Emerging Markets

Executive Summary US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the main problem is elevated inflation. This heralds higher interest rates and a stronger currency. Hence, the Chinese yuan will depreciate against the greenback. When the RMB weakens versus the US dollar, commodity prices usually fall, and EM currencies and asset prices struggle. Faced with surging unit labor costs, US companies will continue to raise their prices to protect their profit margins and profitability. This will lead to one of the following two possible scenarios in the months ahead. Scenario 1: If customers are willing to pay considerably higher prices, nominal sales will remain robust, profits will not collapse, and a recession is unlikely. However, this also implies that the Fed will have to tighten policy by more than what is currently priced in by markets. Scenario 2: If customers push back against higher prices and curtail their purchases, then the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink, and their profits will plunge.  In both scenarios, the outlook for stocks is poor. However, one key difference is that scenario 1 is bearish for US Treasurys while scenario 2 is bond bullish. Bottom Line: On the one hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is bad for EM financial markets. On the other hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets underperform and the US dollar generally appreciates in this environment. This is also a toxic backdrop for EM financial markets.   Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future. There are also plenty of contradictory data to support all the above scenarios.  As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points. The S&P 500 index has rebounded from its 3-year moving average, which had previously served as a major support (Chart 1). Yet, the rebound has faltered at its 200-day moving average. Its failure to break decisively above this 200-day moving average entails that a new cyclical rally is not yet in the cards. Chart 1The S&P 500 Is Stuck Between Technical Resistance And Support Lines The S&P 500 index will remain between these resistance and support lines until investors make up their minds about the economic outlook. The EM equity index has been unable to rebound strongly alongside US stocks. A major technical support that held up in the 1998, 2001, 2002, 2008, 2015 and 2020 bear markets is about 15% below the current level (Chart 2). Hence, we recommend that investors remain on the sidelines of EM stocks. Chart 2EM Share Prices Are Still 15% Above Their Long-Term Technical Support Level BCA’s Emerging Markets Strategy team’s macro themes and views remain as follows: Related Report  Emerging Markets StrategyCharts That Matter In China, the main economic risk is deflation and the continuation of underwhelming economic growth. Core and service consumer price inflation are both below 1% and property prices are deflating. Falling prices amid high debt levels is a recipe for debt deflation. We discussed the government’s stimulus – including measures enacted for the property market – in the August 11 report. The latest announcement about the RMB 1 trillion stimulus does not change our analysis. In fact, we expected an additional RMB 1.5 trillion in local government bond issuance for the remainder of the current year. Yet, the government authorized only an additional RMB 0.5 trillion. This is substantially below what had been expected by analysts and commentators in recent months.   In Chinese and China-related financial markets, a recession/deflation framework remains appropriate. Onshore interest rates will drop further, the yuan will depreciate more, and Chinese stocks and China related plays will continue experiencing growth/profit headwinds. Meanwhile, the US economy has been experiencing stagflation this year. Chart 3 shows that even though the nominal value of final sales has expanded by 8-10%, sales and output have stagnated in real terms (close to zero growth). Hence, nominal sales and corporate profits have so far held up because companies have been able to raise prices by 8-9.5% (Chart 4). Is this bullish for the stock market? Not really. Chart 3US Stagflation: Strong Nominal Growth, But Small In Real Terms Chart 4US Corporate Profits Have Held Up Because Of Pricing Power/Inflation The fact that companies have been able to raise their selling prices at this rapid pace implies that the Fed cannot stop hiking rates. Besides, US wages and unit labor costs are surging (Chart 9 below). The implication is that inflation will be entrenched and core inflation will not drop quickly and significantly enough to allow the Fed to pivot anytime soon. Overall, US economic data releases have been consistent with our view that although real growth is slowing, the US economy is experiencing elevated inflations, i.e., a stagflationary environment. Critically, wages and inflation lag the business cycle and are also very slow moving variables. Hence, US core inflation will not drop below 4% quickly enough to provide relief for the Fed and markets. Is a US recession imminent? It depends. One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that they are already rolling over (Chart 5). Hence, business owners and CEOs will attempt to raise selling prices further. Chart 5US Companies Will Attempt To Raise Selling Prices To Protect Their Profit Margins This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral will persist. The Fed will have to raise rates much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and curtail their purchases, output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge.  Suffering a profit squeeze, companies will lay off employees, wage growth will decelerate, and high inflation will be extinguished. In this scenario, bond yields will drop significantly but plunging corporate profits will weigh on share prices. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor.   Finally, as we have repeatedly written, global trade is about to contract. Charts 10-18 below elaborate on this theme. This is disinflationary/recessionary. Investment Conclusions On the one hand, the Chinese economy and global trade are experiencing deflation/recession dynamics. Cyclical assets struggle and the US dollar does well in this environment. This constitutes a toxic backdrop for EM financial markets. On the other hand, the US has a genuine inflation problem. The upshot is that the Fed cannot pivot too early. The Fed’s hawkish rhetoric will support the US dollar. A strong greenback is also bad for EM financial markets. Thus, we do not see any reason to alter our negative view on EM equities, credit and currencies. Investors should continue underweighting EM in global equity and credit portfolios. Local currency bonds offer value, but further currency depreciation and more rate hikes remain a risk to domestic bonds. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Messages From Various US High-Beta / Cyclical Stock Prices US high-beta consumer discretionary, industrials, tech and early cyclical stocks have not yet broken out. The rebounds in high-beta tech and industrials have been rather muted. We are watching these and many other market signs and technical indicators to gauge if the recent rebounds can turn into a cyclical bull market. Chart 6 Chart 7 Falling Global Trade + Sticky US Inflation = US Dollar Overshot On the one hand, US household spending on goods ex-autos is already contracting and will drop further. The same is true for EU demand. The reasons are excessive consumption of goods over the past two years and shrinking household real disposable income. As a result, global trade is set to shrink, which is positive for the US dollar. On the other hand, surging US unit labor costs entail that core CPI will be very sticky at levels well above the Fed’s target. Hence, the Fed will likely maintain its hawkish bias for now, which is also bullish for the greenback. In short, the US dollar will continue overshooting.  Chart 8 Chart 9 Chinese Exports Will Contract, And Imports Will Fail To Recover Chinese export volume growth has come to a halt. Shrinking imports of inputs used for re-export (imports for processing trade) are pointing to an imminent contraction in the mainland’s exports. Further, Chinese import volumes have been contracting for the past 12 months. The value of imports has not plunged only because of high commodity prices. As commodity prices drop, import values will converge to the downside with import volumes. This is negative for economies/industries selling to China. Chart 10 Chart 11 Global Manufacturing / Trade Downtrend Is Intact China buys a lot of inputs from Taiwan that are used in its exports. That is why the mainland’s imports from Taiwan lead the global trade cycle. This is presently heralding a considerable deterioration in global trade.  In addition, falling freight rates and depreciating Emerging Asian (ex-China) currencies are all currently pointing to a further underperformance of global cyclicals versus defensive sectors. Chart 12 Chart 13 Chart 14 Taiwan Is A Canary In A Coal Mine Taiwanese manufacturing companies have seen their export orders plunge and their customer inventories surge. This has occurred in its overall manufacturing and semiconductor companies.  This corroborates our thesis that global export volumes will contract in the coming months. Chart 15 Chart 16 Korean Exporters Are Struggling Korean export companies are experience the same dynamics as their Taiwanese peers. Semiconductor prices and sales are falling hard in Korea. Export volume growth has come to a halt and will soon shrink. Chart 17 Chart 18 EM Equities: Cheap And Unloved? The EM cyclically adjusted P/E (CAPE) ratio has fallen to one standard deviation below its mean. Based on this measure, EM stocks are currently as cheap as they were at their bottoms in 2020, 2015 and 2008. EM share prices in USD deflated by US CPI are now at two standard deviations below their long-term time-trend. This is as bad as it got when EM stocks bottomed in the previous bear markets. The reason for EM stocks poor performance and such “cheapness” is corporate profits. EM EPS in USD has been flat, i.e., posting zero growth in the past 15 years. Besides, EM narrow money (M1) growth points to further EM EPS contraction in the months ahead. Chart 19 Chart 20 Chart 21 Chart 22 Commodity Prices Remain At Risk China needs lower interest rates and a weaker currency to battle deflationary pressures. In the US, the problem is inflation, which heralds higher interest rates and a stronger currency to fight rising prices. Hence, the yuan will depreciate versus the greenback. When the RMB depreciates versus the US dollar, commodity prices usually fall. Further, commodity currencies (an average of AUD, NZD and CAD) continue drafting lower. This indicator correlates with commodity prices and also presages further relapse in resource prices. Chart 23 Chart 24 Oil Prices: A Major Top In Place, But Geopolitics Will Drive Near-Term Fluctuations Chinese crude oil imports have been contracting for almost a year. Global (including US) demand for gasoline has relapsed. Meantime, Russia’s oil and oil product exports have fallen only by a mere 5% from their January level. This explains why oil prices have recently fallen. Oil lags business cycles: its consumption will shrink as global growth downshifts. However, geopolitics remain a wild card. Hence, we are uncertain about the near-term outlook for oil prices. That said, oil has made a major top and any rebound will fail to last much longer or push prices above recent highs. Chart 25 Chart 26 Chart 27 Chart 28 What Is Next For The Chinese RMB? The Chinese yuan will continue depreciating versus the US dollar. China needs lower interest rates and a weaker currency to battle deflationary pressures. While currency is moderately cheap, exchange rates tend to overshoot/undershoot and can remain cheap/expensive for a while. The CNY/USD has technically broken down. Interestingly, the periods of RMB depreciation coincide with deteriorating global US dollar liquidity and, in turn, poor performance by EM assets and commodities. Chart 29 Chart 30 Chart 31 Stay Put On Chinese Equities Odds are rising that Chinese platform companies will likely be delisted from the US as we have argued for some time. Hence, international investors will continue dampening US-listed Chinese stocks. The outlook for China’s economic recovery and profits is downbeat. This will weigh on non-TMT stocks and A shares. Within the Chinese equity universe, we continue to recommend the long A-shares / short Investable stocks strategy, a position we initiated on March 4, 2021. Chart 32 Chart 33 Chart 34 Chart 35 Messages For Stocks From Corporate Bonds Historically, rising US and EM corporate bond yields led to a selloff in US and EM share prices, respectively. Corporate bond yields are the cost of capital that matters for equities. Unless US and EM corporate bond yields start falling on a sustainable basis, their share prices will struggle. Corporate bond yields could increase because of either rising US Treasury yields or widening credit spreads. Chart 36 Chart 37 EM Currencies And Fixed-Income: An Unfinished Adjustment The profiles of EM FX and credit spreads suggest that their adjustment might not be complete. We expect further EM currency depreciation and renewed EM credit spread widening. EM domestic bond yields have risen significantly and offer value. However, if and as US TIPS yields rise and/or EM currencies continue to depreciate, local bond yields are unlikely to fall. To recommend buying EM local bonds aggressively, we need to change our view on the US dollar. Chart 38 Chart 39 Chart 40 Chart 41   Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Special Report

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Executive Summary Russia’s Crude Oil Output Will Fall Russia will have to lower oil production to ensure output it hasn’t placed with non-EU buyers does not tax its limited storage facilities, ahead of the bloc’s December 5 embargo. The EU’s insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonight’s close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russia’s Crude Oil Output Will Fall Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EU’s embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russia’s crude sales last month – ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russia’s seaborne crude oil sales, according to Bloomberg data. Related Report  Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end – vs its current output of 10.6mm b/d output presently – and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSA’s max capacity is 12mm b/d, while the UAE’s is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producers’ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply Chart 3Spare Capacity Concentrated In Core OPEC 2.0 Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand – particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year – +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand – the US and Europe – show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level – even with China’s negative y/y growth – while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track – it excludes the market-share wars of 2015-17 and that of 2020, and the pandemic’s effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after they’ve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EU’s embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will push crude oil prices higher and inventories lower (Chart 7).3  Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonight’s close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate inventories – diesel and heating oil mostly – were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the People’s Bank of China’s decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 Chart 9     Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloyd’s List 9 August 2022. The report notes, “All the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.“ 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022