Economy

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Chart 5B… But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment Chart 7Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Dear Client, Please note that this report will be our final publication of the year (what a year!). In addition to the Special Report we are sending you, please join me for the two webcasts I am hosting ("China 2021 Key Views: Shifting Gears In The New Decade") today at 10:00AM EST (English) and Thursday at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin).  Our publishing schedule will resume on January 6, 2021 with our monthly China Macro and Market Review. Our China Investment Strategy team wishes you a safe, healthy, and happy holiday season! Best regards, Jing Sima, China Strategist   Highlights Chinese crude steel output growth will moderate considerably next year, leading to a sharp reduction in the country’s iron ore imports. Rising domestic iron ore production as well as increasing use of scrap steel will partially substitute Chinese overseas purchases of iron ore next year. In the meantime, the global iron ore output growth will likely be stronger in 2021 than this year. Both iron ore and steel prices are vulnerable to the downside in 2021. Feature Global iron ore prices have rallied over 60% since February, propelled by surging Chinese iron ore imports (Chart 1). China accounts for about 70% of global iron ore imports (Chart 2). Chart 1Iron Ore: Surging Prices On Strong Chinese Imports Chart 2China Accounts For 70% Of Global Iron Ore Imports Iron ore is mainly used in the steel-making process. The surge in Chinese iron ore imports this year was largely due to its strong crude steel1 output growth. Chart 3Strong Crude Steel Production In China For past six months of this year, crude steel output increased by 8.2% compared with a year ago in China, while having contracted considerably in the rest of world (Chart 3, top panel). As the world’s largest steel producer, China currently accounts for 60% of world crude steel output (Chart 3, bottom panel).  However, the odds are that China’s crude steel output growth will decline considerably next year causing a sharp reduction in the country’s iron ore imports. In addition, rising domestic iron ore extraction as well as increasing use of scrap steel next year also point to a drop in Chinese iron ore imports in 2021. Moreover, global iron ore output is set to increase in 2021, putting further downward pressure on iron ore prices. While global steel output outside of China will likely increase next year, the increase in the world ex-China’s iron ore imports will not offset the drop in the Chinese iron ore imports. This is because nearly half of steel output outside China uses an electric-furnaced steelmaking process mainly requiring scrap steel. Puzzling Surge In Chinese Iron Ore Imports Chart 4Stronger Steel Output Growth But Weaker Iron Ore Imports In 2018 And 2019 It is not always true that strong Chinese steel output growth will boost the country’s iron ore imports. China’s annual crude steel output growth was much higher in both 2018 and 2019 than this year. Yet, the country’s iron ore imports still dropped by 1% in 2018 and only rose slightly in 2019, much lower than the strong 11% growth so far this year (Chart 4). The surge in Chinese iron ore imports this year was due not only to strong domestic steel output, but also to limited scrap steel availability, weak domestic iron ore production, and low domestic iron ore inventory. First, scrap steel availability and domestic iron ore supply can be swing factors that determine Chinese iron ore imports. Both scrap steel and domestically mined iron ore can be used as a replacement for imported iron ore in the steel-making process. China’s post-pandemic steel output growth this year reached a similar rate as in 2019, but this year’s scrap steel availability was limited due to a pandemic-induced disruption in the domestic scrap steel supply chain earlier this year. Meanwhile, Chinese authorities started clamping down on ferrous scrap imports in July 2019 due to environmental concerns. This has caused a collapse in the country’s scrap steel imports since then (Chart 5). Chart 5Tighter Scrap Steel Supply In 2020 In comparison, the scrap steel supply was more abundant in the past two years, thereby reducing the need for the country’s iron ore imports. China’s supply-side reforms and a nationwide clampdown on illegal sub-standard steel (Ditiaogang) production in 2017 led to a significant increase in scrap steel supply for steel producers in 2018. The World Steel Association data shows that Chinese crude steel output from the electric-furnace steel-making process—mainly using scrap steel as the feedstock—jumped significantly to a 33% annual growth rate in 2018.  In 2019, despite the decline in the country’s scrap steel imports, total scrap steel supply in China still had a net increase due to a 9% year-on-year growth in domestic scrap steel supply. Second, China’s domestic iron ore output during the first ten months of this year only rose by 0.4% year on year, compared with the sharp increase of approximately 11% in 2019 (Chart 6, top panel). Chart 6Weaker Domestic Iron Ore Output Growth This Year Finally, China’s iron ore inventory level remains low relative to its crude steel output this year, following a substantial destocking cycle in 2018 and 2019 (Chart 6, bottom panel). Chinese ore inventory increased by three million tons so far this year, after having declined 14 million tons in 2019 and nine million tons in 2018. Bottom Line: The surge in Chinese iron ore imports this year was due not only to strong domestic steel output, but also to low iron ore inventory, weak domestic iron ore production and limited scrap steel availability. Substitutes For China’s Imported Iron Ore Both domestic iron ore output and scrap steel supply are likely to rise in 2021. This will reduce the need for imported iron ore in China’s steel-making process.  Chart 7Chinese Iron Ore Output Is Set To Go Up In 2021 The considerable increase in profit margins for Chinese iron ore domestic miners and a declining number of loss-generating companies herald an upside for iron ore output in China (Chart 7). Chinese iron ore output in the past 12 months was still 56% lower than its peak output in 2014. We expect a 5-7% increase in the country’s iron ore output in 2021. Domestic scrap steel supply will also increase considerably in the coming years as the country puts more emphasis on the “green and sustainable development” of its economy. The increasing use of scrap steel clearly fits this narrative, as using one ton of scrap steel in the steel-making process can reduce emissions of 1.6 tons of carbon dioxide and three tons of solid waste.   Chinese domestic scrap steel supply is expected to reach 290-300 million tons by 2025 from approximately 240 million tons in 2019. This suggests an annual increase of about eight to 10 million tons in the country’s domestic scrap steel supply over the next five years. The use of one ton of scrap steel in the steel-making process can reduce iron ore imports by 1.65 tons. This means the increase of eight to ten million tons of scrap steel could reduce iron ore imports by about 13-17 million tons in the coming year. All else being equal, this alone would reduce this year’s 1,074 million tons of Chinese iron ore imports by 1.2-1.5% in 2021.   Moreover, China is also likely to allow the resumption of ferrous scrap imports in 1H2021. The country plans to reclassify eligible ferrous scrap as a recyclable resource so it would be no longer subject to the import ban. The country is expected to release new standards for steel scrap imports by the end of 2020. Scrap imports peaked at 13.7 million tons in 2009 and plunged to 180,000 tons by 2019. We expect China’s scrap steel imports to increase to 1-1.5 million tons in 2021 (Chart 5 on page 4).  The increased use of steel scrap and domestic iron ore will boost the bargaining power for Chinese steelmakers, as there will be greater volumes of raw materials available to Chinese steel mills. Bottom Line: The availability of steel scrap and domestic iron ore is set to increase for Chinese steel producers. This will likely lead to a considerable reduction in Chinese iron ore imports in 2021. What About China’s Steel Output In 2021? Chinese steel output remains a major determinant for the country’s iron ore imports. The growth of crude steel output in China is generally determined by the country’s underlying steel demand, the steel companies’ profit margins, and the extent of capacity expansion in that year. It is also subject to the government’s regulations in the steel sector.2 Chart 8Chinese Steel Consumption Structure First, our research shows that Chinese underlying steel demand growth will decline considerably next year. Chart 8 shows the structure of China’s underlying steel consumption in 2019. Chart 9Weaker Steel Demand Growth From Construction In 2021 About 55% of Chinese steel consumption is consumed in the construction sector. The sector includes development of properties and traditional infrastructure. There is a close correlation between building construction area starts and Chinese total steel demand proxy (Chart 9, top panel). The latter is calculated as China’s steel output plus net imports. Steel is heavily used in the early construction stage of buildings. Traditional infrastructure3 is also a major user of steel products. This year’s boost in traditional infrastructure investment also contributed a sharp rebound in steel use (Chart 9, bottom panel). As government credit and fiscal stimulus have already peaked, traditional infra-structure investment growth will decelerate from the current level. The weakness will be especially pronounced in 2H2021. Regarding building construction, in the October report, we made a case for a moderate growth in property starts over the following six months. For 2021 in its entirety, odds favor a slight contraction in building construction starts. The country’s property demand faces strong structural headwinds. In the meantime, the Chinese authorities seem determined to deleverage the country’s real estate developers. Hence, subdued property demand and shortage of financing for real estate developers will likely to lead to a decrease in building starts. Chart 10Chinese Machinery Output Will Likely Have A Growth Deceleration Next Year   The machinery sector accounted for 17% of Chinese steel consumption in 2019. Chinese machinery output has experienced significant growth this year due to fiscal stimulus. For example, construction machinery, including excavators, loaders, cranes, road rollers, bulldozers, ball graders and spreaders, surged 40% over the past six months and the annualized output reached a record high (Chart 10). We expect a growth deceleration in Chinese machinery output next year due to peak stimulus in 4Q2020. The automobile and shipbuilding sectors accounted for 6% and 2% of Chinese steel consumption in 2019, respectively. Automobile output showed a strong rebound in the past six months while the output of civilian ships was still in a deep contraction during the same period (Chart 11). We expect steel consumption in both sectors to improve only slightly in 2021, which will not offset the steel demand growth reduction in the construction and machinery sectors. The home appliance sector contributed 2% of Chinese steel consumption in 2019. Next year’s government-targeted stimulus in the consumption segment may provide a boost in output of home appliances, albeit a modest one (Chart 12). In addition, global demand for freezers and refrigerators due to the pandemic may diminish. Overall, we expect steel consumption in the home appliance sector will grow only slightly. Chart 11Steel Consumption Next Year Will Rise Slightly In Automobile And Shipbuilding Sectors… Chart 12… As Well As In The Home Appliance Sector The China Iron and Steel Association estimates that Chinese steel demand year-on-year growth for the first ten months of this year was at about 10.3%. We expect it to fall considerably to 3-5% next year, mainly due to diminishing steel demand growth in the construction and machinery sectors; combined, this accounts for about 72% of Chinese steel demand. Second, weakening demand growth will push down steel prices more than iron ore prices, resulting in a profit margin squeeze. This will force some unprofitable steel-making companies out of the market.   Chart 13Falling Profit Margins Of Chinese Steel Producers May Weigh On Their Steel Output Chart 13 shows a close correlation between crude steel output and steelmakers’ profit margins. Despite a recent rebound, Chinese steel producers’ profit margins have fallen sharply from last year. Finally, the new version of the capacity swap policy for the steel sector, which is expected to be released soon, will get stricter. The capacity swap policy, introduced by the authorities in 2017 and in effect since January 1, 2018, has allowed steel producers to add new capacity to replace obsolete capacity at a ratio of 1:1-1.25 (the range depends on region). Recently, it has been reported that the new version of the capacity swap policy will raise the ratio to 1:1.25-1.5. This new policy, if implemented next year, will likely curb new steel production capacity in 2021. Bottom Line: China’s steel output growth is likely to drift lower next year mainly due to diminishing steel demand growth. This will also weigh on Chinese iron ore imports. More Global Iron Ore Supply In 2021 Global iron ore supply outside China will go up next year due to larger capex. The world’s top four iron ore producers—Rio Tinto, Vale, BHP and Fortescue Metals Group (FMG) account for about half of global iron ore production. The year-on-year growth of their aggregate iron ore output will likely increase from 2% this year to 4-6% in 2021.  Table 1 shows the capex of these four companies this year and in 2021. All four will increase their capex considerably in 2021. Table 1The Capex of the World’s Top Four Iron Ore Producing Companies In 2020 & 2021 Chart 14Both Australian And Brazilian Iron Ore Producers Are Set To Increase Their Iron Ore Output Their aggregate capex will surge by 22% year on year in 2021. In particular, FMG4 will boost its capex by 60% next year. In 2019, 92% of FMG’s iron ore sales went to China. Next year, we expect Vale to considerably increase its iron ore output and exports to compete with Australian iron ore miners (Chart 14).  Very high current iron ore prices will likely boost the capex of other iron ore producers next year as well. We expect global iron ore output growth to accelerate in 2021. Moreover, the giant Simandou iron ore deposit in Guinea—the often-called “Pilbara-killer” (the Pilbara region accounts for over 90% of Australian iron ore exports)—is getting closer to development (Box 1).       Box 1 The Giant Simandou Iron Ore Deposit There are four blocks in the Simandou deposit, all of which involve participation from Chinese companies. The SMB-winning consortium—including one Singaporean company, one Guinean company and three Chinese companies—won the tender last year to develop blocks 1 and 2. Rio Tinto, Chinalco and the Guinean government own blocks 3 and 4. Last month, Guinea’s government approved the consortium’s plan to build a railroad and deep-water port to export output from the massive Simandou iron ore deposit to key markets including China. The consortium aims to bring the two blocks into production by 2025, with the first phase of iron ore export targeted at 80 million tons. One estimate is that Guinea’s combined annual iron ore production from blocks 1-4 could be 120 million tons per year (phase 1) by 2026 and may increase to 220 million tons per year (phase 2) by 2030. The 220 million tons of iron ore is equivalent to approximately 15% of the global seaborne iron ore trade in 2019. Investment Implications Chart 15Both Iron Ore And Steel Prices Are Vulnerable To The Downside In 2021 Both iron ore and steel prices are vulnerable to the downside next year. We expect prices of Chinese imported iron ore (62% grade) to decline around 30% from current US$155 per ton to about US$100-110 per ton in 2021 (Chart 15, top panel). We expect the Chinese steel products price index to drop 15% from the current 158 to the range of 130-140 in RMB terms in 2021 (Chart 15, bottom panel).   Ellen JingYuan He  Associate Vice President ellenj@bcaresearch.com   Footnotes 1According to the World Steel Association, crude steel is defined as steel in its first solid (or usable) form, including ingots, semi-finished products (billets, blooms, slabs), and liquid steel for castings. 2For example, there were mandated production cuts during the supply-side reform in the previous several years and frequent output halts aiming to reduce winter pollution. 3Traditional infrastructure is made up of three categories: (1) transport, storage and postal services; (2) water conservancy, environment and utility management; and (3) electricity, gas and water production and supply. 4In November 2020, FMG signed 12 memoranda of understanding (MoU) with major Chinese steel mills, procurement partners and financial institutions on the sidelines of the third China International Import Expo. The MoUs are valued cumulatively in the range of US$3 to $4 billion. Cyclical Investment Stance Equity Sector Recommendations