. 3The import quota for independent refiners in 2021 has been increased by 20% (about 823 kbpd), and the country’s refinery capacity will expand at about 500 kbpd per year over 2021-2025. Cyclical Investment Stance Equity Sector Recommendations

Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1  Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens Chart 10Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification