Tail risk 3: China-led commodity weakness Commodity collapse hedge: buy AUD/USD 6m 0.67 digital put Metal and bulk commodity prices have skyrocketed in anticipation of infrastructure spending in the US, We are wary of this rally: tax cuts are likely to be the first line of fiscal stimulus and potentially easier to get through Congress than sizeable infrastructure spending, which in any case will take a longer time to impact commodity demand (allowing for supply adjustments). Perhaps most importantly, China is still the swing factor for global commodity prices and the risks here remain to the downside. The recent dramatic rise for China-linked bulk commodity prices, especially coal, has been driven by a combination of supply and demand imbalances (China floods, pit closures and inventory shortages) and an apparent rise in speculative activity in futures markets that has already drawn attention from regulators (Chart 76). Our resource analysts have raised forecasts but still see moderation over 2017 (Chart 77). The futures forward curve has already moved into backwardation. We see iron ore prices back at USD50/t in 2017 compared to a current spot price of USD74. While global reflation might be positive for commodities, there are reasons for caution: « We expect Chinese property investment, the most commodity-intensive sector of the economy, to slow in 2017. e Sizeable RMB depreciation would be an additional deflationary impulse for industrial commodities. « There will be a supply response as current prices bring uneconomic producers back on line, admittedly with a lag. ¢ There is potential for trade friction to impact regional trade while higher US rates are already impacting regional EM currencies. Australia is especially exposed to intra-regional trade and resource demand from the region. Persistent supply/demand imbalances ahead of Chinese New Year might delay commodity weakness until after 1Q17, especially for coking coal due to a preference for thermal coal supp