Emerging Markets

Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Chart 4… Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights There is a tentative decline in geopolitical risk: An orderly Brexit or no Brexit is the likely final outcome and the U.S.-China talks are coming together. The outstanding geopolitical risks still warrant caution on global equities in the near term. Internal and external instability in Saudi Arabia, any American persistence with maximum pressure sanctions on Iran, and domestic instability in Iraq pose a risk to global oil supply. Go long spot crude oil and GBP/JPY. Feature Chart 1A Tentative Decline In Geopolitical Risk Our views on Brexit and the U.S.-China trade talks are coming together, resulting in a tentative decline in geopolitical risk (Chart 1). The British parliament still needs to ratify Boris Johnson’s exit agreement, painstakingly negotiated with the EU in a surprise summit this week. He may not have the votes. If he fails then he will have a basis to seek an extension to the Brexit deadline on October 31. But it is clear that the EU is willing to allow compromises to prevent a no-deal exit shock from exacerbating the slowdown in the European economy. An orderly Brexit is the final outcome (or no Brexit at all if an election and new referendum should say so). We are removing the $1.30 target on our long GBP/USD call in light of these developments and going long GBP/JPY. Similarly, while uncertainty lingers over U.S.-China relations, it is clear that President Trump is sensitive to the impact of the manufacturing recession and the risk of an overall recession on his reelection prospects. He is therefore pursuing a ceasefire and delaying tariffs. China is minimally reciprocating to forestall a collapse in relations. The December 15 tariff hike will be delayed and, if a ceasefire fails to improve the economic outlook, we expect Trump to engage in some tariff rollback on the pretext that talks are “making progress.” However, we do not expect a bilateral trade agreement or total tariff rollback. And other factors (like political risks in Greater China) could still derail the process. The outstanding geopolitical risks still warrant caution on global equities in the near term. These risks include a collapse in the U.S.-China talks (e.g. due to Hong Kong, Taiwan, or the tech race), and the ascent of Elizabeth Warren as the front runner in the Democratic Party’s early primary election. There is also the risk of another oil price shock emanating from the Middle East, which we discuss in this report. The Aftermath Of Abqaiq It has been a geopolitically eventful summer in the Middle East (Diagram 1). While there were plenty of warning shots, the September 14 drone and missile strikes on Saudi Aramco infrastructure was the big bang – wiping out 5.7 mm b/d of crude oil supplies overnight (Chart 2). The attacks were significant not only in terms of their impact on global oil markets, but also because they exposed the U.S.’s and Saudi Arabia’s reluctance to engage in a full-scale military confrontation with Iran. It is too early to call peak tensions in the Persian Gulf. Diagram 1Timeline: Summer Fireworks In The Persian Gulf Chart 2Closing Hormuz Would Be The Biggest Oil Shock Ever It is too early to call peak tensions in the Persian Gulf. The October 11 strike on an Iranian-owned oil tanker in the Red Sea and the reported U.S. cyber-attacks against Iranian news outlets may well mark the “limited retaliation” that we expected. Nevertheless, last month’s events uncovered vulnerabilities that suggest that even if the U.S. and its Gulf allies back off, geopolitical risk will remain elevated. Chart 3Saudis Are Profligate Defense Spenders The most obvious outcome of the September 14 attack is the realization of just how vulnerable Saudi Arabia is to attacks by its regional enemies. Despite being the third most profligate defense spender in the world – and the first relative to GDP (Chart 3) – Saudi Arabia was unable to protect its critical infrastructure. For that, Crown Prince Mohamed bin Salman (MBS) will surely face domestic pressure. After five years, Saudi Arabia has little to show from its war in Yemen, other than a humanitarian crisis that has hurt its international standing. Instead, the operation has been a burden on the kingdom’s finances and a nuisance to security in the southwestern provinces of Najran, Jizan and Asir, where the Iran-allied Houthis have conducted regular attacks on oil infrastructure and airports. Some domestic disquiet will be defused if the Yemen war is downgraded or resolved. Saudi Arabia recently accepted the olive branch extended by the Houthis and is reportedly in talks to deescalate. But this will not fully eliminate domestic uncertainty. After all, MBS’s other initiatives – in Syria, in Iraq, in lobbying the U.S. – are also in jeopardy. The conspiracy theory surrounding the September 29 murder of General Abdulaziz al-Faghem, King Salman’s longstanding personal bodyguard, is case in point. Rumor has it that the king was enraged upon hearing of the Houthi movement’s September 28 capture of three Saudi military brigades, and decided to revoke the Crown Prince’s title, instead appointing the youngest Sudairi brother, Prince Ahmed bin Abdulaziz, in his place.1 The ploy was allegedly uncovered, resulting in General al-Faghem’s murder.2 This is entirely speculation and we find the idea of MBS’s removal to be highly doubtful. The King’s and Crown Prince’s joint appearance during President Vladimir Putin’s visit to the kingdom earlier this week should dispel speculation about a brewing palace coup. Nevertheless, the murder itself is extremely concerning and reinforces independent reasons for concerns about internal stability. Chart 4Impatient Diversification Threatens Domestic Stability The pursuit of the Saudi reform agenda, “Vision 2030,” is premised first and foremost on the consolidation of power in the hands of MBS and his faction. The appointment of King Salman’s son, Prince Abdulaziz, as energy minister was motivated by a desire to expedite the initial public offering of state oil giant Saudi Aramco, which could begin as early as November. This was preceded by the appointment of Yasir Al-Rumayyan, head of the sovereign wealth fund and a close ally of MBS, as chairman of Aramco. Moreover, wealthy Saudis – some of whom were detained at the Ritz Carlton in November 2017 – are reportedly being strong-armed into buying stakes in the pending IPO. While weaning Saudi Arabia’s economy off of crude oil is the best course of action for long-term stability (Chart 4), the transition will threaten domestic stability. Meanwhile the conflict with Iran is far from settled. Bottom Line: The September 14 drone strikes on key Saudi oil infrastructure revealed both Saudi Arabia’s and the U.S.’s unwillingness to engage in military action against and a full confrontation with Iran. This will raise concerns regarding the kingdom’s ability to defend itself. Moreover, Saudi Arabia remains vulnerable to domestic pressure as MBS strives to maintain his consolidation of power in recent years and pursues Vision 2030. Internal or external instability in Saudi Arabia poses a risk to global oil supply. Iran’s Resistance Economy Can Handle Trump’s Maximum Pressure Chart 5Iran's Economy Is Feeling The Bite On the other side of the Persian Gulf, the Iranians are displaying a higher pain threshold than their enemies. The economy is suffering under the U.S.’s crippling sanctions, with exports at the lowest level since 2003 (Chart 5). The IMF expects Iran’s economy to contract by 9.5% this year, with annual inflation forecast at 35.7%. Oil exports, the lifeblood of its economy, are down 89% YoY. Nevertheless, Iran is well-versed in the game of chicken, it is methodically displaying its ability to create havoc across the region, and it has not waivered in its stance that President Trump must ease sanctions and rejoin the 2015 nuclear deal if it is to engage in bilateral talks. All the while, Iran continues to reduce its nuclear commitments. On September 5, Rouhani indicated plans to completely abandon research and development commitments under the Joint Comprehensive Plan of Action (JCPOA) and to begin working on more advanced uranium enrichment centrifuges which was capped at 3.7% under the JCPOA (Table 1). We also expect Iran to follow-through on its threat of withdrawing from the Nuclear Non-Proliferation Treaty (NPT) if Trump maintains sanctions. Table 1Iran Is Walking Away From 2015 Nuclear Deal The same resolve cannot be shown on the part of the United States or Saudi Arabia. Chart 6Americans Do Not Support War With Iran President Trump is constrained by the risk of an Iran-induced oil price shock ahead of the 2020 election. He is therefore eager to deescalate tensions with Iran. He is abandoning the field in Syria (on which more below), opting to add a symbolic 1,800 troops into Saudi Arabia for deterrent effect instead. This defensive posture is being undertaken within the context of American public opinion, which opposes war with Iran or additional military adventures in the Middle East (Chart 6). This signifies the U.S.’s strategic deleveraging from the Middle East in order to shift its focus to Asia Pacific, where America has a greater priority in managing the rise of China. At the same time, negotiations between the Saudis and Yemeni Houthis suggest a lack of Saudi appetite for all-out conflict with Iran, clearing the way for a diplomatic solution. As Rouhani stated “ending the war in Yemen will pave the ground for de-escalation in the region,” specifically between Saudi Arabia and Iran. The Saudis have amply signaled in the wake of the Abqaiq attack that they wish to avoid a direct confrontation, particularly given the Trump administration’s apparent unwillingness (under electoral constraint) to continue providing a “blank check” for MBS to conduct an aggressive foreign policy. Already the United Arab Emirates – a key player in the Saudi-led coalition against Yemen – has distanced itself from Riyadh and sought to ease tensions with Iran. It recently reduced its commitment to the Yemen war and engaged in high-level meetings with Iran. The UAE’s national security adviser, Tahnoun bin Zayed, visited Tehran on a secret mission, the latest in a series of backchannel efforts to mediate between Saudi Arabia and Iran. Other reported efforts at diplomacy include visits by Iraqi and Pakistani officials. The remaining uncertainty is whether Trump will quietly ease sanctions on Iran, and whether Iran will quit while it is ahead. If Trump maintains maximum pressure, Iran may need to stage further attacks and oil disruptions to threaten Trump’s economy and encourage sanction relief. Otherwise, Iran, smelling American and Saudi fear, could overstep its bounds and commit a provocation that requires a larger American response, thus re-escalating tensions. While Trump’s economic and electoral constraint suggests that he will ease sanctions underhandedly, Iran’s risk appetite is apparently very high: Abqaiq could have gone terribly wrong. It also has an opportunity to flex its muscles and demonstrate American inconstancy to the region. This could lead to miscalculation and a more significant oil price shock than already seen. Bottom Line: Iran has remained steadfast in its position while the United States, Saudi Arabia, and their allies appear to be capitulating. They have more to lose than gain from all-out conflict. But Iran’s decision-making is opaque and any American persistence with maximum pressure sanctions will motivate additional provocations, escalation, and oil supply disruption. Making Russia Great Again? Recent events in Turkey and Syria do not come as a surprise. We have long highlighted a deeper Turkish intervention into Syria as a regional “black swan” event. In August we warned clients that the Trump-Erdogan personal relationship would not save Turkey from impending U.S. sanctions. In September we warned that Turkish geopolitical risk premia had collapsed, as measured by our market-based GeoRisk indicator, and that this collapse was certain to reverse in a major way, sending the lira falling. As we go to press the Turks have declared a ceasefire to avoid sanctions but nothing is certain. Putin has pounced on the opportunity to capitalize on the U.S. retreat. If Turkey is the loser, who is the winner? First, Trump, who benefits from fulfilling a campaign pledge to reduce U.S. involvement in foreign wars – a stance that will ultimately be rewarded (or at least not punished) by a war-weary public. Second, Iran and Russia, Syria’s major allies, who have invested greatly in maintaining the regime of Bashar al-Assad throughout the civil war and now face American withdrawal and heightened U.S. tensions with its allies and partners in the region as a result. Iran benefits through the ability to increase its strategic arc, the so-called “Shia Crescent,” to the Mediterranean Sea. Russia benefits through solidifying its reclaimed status as a major player in the Middle East – an indication of global multipolarity. President Vladimir Putin has pounced on the opportunity to capitalize on the U.S. retreat with official visits to both Saudi Arabia and the UAE this week. He made promises of both stronger economic ties and the ability to broker regional power. On the economic front, the Russian Direct Investment Fund (RDIF) selected Saudi Arabia as the venue for its first foreign office, signaling its interest in the region. It has already approved 25 joint projects with investment valued at more than $2.5 billion. There are also talks of RDIF-Aramco projects in the oil services sector worth over $1 billion and oil and gas conversion projects worth more than $2 billion. Moreover, RDIF signed multiple deals worth $1.4 billion with UAE partners. Chart 7Russia Has Been Complying With OPEC 2.0 Cuts Most importantly, the Saudis and Russians share the same objective of supporting global oil prices and have been jointly managing OPEC 2.0 supply since 2017 (Chart 7). Russia’s approach to the region focuses on enhancing its all-around strategic influence. Chart 8Erdogan Is Playing Into Turkish Concerns About Syrian Refugees Although Russia’s allies include Iran and Syria – Saudi Arabia’s rivals – it has presented itself as a pragmatic partner to other powers, including Turkey and even the Saudis and Gulf states. As such, the Kremlin has leverage on both sides of the regional divide, giving it the potential to serve as a power broker. However, any Saudi purchase of the Russian S-400 defense system, long under negotiation, would unsettle the United States. Turkey is threatened with American sanctions for its purchase of the same system.3 The U.S. may be willing to tolerate some increased Russian influence in the Middle East, but a defense agreement may be its red line. The Trump administration still wields the stick of economic sanctions. Growing Russian influence extends beyond the Gulf states. The U.S.’s withdrawal from northeast Syria last week and the Turkish invasion is a gift to the Russians. They are now the only major power from outside the Middle East engaged in Syria. They have embraced this position, positioning themselves as peace brokers between the Syrian regime, with whom they are allied, and Turkey, as well as the Turkish arch-enemy, the Kurds, who now lack American support and must turn to Syria and Russia for some kind of arrangement to protect themselves. Russia has therefore cemented its return as a strategic player in the region, after its initial intervention in Syria in 2015. Turkey’s incursion into Syria is an attempt by President Erdogan to confront the battle-hardened Syrian Kurds and prevent a Kurdish-controlled continuous border with Syria, and to distract from his weakened domestic position. He is striving to garner support by playing to broad Turkish concerns about Syrian refugees in Turkey (Chart 8). The intervention will seek to create a space for refugees to be placed on the Syrian side of the border. However given that there is little domestic popular support for a military intervention, he runs the risk of further alienating voters, who are already losing patience with his ruling Justice and Development Party (AKP). So far, the incursion has the official support of all Turkey’s political parties except the Kurdish Peoples’ Democratic Party (HDP). However this will change as the intervention entails western economic sanctions, a drawn-out military conflict, and limited concrete benefits other than the removal of refugees. Chart 9Turkey's Already Vulnerable Economy Will Take A Hit The already vulnerable economy is likely to take a hit (Chart 9). Markets have reacted to the penalties imposed by the U.S. so far with a sigh of relief as they are not as damaging as they could have been – i.e. Turkish banks were spared.4 However, this is just the opening salvo and more sanctions are on the way – Congress is moving to impose sanctions of its own, which Trump is unlikely to veto. Moreover, the European Union is following suit and imposing sanctions of its own, including on military equipment. Volkswagen already announced it is postponing a final decision on whether to build a $1.1 billion plant in Turkey. This comes at a time of already existing sensitivities with the EU over Turkish oil and gas drilling activities in waters off Cyprus. EU foreign ministers are responding by drawing up a list of economic sanctions. These economic risks will likely hold back the central bank’s rate cutting cycle as the lira and financial assets will take a hit. Bottom Line: The U.S. pivot away from the Middle East is a boon for Moscow, which is pursuing increased cooperation in the Gulf and gaining influence in Syria. Russia is marketing itself as a strategic player and effective power broker. Erdogan’s incursion in Syria, while motivated by domestic weakness, will backfire on the Turkish economy. Maintain a cautious stance on Turkish currency and risk assets. Iraq Is The Fulcrum Iraq’s geographic position, wedged between Saudi Arabia and Iran, renders it the epicenter of the regional power struggle. In the wake of the Trump administration’s maximum pressure campaign on Iran we have frequently highlighted that a dramatic means of Iranian pushback, short of closing shipping in the Strait of Hormuz, is fomenting unrest in an already unstable Iraq. This would be a threat to U.S. strategy as well as to global oil supplies. Iraq is the epicenter of the regional power struggle. In this context, Iraq’s revered Shia cleric Muqtada al-Sadr’s visit to Iran on September 10, just four days ahead of the September Saudi Aramco attack, raises eyebrows. Sadr is the key player in Iraq today and over the past two years he had staked out a position of national independence for Iraq, eschewing overreliance on Iran. A rapprochement between Sadr and Iran is a negative domestic development for Iraq, which has recently been making strides to reduce Iran’s political and military grip. It would undermine Iraqi stability by increasing divisions over ideology, sect, economic patronage, and national security. There is speculation that Sadr’s trip was intended to discuss Prime Minister Adel Abdul Mahdi, who is perceived as weak and incapable of managing the various powers on Iraq’s political scene. The violent protests rocking Iraq since early September support this assessment. Protestors are motivated by discontent over unemployment, poor services, and government corruption, which are perceived to have mostly deteriorated since the start of Abdul Mahdi’s term (Chart 10). While Abdul Mahdi has announced some reforms in response to the popular discontent, including a cabinet reshuffle and promises of handouts for the poor, they have done little to quell the protests. The popular demands are only one of the existential threats facing the government. The second and potentially more serious risk is the security threat. Iraq has been failing at its attempts to formally integrate the Popular Mobilization Units (PMU) – Iran-backed paramilitary groups that were instrumental in ISIS’s defeat – into the national security forces. This is essential in order to prevent Iran from maintaining direct control of security forces within Iraq. A majority of the public agrees that the PMU should not play a role in politics (Chart 11), reflecting the underlying trend demanding Iraqi autonomy from Iran. Chart 10Rising Discontent In Iraq Chart 11Little Support For A Political Role For The PMU Given that the PMU is in effect an umbrella term for ~50 predominantly Shia paramilitary groups, internal divisions exist within the forces which compete for power, legitimacy, and resources. Recently, it has been purging group leaders perceived as a threat to the overall forces and the senior leadership which maintain strong links to Iran. Chart 12Iraq Is Divided Across Political Affiliation This internal struggle also reflects the intra-Shia struggle for power among Iraq’s main political parties. On the one side there is the conservative, pro-Khamenei bloc led by former Prime Minister Nouri al-Maliki and PMU commander Hadi al-Ameri, and on the other is the reformist, nationalist leader Muqtada al-Sadr’s joined by Ammar al-Hakim. Given that most Iraqis view their country as a divided nation across political affiliation, this is a risk to domestic stability (Chart 12). Thus even if the wider risk of regional tensions abates and reduces the threat of sabotage to oil infrastructure and transportation, the current domestic situation in Iraq remains uneasy. But given that we do not see the regional tensions abating yet – due to either American maximum pressure or Iranian hubris – this dynamic translates into an active threat to oil supplies, with 3.4 mm b/d of exports concentrated in the southern city of Basra. Bottom Line: Heightened domestic instability in Iraq poses a non-negligible threat to oil supplies. This risk is compounded by Iraq’s location as a geographic buffer between regional rivals Iran and Saudi Arabia, and Iran’s interest in fomenting unrest to pressure the U.S. into relaxing sanctions. Investment Conclusions The common thread across the Middle East is a persistent threat to global oil supply in the wake of the extraordinary Abqaiq attack. First, it cannot be stated with confidence that Iran will refrain from causing additional oil disruptions, as it is convinced that President Trump’s appetite for conflict is small (and Trump is indeed constrained by fear of an oil shock). President Rouhani has an interest in removing Trump from power, which an oil shock might achieve, and the Supreme Leader may even be willing to risk a conflict with the United States as a means of increasing support for the regime and infusing a new generation with revolutionary spirit. Iran loses in a total war, but Tehran is convinced that the U.S. does not have the will to engage in total war. Second, Russia’s interest in the region is not in generating a durable peace but in filling the vacuum left by the United States and making itself a power broker. Any instability simply increases oil prices which is positive for Russia. Third, Iraq’s instability is both domestically and internationally driven. It is nearly impossible to differentiate between the two. Iranian hubris could manifest in sabotage in Iraq. Or Iraq could destabilize under the regional pressures with minimal Iranian encouragement. Either way the world’s current below-average spare oil production capacity could be hit sooner than expected if shortages result. Go long spot crude oil. On equities, with a U.S.-China ceasefire in the works, and little chance of a no-deal Brexit, we see our cyclically positive outlook reinforced, though we maintain near-term caution due to U.S. domestic politics. In terms of equity focus, we are overweight European equities in developed markets and Southeast Asian equities in emerging markets.   Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Sudairi branch of the al-Saud family is made up of the seven sons of the late King Abdulaziz and Hussa al-Sudairi of the powerful Najd tribe. 2 Please see TRT World “Killing of Saudi King’s Personal Bodyguard Triggers Speculation,” October 2, 2019, available at https://www.trtworld.com. 3 In the wake of the attack on Saudi Aramco oil facilities, President Putin trolled the U.S. by recommending that Saudi Arabia follow the footsteps of Iran and Turkey in purchasing Russia’s S-300 or S-400 air defense systems. 4 The U.S. penalties include sanctions against current and former officials of the Turkish government, a hike in tariffs on imports of Turkish steel back up to 50 percent, and the halt in negotiations on a $100 billion trade deal.

Special Report

Today we are also publishing a Special Report titled Chinese Auto Demand: Time For A Recovery? Highlights India is the third-largest world consumer of crude oil. Hence, fluctuations in its oil consumption is a non-negligible factor behind global oil prices. India’s petroleum demand growth is slowing cyclically due to the domestic demand slump and a dramatic drop in vehicle sales. This, combined with China’s ongoing slowdown in petroleum product demand, will have a non-trivial impact on oil prices in the next six months. From a structural perspective, India’s long-term demand growth for petroleum is decelerating as well. Feature India’s petroleum products consumption growth is slowing. Chart 1India Is The World's Third Largest Crude Oil Consumer India is the world’s third-largest consumer of crude oil, guzzling 5% of global consumption (Chart 1). Hence, fluctuations in India’s crude oil/petroleum consumption is a non-negligible factor affecting global oil prices. India’s petroleum products consumption growth is slowing. This comes on top of China’s ongoing petroleum demand deceleration. Together, the two countries account for 19% of the world’s oil intake. Therefore, deceleration in their oil consumption growth will have a considerable impact on the outlook for global oil demand growth. A Pronounced Cyclical Oil Demand Slump Indian petroleum consumption growth has decelerated significantly on the back of slumps in Indian domestic spending and economic activity (Chart 2). Please click on this link for an in-depth analysis on the domestic demand slump in India. Chart 2Indian Petroleum Consumption Growth Has Been Dwindling Specifically, vehicle purchases and industrial sectors have been hit hard. These sectors are critical for Indian petroleum consumption, since transportation demand accounts for 50% and industrial activity for around 25% of total petroleum consumption (Chart 3). Indian vehicle sales have been in freefall. Chart 3Transportation & Industry Guzzle The Most Fuel In India Chart 4Indian Vehicle Sales Are In Deep Contraction Indian vehicle sales have been in freefall. Chart 4 shows passenger car sales are shrinking at 30% and sales of two and three-wheeler units are contracting at 20% from a year ago. Moreover, commercial vehicles and tractor unit sales are falling at annual rates of 35% and 10%, respectively. Chart 5 illustrates that the number of registered vehicles is expanding at a lower rate than before – i.e., its second derivative has turned negative. This signals a further growth slowdown in gasoline and diesel consumption. We use the second derivative in this analysis because registered vehicles are a stock variable. However, we are trying to explain changes in petroleum consumption which is a flow variable. Therefore, the second derivative of a stock variable (the number of registered cars on the road) explains the first derivative of a flow variable (the growth rate of oil consumption). Looking ahead, vehicle sales will remain in the doldrums because of a lack of financing. In particular, the impulse on auto loans issued by commercial banks is negative (Chart 6). Chart 5Slowing Growth Of Vehicles On The Road = Weaker Pace Of Fuel Consumption Chart 6Indian Banks: Negative Vehicle Loan Impulse More worrisome is the ongoing turmoil in India’s non-bank finance sector (NBFCs), which has also significantly hit auto sales. In the past, the NBFC sector played a major role in funding Indian auto purchases. For instance, according to the ICRA, an independent rating agency in India, NBFCs have helped fund the purchases of 65% of two-wheelers, 30% of passenger cars and around 55% of commercial vehicles – both new and used. Given these non-bank finance companies are currently facing formidable funding and liquidity pressures amid rising NPLs (Chart 7), they are being forced to shrink their balance sheets. This is damaging to auto sales. Please click here for an in-depth analysis on the Indian banking and non-bank finance sectors. Chart 7Major Asset-Liability Mismatches Among Indian Non-Bank Finance Sector Chart 8India's Capex Has Been Weak Turning to the industrial sector, overall Indian capital spending has been weak. India’s real gross fixed capital formation has rolled over, the number of capex projects underway is nosediving and both capital goods imports and production are contracting by 7% and 12% on an annual basis (Chart 8). Falling industrial activity has taken a toll on the consumption growth of petroleum products with industrial applications, such as bitumen, naphtha and petroleum coke, etc. The growth rate in demand for these products is dropping — a significant development since they account for 25% of overall petroleum consumption in India.1  Bottom Line: India’s petroleum consumption growth has been slowing drastically from a cyclical perspective. And Moderating Structural Oil Demand Growth It appears there are structural factors at play that will also reduce India’s long-term demand for petroleum. On top of the cyclical demand slowdown, it appears there are structural factors at play that will also reduce India’s long-term demand for petroleum: Chart 9Impressive Efficiency Gains In India's Vehicle Fleet The fuel efficiency of India’s vehicle fleet is markedly improving (Chart 9). Additionally, since 2015-16 the Indian government has been proactively pursuing new emission/fuel efficiency standards. For instance, emissions standards for new passenger vehicles will fall to 4.2 L/100 KM by 2023 down from its current level of 4.6 L/100 KM. This will lead to a 7% reduction in auto fuel consumption. While this is not a large reduction, the government has the scope to implement even stricter standards since Indian car makers are easily meeting these targets. Finally, the Indian government has been aggressively promoting electric vehicles (EVs) as an alternative to traditional autos. It has made the advancement of this sector a priority. Ownership of EVs is currently negligible in India. However, the government is pushing for EVs to make up 30% of vehicle sales by 2030. In addition, it has been providing incentives such as sales tax cuts and subsidies to the sector. Finally, Mahindra and Tata Motors are already establishing a lead in the EV industry and are developing new EV models in collaboration with foreign automakers.  Bottom Line: The pace of India’s structural demand for petroleum will also be downshifting. Oil Inventory Not A Critical Factor Chart 10China: Oil Inventory Drives Oil Imports Inventory accumulation and destocking can play an important role in oil price fluctuations. For example, inventory accumulation plays a key role in driving Chinese crude oil imports (Chart 10). There is a dearth of data on Indian oil inventories to make a strong inference about its de- and re-stocking cycles. However, we have the following observations: India has the capacity to store 5.33 million tons worth of strategic oil reserves - equivalent to around 10 days of its crude oil consumption. It is not clear whether or not these reserves are at full capacity. However, even if we assume they are only 50% full and the government decides to fill its reserves all at once, this would require the importation of an additional 2.67 million tons of oil, equivalent to only 1.2% of Indian crude oil imports and 0.05% of global crude oil demand. This is a negligible amount, and is unlikely to have any impact on global oil prices. Furthermore, while the Indian government is planning to expand its storage capacity by an extra 6.5 million tons, this will only take place in the next six to eight years. Thus, it will not meaningfully affect oil imports in the medium term. Chart 11India: Oil Consumption Drives Oil Imports Finally, India’s crude oil imports are strongly correlated with its petroleum final consumption (Chart 11). Therefore, it is reasonable to assume that Indian consumption – not the oil inventory cycle – is relevant for crude imports, and by extension for oil prices. Bottom Line: India’s petroleum product and crude oil inventory fluctuations are too small to influence the nation’s crude imports and hence global oil prices. Investment Conclusions From a cyclical perspective, Indian final demand for crude oil has been weakening. A major re-acceleration in economic growth and hence oil demand is not imminent. We discuss the outlook for China’s auto sales in a separate report published today. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. Chart 12Expansion Pace Of Vehicles On The Road Has Downshifted In India & China Our estimations for annual growth in cars on the road (excluding 2-wheelers) has dropped to 5.8% in India and 10.5% in China (Chart 12). This entails a slower pace of oil demand growth than in the past. Besides, if one rightly assumes petroleum consumption per car is declining for structural reasons due to technological advancements by car manufacturers and enforcement of stricter efficiency standards by governments, oil consumption growth will be considerably slower going forward relative to the past 20 years. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. This presents a major risk for crude prices in the next 6 months or so. Beyond the cyclical horizon, the long-term demand outlook for oil is also downbeat. Please note that this is the view of BCA’s Emerging Markets Strategy team, and differs from that of BCA’s house view, which is bullish on oil. Chart 13India’s Relative Equities Performance Benefits From Lower Oil Prices In turn, low oil prices are positive for the relative performance of Indian stocks versus the EM equity benchmark (Chart 13). This was among the primary reasons why we upgraded the allocation to this bourse within an EM equity portfolio to neutral from underweight on September 26, 2019. In absolute terms, the outlook for Indian share prices remains downbeat, as discussed in the same report. Finally, to express our negative view on oil prices, we are reiterating our short oil and copper / long gold position recommended on July 11, 2019. Industrial commodities such as copper and oil will continue to underperform gold prices in the medium term (the next six months). Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com   Footnotes 1      Diesel consumption will also be impacted. While the latter is mostly consumed by the transportation sector in India, diesel does have some industrial applications as well. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations