Geopolitics

Supply - demand fundamentals point to higher oil prices going forward. Our expectation regarding OPEC production remains unchanged: The original cartel led by the Kingdom of Saudi Arabia (KSA) will maintain production discipline this year – likely continuing to over-comply with quotas agreed at the start of the year – to support its long-standing goal to reduce oil inventories globally. Non-OPEC member states in OPEC 2.0 led by Russia also will maintain lower output this year. The OPEC 2.0 coalition will meet July 1 - 2 in Vienna to determine whether it will extend production cuts. On the demand side, we lowered our expectation for this year and next, following the World Bank’s recent downgraded assessment of global GDP growth. Our expectation remains slightly above the EIA’s and the IEA’s. Globally, central bank easing will support demand. Following these adjustments, we are keeping our Brent forecast at $73/bbl this year and lowering our forecast for next year to $75/bbl from $77/bbl. We continue to expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The balance of risk is to the upside. The risk of hybrid warfare (see below) in the Persian Gulf -- and the wider region -- will increase, as Iranian and U.S. positions harden. Highlights Highlights Energy: Overweight. The U.S. Central Command released photos supporting an analysis claiming Iran was responsible for two attacks on commercial shipping in the Persian Gulf last week. The Pentagon deployed an additional 1,000 troops to the region, following this assessment. President Trump, meanwhile, downplayed the attacks, calling them a “very minor event.”1 Base Metals: Neutral. Copper speculators lifted their short position 6k lots to 51.7k lots on CME last week. This is a record short. But the cash market is getting tighter. Treatment and refining charges (TC/RCs) moved lower last week, as Fastmarkets MB’s TC/RC Asia – Pacific index hit $54.10/MT, $05.41/lb. This is the lowest level on record for the index, which was launched in June 2013. A low index reading means copper concentrate is in short supply, forcing refiners to lower the price of their services. We remain long the September 2019 $3.00/lb Calls vs. short the September 2019 $3.30/lb calls. Precious Metals: Neutral. Safe-haven demand continues to support gold prices, although news of a Trump – Xi meeting at the G20 in Japan to re-start trade talks reduced the urgency of buying earlier this week. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Rain continued to soak the U.S. Midwest this past week, putting a bid under grains – particularly corn – and beans. This week’s USDA Crop Progress report showed corn planting still behind schedule (at 92% vs. 100% on average in the 2014 – 18 period in the 18 states that accounted for 92% of total acres planted last year). Feature The information flows to oil markets are becoming internally contradictory. On the one hand, recent attacks on commercial oil-product tankers near the Strait of Hormuz – where close to 20% of the world’s oil supply transits daily – raised the ante in the U.S.-GCC-Iran stand-off.  The attacks follow earlier aggression against shipping and pipelines in the region, and prompted KSA’s Energy Minister Khalid al-Falih to call for a collective response to keep Gulf sea lanes open to allow oil to flow freely worldwide.2 In the post-WWII era, the U.S. has willingly taken on the responsibility of keeping the world’s sea lanes open for the free flow of commodities and finished products. However, based on remarks U.S. President Donald Trump made to Time magazine this week, it would appear the U.S. no longer is willing to shoulder the burden of defending freedom of navigation in the Persian Gulf.3 The presidential sangfroid in the wake of last week’s attacks in the Gulf – which Pentagon analysts insist were launched by Iran – might be explained by the Trump administration’s belief the global oil market is “very well-supplied,” as U.S. Deputy Energy Secretary Dan Brouillette contended in an S&P Global Platts interview this past weekend.4 Indeed, this has become part of the narrative whenever the administration discusses oil markets. Brouillette said abundant crude availability prevented oil prices from spiking to $140/bbl in the wake of the attacks on the two commercial tankers. Will The U.S. Defend Gulf Sea Lanes? The global oil market is “well supplied” as long as the Strait of Hormuz – the most critical chokepoint in the world – stays open. Freedom of navigation on the open seas is the sine qua non of a well-functioning oil market – everything from getting supplies to refiners to getting products to consumers depends on it. Oil is a globally traded, waterborne commodity: ~ 60% of all crude exports are loaded on a ship and sent to refiners, directly or via trading companies.5 A liquid crude market requires an unimpeded shipping market, so that refiners can run their operations in a routine manner. In addition, a smoothly functioning shipping market allows refiners to pick and choose among various grades that can be arbitraged against each other, so they can optimize charging stocks. The market cannot absorb the loss of close to 20mm b/d of crude and refined products, which is what would happen if the Strait shut down. It is the most important choke point in the world (Map 1). We’re sure the White House knows this. President Trump’s professed desire to leave the U.S. commitment to maintaining the free flow of oil out of the Gulf is a “question mark” that might be taken as a taunt to up the ante with Iran. Already, in response to the U.S. re-imposing sanctions on Iranian oil exports after unilaterally abrogating the Joint Comprehensive Plan of Action (JCPOA) agreement, Iran announced it will resume production of enriched uranium for its nuclear program on June 27.6 As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated. The growing tension in this standoff increases the risk of hybrid warfare in the Persian Gulf, which, should it continue to escalate, increases the risk to global oil flows, as Anthony H. Cordesman at the Center For Strategic & International Studies in Washington recently noted: First, the military confrontation between Iran, the U.S., and the Arab Gulf states over everything from the JCPOA to Yemen can easily escalate to hybrid warfare that has far more serious forms of attack. And second, such attacks can impact critical aspects of the flow of energy to key industrial states and exporters that shape the success of the global economy as well as the economy of the U.S.7 There is a risk this hybrid warfare metastasizes into a full-on war in the Gulf, which would threaten the free flow of oil through the Strait of Hormuz. Should the Strait be closed, a global oil-price shock almost surely would occur, which most likely would send oil prices through $150/bbl. At that point either the warfare is contained and resolved quickly, or the world has to line up 20mm b/d of crude oil and refined products to replace the lost supply from the Gulf. As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated (Chart of the Week). Chart of the WeekVolatility Will Remain High OPEC 2.0 Will Maintain Production Discipline Even as tensions in the Persian Gulf escalate, we continue to expect OPEC 2.0 to maintain its production discipline. While the producer coalition agreed to remove 1.2mm b/d of production from the market last December, we estimate year-on-year (y/y) year-to-date (ytd) production of OPEC is down ~ 1.4mm b/d in the January-to-May period. For Russia, production over that period y/y is up 310k b/d ytd. For all of OPEC 2.0, we have the group increasing production in 2H19, but we have it ending 2019 with production 480k b/d lower than last month’s forecast. The increase is mainly from Saudi Arabia, which averages ~ 10.2mm b/d of production in 2H19, roughly 130k b/d below quota. We have Russian production averaging ~ 11.5mm b/d, which is close to quota, in 2H19 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) For the year as a whole, we are forecasting OPEC production will fall 1.6mm b/d this year versus 2018 levels, while Russia’s production grows slightly (~ 80k b/d). For next year, OPEC’s production will stay relatively flat (falling ~ 70k b/d), while we expect Russia’s production to increase 230k b/d (Table 1). Outside OPEC 2.0, the U.S. continues to dominate the production-growth story, led by increasing shale-oil output (Chart 2). We expect shale output to grow ~ 1.2mm b/d this year and just over 1mm b/d in 2020. Chart 2U.S. Shales Dominate Non-OPEC Production Growth Global Demand Is Holding Up While we do expect somewhat lower demand this year and next versus where we were earlier this year, we still expect consumption to remain fairly robust. We expect demand to grow ~ 1.35mm b/d this year and 1.55mm b/d next year, down from 1.50mm and 1.60mm b/d, respectively, in our base case. As always this is led by non-OECD demand growth, which we expect will clock in with an increase of just over 1mm b/d this year versus last year, and 1.3mm b/d next year on average. EM commodity importers will dominate growth, as usual (Chart 3). Trade-war concerns will continue to dominate headlines, but even so, demand remains reasonably stout. While it always is possible the U.S. and China will be able to resolve their trade war – perhaps in dramatic fashion following the G20 meeting in Japan – our colleagues in BCA Research’s doubt it.8 Continuing Sino – U.S. and Iranian – U.S. tension could keep the USD relatively well bid, which will present a headwind to oil demand.  That said, we believe central banks generally will feel compelled to remain accommodative so long as trade wars persist. This accommodation, coupled with fiscal stimulus in many of the systemically important economies, will be supportive of demand overall, EM demand in particular. Chart 3EM Oil Demand Growth Once Again Leads The World Bottom Line: Supply – demand balances indicate crude oil prices still have room to run in 2H19 and next year. We are maintaining our forecast of $73/bbl for Brent this year. We are lowering our forecast for 2020 to $75/bbl (Chart 4). We expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The combination of stout demand growth, production discipline by OPEC 2.0 and capital discipline by U.S. shale producers will allow inventories to resume drawing this year (Chart 5). Chart 4Supply - Demand Balances Point To Higher Prices Chart 5Stout Demand, Supply Discipline Will Allow Inventories To Draw   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see Analyst: New Photos Are ‘Smoking Gun’ Proving Iranian Involvement in Tanker Attack published by USNI News, and Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. 2      Please see Saudi Energy Minister calls for collective effort to secure shipping lanes published by reuters.com June 17, 2019. 3      Please see Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. Tessa Berenson reported: “Facing twin challenges in the Persian Gulf, President Donald Trump said in an interview with TIME Monday that he might take military action to prevent Iran from getting a nuclear weapon, but cast doubt on going to war to protect international oil supplies.“I would certainly go over nuclear weapons,” the president said when asked what moves would lead him to consider going to war with Iran, “and I would keep the other a question mark.” 4      Please see Interview: Abundant oil supply prevented spike to $140/b after ship attacks - US DOE deputy published by S&P Global Platts June 16, 2019. 5      Please see World Oil Transit Chokepoints published by the U.S. EIA. 6      Please see Iran nuclear deal: Enriched uranium limit will be breached on 27 June published by bbc.co.uk June 17, 2019.  JCPOA agreement between Iran and the so-called P5+1 nations – China, France, Germany, Russia, the U.K. and the U.S. – allowed Iran to return to global markets in exchange for limiting its nuclear development.  Please see The Joint Comprehensive Plan of Action (JCPOA) at a Glance published by Arms Control Association in May 2018.    7      Please see The Strategic Threat from Iranian Hybrid Warfare in the Gulf published by CSIS June 13, 2019. 8      Please see Policy Risk Restrains Oil Prices published by BCA Research’s Commodity & Energy Strategy May 30, 2019, where we reprise the different policy risks oil markets are contending with at present, particularly the trade war.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Closed

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Highlights Bad news is still looming in the trade war. Public opinion polling in the U.S. gives President Trump more leeway to push the envelope on tariffs and sanctions against China than the consensus recognizes. Trump’s tendency to push the envelope is forcing China into a corner in which structural concessions become too risky. Unrest in Hong Kong reveals the city-state’s political woes as well as the tail-risk of a geopolitical incident in Taiwan. Tariffs on Mexico are still possible. Close long MXN/BRL. Maintain tactical safe-haven plays. Feature Judging by the S&P 500, the Federal Reserve has cut interest rates and the G20 summit between Presidents Donald Trump and Xi Jinping has been a success (Chart 1). Chart 1Trade War? Who Cares! The problem is that there is not yet a compelling, positive, political catalyst on the trade front. And the Fed has an incentive to wait until after the June 28-29 G20 to make its decision on any cut. At least in the case of the December 1 G20 summit in Buenos Aires there was significant diplomatic preparation ahead of time. That is not yet the case for the summit in Osaka, Japan. And even Buenos Aires ended up being a flop given the subsequent tariff escalation. We are maintaining our tactical safe-haven recommendations – long gold, Swiss bonds, and Japanese yen – until we see a clearer pathway for the risk-on phase to resume amid a summer loaded with fair-probability geopolitical risks: Trump’s aggressive foreign policy, the Democratic primary, China’s domestic policy, the U.S. immigration crisis, and Brexit. Beyond this near-term caution, we agree with BCA’s House View in remaining overweight equities on a cyclical basis (12 months). China’s economic stimulus is likely to pick up further this summer and it still has the capacity to deliver positive surprises. Preparing For The G20 Over the course of this year we have argued for a 50% chance and then 40% chance that the U.S. and China would conclude a trade deal by the G20 summit. However, Commerce Secretary Wilbur Ross and other administration officials, including Chief of Staff Mick Mulvaney, have recently indicated that the best case at the G20 is for the leaders to have dinner and agree to a new timetable that aims to close the negotiations in the coming months. The Trump-Xi summit itself remains unconfirmed as we go to press. This suggests that we were too optimistic about even a barebones trade deal at the G20. We are now extending our time frame to the November 2020 election -- the only deadline that really matters. Diagram 1 presents a cogent and conservative decision tree that results in a 41% chance of a major, Cold War-style escalation in tensions; a 27% chance of a minor escalation that is contained but without a final trade agreement; and a 28% chance of a tenuous or short-term deal. It gives only a 4% chance of a “grand compromise” that initiates a new phase of re-engagement between the two economies. These outcomes clearly represent a large downside risk given where equities are positioned today. Diagram 1Trade War Decision Tree (Updated June 13, 2019) Why such gloom when the two sides may be on the brink of a new tariff ceasefire? First, delaying the talks beyond the G20 is disadvantageous for Trump and will make him angry sooner or later. The Trump administration, unlike its predecessors, has made a point of opposing China’s traditional playbook of drawing out negotiations. China benefits in talks over the long run because it gains economic and strategic leverage. This has been the case in every major round of dialogue since the 1980s and it is specifically the case today, as China gradually stimulates its way out of the slowdown that afflicted it at the time of the last G20 (Chart 2). Chart 2China's Bargaining Leverage To Improve On Stimulus Trump would not have called a ceasefire on Dec. 1, 2018 if the stock market had held up amid Fed rate hikes and the Sept. 24 implementation of the 10% tariff on $200 billion. This year the U.S. equity market has bounced back and the Fed has paused, but China’s economy has not yet fully recovered. This gives Trump an advantage that may not last if the talks extend through the rest of the year. And this reasoning explains why Trump raised the tariff rate and blacklisted China’s tech companies in May – to try to clinch a deal by the end of June. He is also threatening to impose tariffs on the remaining $300 billion worth of imports if Xi snubs him in Osaka. If the G20 fails to produce progress, we would bet that Trump will proceed with a sweeping tariff on the remaining $300 billion worth of Chinese imports, whether immediately after the summit or at some later point when he decides that the Chinese are indeed playing for time. How can we be confident of this? After all, Trump’s approval rating has fallen since he escalated the trade war in May and it remains well beneath the average post-World War II presidents at this stage in their first terms, including President Obama’s rating in the summer of 2011 (Chart 3). Recent opinion polls suggest that voters are getting wise to the negative impact of tariffs on their pocketbooks. The financial and political constraints on Trump are not very pressing. We are confident because the financial and political constraints on Trump are not very pressing, at least not at the moment. First, the stock market has risen despite the tariff hikes, so Trump is likely emboldened. Second, Trump is less constrained in the use of tariffs than in other areas. He is bogged down with a Democratic Congress, investigations, and scandals at home. He cannot pursue policy through legislation – he shifted to the threat of tariffs on Mexico because he could not build his border wall. By turbo-charging his trade policy and foreign policy – against China, Iran, Mexico, Russia, most recently Germany … basically everyone except North Korea – he creates the option of turning 2020 into a “foreign policy election” rather than an election about the economy or social policy. A strong economy has not enabled him to break through his ceiling in public opinion thus far and he will lose a social policy election easily (see health care). The risk of his aggressive foreign policy is that it triggers an international crisis. But that would likely benefit him in the polls, given the natural inclination to defend America against foreign enemies. See George W. Bush, 2004 (Chart 4). Third, popular opposition to Trump’s trade war is not clear-cut – voters are ambivalent. In the past we have shown that President Trump’s 2020 run still depends on his ability to increase voter turnout among whites, specifically white males, low-income whites, and whites without college degrees. Recent polls suggest that voters have turned against tariffs and the trade war – namely the Quinnipiac and Monmouth University polls released in late May after the latest tariff hike. But it is essential to dig beneath the surface. These polls reveal that the key voting groups look more favorably than the rest of the country upon Trump’s policies on both trade and China (Chart 5). These voters’ assessment of Trump’s performance overall, across a range of policies, is not disapproving, despite all of the unorthodox and disruptive decisions that Trump has made in his presidency thus far (Chart 6). American voters are neither as enthusiastic about free trade nor as appalled by protectionism as the headline polling suggests. For instance, take the Monmouth University poll, which asked very specific questions about trade, tariffs, and retaliation. If we combine the group of voters who are clearly protectionist with those who are “not sure” or think the answer “depends,” the results do not suggest that Trump is heavily constrained (Table 1). Table 1Americans Are Not As Pro-Free Trade As It Seems In swing counties 51% of voters think that free trade is either a bad idea or are undecided. And even 57% percent of voters in counties that voted for Hillary Clinton by more than a 10% margin are in favor of tariffs or unsure. And a majority of voters in the most relevant categories – independents, moderates, non-college graduates, low-income earners – believe that Trump’s tariffs will bring manufacturing back, a highly relevant point for an election that will likely swing on the Rust Belt yet again. This includes Clinton’s most secure districts (Chart 7)! The point is not that Trump lacks political constraints on the trade war – after all, these voters are on the borderline in many cases and concerned about all-out trade war with China. Rather, his aggressive trade tactics enable him to reconnect with and energize his voter base at a time when his other signature policies are tied down. This is critical because his reelection prospects, which we have pegged at 55%, are in great peril, at least judging by his lag in the head-to-head polling against the top Democrats in swing states. Bottom Line: Going forward, Trump has more room to push the envelope than investors realize. A failed G20 summit poses the risk of another selloff in global equities. We are maintaining our tactical safe-haven trades.   What About Xi Jinping’s Constraints? Xi is president for life and must be attentive to long-term ramifications. Chart 8Xi Jinping's Immediate Constraint If Trump is tempted to continue pushing the envelope, will President Xi back down? While not constrained by the stock market or elections, he does face the prospect of instability in the manufacturing sector and large-scale unemployment (Chart 8), which Beijing has not had to deal with for 20 years. The point is not to claim that laid-off Chinese workers will turn around and protest against their own country in the face of gunboat diplomacy by capitalist imperialists – on the 70th anniversary of the regime, no less. Rather, Xi is president for life and must be attentive to the long-term ramifications of a disruptive transition in the excessively large manufacturing sector. This would cause economic and, yes, ultimately socio-political problems for him down the road. If Trump continues to move toward his 2016 campaign pledge of a 45% tariff on all Chinese imports, as the 2020 election approaches, China’s leaders have far less incentive to put their careers (and lives) on the line to produce structural concessions. A tariff covering all Chinese goods is an absolutist position that China can only address by doubling down on its demand for full tariff rollback. Yet Trump needs to retain some tariffs to enforce the implementation of any agreement. Thus slapping tariffs on all Chinese imports is almost, but not quite, an irreversible step. This is captured in Diagram 1 via the 29% chance that tensions are contained even if a deal falls through. Tensions are even less likely to be contained if the Trump administration follows through on its threats against China’s tech sector. On August 19, the Commerce Department will decide whether to renew the license for U.S. companies to sell key components to Huawei and other blacklisted companies. If the administration denies the license – and moves further ahead with export controls on emerging and foundational technologies – then Beijing faces an outright technological blockade. It will retaliate against U.S. companies – a process already beginning1 – and will likely act on other threats such as a rare earths embargo. In this case strategic tensions will escalate dramatically, including saber-rattling in the air, in cyberspace, or on the high seas. At the moment political frictions in Hong Kong are exacerbating U.S.-China distrust. Bottom Line: Since President Xi’s constraints are longer-term, he has the ability to deny structural concessions to Trump. But Trump’s ability to push the trade war further and further risks forcing China to a point of no return. There is not a clear basis for the geopolitical risk affecting the global trade and growth outlook to fall. Hong Kong: A New Front In The U.S.-China Struggle The large-scale protests that have erupted in Hong Kong – first on April 28 and most recently on June 9 –are important for several reasons: they highlight the immense geopolitical pressure in East Asia emanating from China’s “New Era” under Xi Jinping; they are rapidly becoming entangled in U.S.-China tensions, particularly over technological acquisition; and they foreshadow the political instability on the horizon in Taiwan. Tensions have been rising between Hong Kong and mainland China since the Great Recession and the shock to capitalist financial centers around the world. The tensions are symptomatic of the dramatic change in China over the past decade; the decline of the post-Cold War status quo; and the broader decline of the western world order (e.g. the British Empire). After all, the West is lacking tools to preserve the rights and privileges that Hong Kong was supposed to be guaranteed when the transfer of sovereignty occurred in 1997. More immediately, the current protests are part of a process going back to 2012 in which the disaffected and marginalized parts of Hong Kong society began speaking up against the political establishment. This emerged because of high income inequality (Chart 9), shortcomings in quality of life, excessive property prices (Chart 10), and the mainland’s reassertion of Communist Party rule and encroachments on Hong Kong’s autonomy. Chart 10Another Source Of Hong Kong's Unrest A simple comparison with Singapore, the other major East Asian city-state, shows that Hong Kong has trailed in GDP per capita and wage gains, while property price inflation has soared ahead (Chart 11). These structural economic factors contributed to the emergence of the “Occupy Central” protests in 2014, which were smaller than today’s protests but signaled the abrupt shift in the political sphere toward disenchantment and activism. Chart 11Why Hong Kong Is Not As Quiet As Singapore The 2016 elections for the Legislative Council (LegCo) resulted in a fiasco by which a number of pro-democracy activists, known as “localists,” were squeezed out of the legislature through a combination of juvenile mistakes and heavy-handed intervention by Beijing and the pro-mainland Hong Kong authorities (Chart 12 A&B). Beijing exploited the occasion to extend its legal writ over Hong Kong society and curb some of the city’s freedoms.2 The democratic opposition and dissidents have been sidelined or repressed — and now they face the prospect of being extradited, given that the LegCo is highly likely to pass the “Fugitive Offenders and Mutual Legal Assistance in Criminal Matters” bill that sparked the protests this year. The exclusion of the localists from power runs the risk of radicalizing them and increasing disaffection, making mass protests likely to recur both in the near term and in future. Hong Kongers are losing confidence in the “One Country, Two Systems” arrangement (Chart 13). They are similarly becoming more disillusioned with mainland China, adding fuel to the fire over time (Chart 14). However, in the specific case of the city-state, there is no alternative to Beijing’s ultimate say – and the older generations will continue to support the political establishment. Nevertheless Hong Kong’s discontents will become entangled in the broader Cold War emerging between the U.S. and China. Beijing is accusing the protesters of being lackeys of foreign powers. The U.S. Congress, on both sides of the aisle, is threatening to declare that Hong Kong is no longer sufficiently autonomous from Beijing and therefore no longer eligible for special privileges. Hong Kong faces rising political dependency on China and the potential for special relations with the United States to decline. Part of Washington’s concern lies with Beijing’s aggressive technological acquisition program. Hong Kong has been able to import advanced dual-use technology products from the United States without Beijing’s restrictions. This is not apparent from the proportion of exports but it is important on the technological level (Chart 15). It introduces a backdoor for China to acquire these goods and has prompted a rethink in Washington. Hong Kong is also accused of facilitating the circumventing of sanctions on U.S. enemies. It thus faces rising political dependency on China and the potential for special relations with the United States to decline. These pressures also highlight why we view Taiwan as a potential “Black Swan.” Similar political fissures are emerging as Beijing expands its economic and military dominance over Taiwan. Of course, the political backlash against Beijing has recently been receding in Taiwanese opinion, due to the fact that the nominally pro-independence Democratic Progressive Party has lost most of the momentum it gained after the large-scale “Sunflower” student protests of 2014 (Chart 16). But there are still several reasons that the January 2020 election could become a geopolitical flashpoint: namely the developments in Hong Kong, China’s handling of them, Beijing’s tensions with Washington, and the Trump administration’s temptation to achieve some key goals with the Tsai Ing-wen administration before it leaves office (including arms sales). Even if the Taiwanese political winds shift to become less confrontational toward Beijing after January, the time between now and then is ripe for an “incident” of some kind. Beyond that, the pro-independence opposition will begin activating and marching against the next government if it proves obsequious to the mainland. Chart 16Taiwan: Pro-Mainland Forces Revive Over the long run, Taiwan is far more autonomous than Hong Kong, harder for Beijing to control, and much more attractive for Beijing’s enemies to defend – namely the U.S. and Japan. Moreover, as the tech conflict with Washington heats up, Taiwan becomes vital for China’s technological self-sufficiency, putting it at higher risk (Chart 17). Beijing will also frown upon the role of Taiwanese companies like FoxConn for taking early steps to diversify the supply chain away from China. This regional strategic reality is not conducive to U.S.-China trade negotiations. And even aside from the U.S., Beijing’s growing power generates resistance from its periphery. This is true of Chinese ally North Korea, which is trying to broaden its options, as well as a historic enemy like Vietnam. Other countries at a bit more of a distance are trying to accommodate both Beijing and Washington, but are increasingly seeing their regimes vacillate based on their orientation toward China – this is true of Thailand in 2014, the Philippines in 2015, South Korea in 2017, and Malaysia in 2018. These changes inject economic policy uncertainty on the country level. Over the long run we see Southeast Asia as a beneficiary of the relocation of supply chains out of China. But at the moment, with the trade war escalating and unresolved and with China taking a heavier hand, we are only recommending holding relatively insulated countries like Thailand. Bottom Line: Our theme of U.S.-China conflict is intertwined with our theme of geopolitical risk rotation to East Asia. States that have domestic-oriented economies, limited exposure to China, or greater U.S. support – including Japan, Thailand, South Korea, Indonesia, and Malaysia – face less geopolitical risk than those heavily exposed to China (Taiwan) or that lack U.S. security guarantees (Hong Kong, Vietnam). Investment Recommendations In addition to our safe-haven tactical trades – long spot gold, long Swiss bonds, and long JPY-USD – we are maintaining our long recommendation for a basket of companies in the MVIS global rare earth and strategic metals index. The basket includes companies not based in mainland China that have seen their stock prices appreciate this year yet have a P/E ratio under 35 (Chart 18). Chart 18Go Long Rare Earth Firms Ex-China We remain short the CNY-USD on the expectation that trade tensions will encourage Beijing to use depreciation as a countervailing tool, despite our expectation of increasing fiscal-and-credit stimulus. Over the long run, we would observe that trade escalation between the U.S. and China bodes poorly for China’s long-term productivity and efficiency. The basis for a reduction in trade tensions is a recommitment to the liberal structural reform agenda that Chinese state economists outlined at the beginning of Xi Jinping’s term in 2012-13. The current trajectory of “the New Long March,” in which Beijing pursues personalized power and uses stimulus to improve self-sufficiency and import-substitution, goes the opposite direction. It is not a pathway for innovation, openness, and technological progress. A simple comparison of China’s long-term equity total return highlights the market’s lack of enthusiasm about the current administration’s approach (Chart 19). The contexts were different, but the earlier outperformance grew from painful structural reforms and a grand compromise with the United States in the late 1990s and early 2000s. Chart 19The Market Wants Reforms And Trade Deal We are closing our long MXN / short BRL trade for a gain of 4.6%. This trade has bounced back from the U.S.-Mexico deal to avert tariffs. The agreement was not entirely hollow compared to earlier agreements: it calls for Mexico to accelerate the deployment of the National Guard to stem the flow of refugees from Guatemala and central America and expand the Migrant Protection Protocols across the southern border. Trump’s reversal – under Senate pressure, entirely unlike the China dynamic – gave the peso a boost, benefiting our trade. However, one of the fundamental reasons for this trade – the improvement in Mexico’s relative current account balance – has now rolled over (Chart 20) and the tariff threat will reemerge if Mexico proves unable or unwilling to stem the inflow of asylum seekers into the United States (Chart 21). Chart 20Peso Has Outperformed The Real   As we go to press, the attacks on tankers in Oman highlight our view that oil prices will witness policy-induced volatility and a rising geopolitical risk premium as “fire and fury” shifts to the U.S. and Iran in the near-term. Our expectation of increasing Chinese stimulus helps underpin the constructive view on oil and energy-producing emerging markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The American Chamber of Commerce in China and Shanghai released a survey on May 22, 2019 revealing that while 53% of companies have not yet experienced “non-tariff” retaliation by Chinese authorities, 47% had experienced it: 20.1% through increased inspections; 19.7% through slower customs clearance; 14.2% through slow license approvals; another 14.2% through bureaucratic and regulatory complications; and smaller numbers dealing with problems associated with American employees’ visas, increased difficulty closing investment deals, products rejected by customs, and rejections of licenses and applications. 2 We noted at the time, “Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.” See BCA Geopolitical Strategy, “Strategic Outlook 2017: We Are All Geopolitical Strategists Now,” December 14, 2016, available at www.bcaresearch.com.

Special Report

Highlights The odds of universal health care legislation being enacted in the U.S. by 2022 are about 10%-15%. Former Vice President Joe Biden is the most likely Democratic candidate in 2020, but the alternative is most likely a progressive candidate seeking universal health care. Trump is slightly favored to win in 2020, but a Trump loss is likely to translate into full Democratic control of the U.S. government, making ambitious legislation more likely to pass Congress. An overweight portfolio allocation in the S&P health care index is a sensible and defensive move. Fear selling in health care stocks could easily return but would create an exploitable trading opportunity at this late stage of the cycle. We are executing the upgrade of the S&P health care index via an upgrade of the S&P health care equipment index, which has seen a material valuation de-rating at the same time as profits are expanding, to overweight. Feature Will The Democrats Win? Can They Pass Universal Health Care? “Medicare for All,” or government-led universal health care in the United States, is less likely to become the law of the land by 2022 than the market expects. We put the probability at around 10%-15%. Here’s why. The industry faces only two certainties: Americans are getting older and the federal government is increasing its involvement. The former is a secular driver for health care demand. The latter is an inference drawn from the fact that the Republican Party failed to repeal the Affordable Care Act, or Obamacare, even when it had full control of government. It is very unlikely that the Republicans will get another chance at repeal. It is also very unlikely that the public will tolerate the current status quo forever. The result is that the U.S. will eventually end up with a restored Obamacare or an altogether new system with a greater government role. The Republican failure to repeal was not idiosyncratic – it was not based on the fact that the late Senator John McCain, who cast the decisive vote on July 27, 2017, had been diagnosed with brain cancer earlier that year. Rather, it was structural – the repeal failed because (1) it is always extremely difficult to remove an entitlement once it has been given to voters and (2) a slim majority of Americans approved of Obamacare – and still do (Chart 1). Republicans went on to dismantle aspects of Obamacare, including the problematic “individual mandate.” But they did so without replacing it. The result was a severe electoral defeat in the 2018 midterm elections, despite a huge drop in the unemployment rate (Chart 2) – which matters directly in a country where 49% get their health insurance through their employer. Health care was the single most important issue driving people to vote against the ruling party in November 2018, judging by both pre-election polls and exit polls (Charts 3 & 4). Chart 2Low Unemployment Has Not Solved Health Care Woes The need for reform is manifest. It is widely known that the U.S. spends more than other countries on health care (Chart 5) and yet achieves worse results: preventable mortality is higher than in other countries that spend less (Chart 6). Democrats have tried to overhaul the system since 1993. Even President Trump is seeking to cap prescription drug prices and maintain the Obamacare requirement that health care insurers accept customers with “pre-existing conditions.” Uncertainty has risen since the Republicans’ midterm defeat, which increases, or is seen as increasing, the odds of a Democratic victory in 2020. Such a victory would mark the third time in 12 years that American policy would witness a 180-degree reversal – and it would have a major impact on the health sector (Chart 7). Chart 7The Sector's Response To Major Political Events In truth Trump is still favored to win in 2020, on the back of the incumbent advantage – as long as the economy holds up. But with a chronically weak approval rating, and narrow 2016 margins of victory and the aforementioned midterm losses in key swing states, his odds of reelection are probably not much better than 55%. Meanwhile the Democrats are swinging to the left and may not settle simply for restoring Obamacare. Left-wing or “progressive” candidates for the Democratic nomination are polling in line with traditional center-left candidates (Chart 8), which is highly unusual (even compared with the 2007-08 race). Candidates are crowding onto the democratic socialist bandwagon in the wake of Bernie Sanders’s formidable challenge to Hillary Clinton and her subsequent loss to Trump. Could a progressive candidate win the nomination? Certainly. Former Vice President Joe Biden leads the pack at this early stage in the nomination process. He would seek to restore and build upon Obamacare. The second-ranked candidate is Sanders, whose initial proposal to create Medicare for All has transformed the national debate. Following Sanders are Senators Kamala Harris, who co-sponsored the latest version of the bill with Sanders, and Elizabeth Warren, an outspoken progressive who is also in favor of universal health care (Chart 9). Sanders does have a path to winning the nomination, as the leading progressive candidate at a time when the party is becoming more progressive. He performs better than Biden in head-to-head polls against Trump in the key battleground states (Chart 10). Strategic voters will have trouble convincing fellow Democrats that they should not vote for him because he is unelectable: he has a clear electoral path to the White House via Michigan, Pennsylvania, and Wisconsin, where he performed well in 2016 and polls well today. If Sanders has a chance, then Medicare for All has a chance. Because it is extremely difficult to unseat an incumbent president, a victory over Trump in 2020 is only likely to occur if there is a surge in voter turnout and Democratic Party support among (1) blue-collar workers who abandoned the Democrats for Trump in 2016, or (2) young voters, women, or minorities. Any such surge would also enable the Democrats to defend their senate seats while picking up Arizona, Colorado, and Maine, which are statewide elections that will be affected by the headline presidential race. And if the Democrats win 50 seats, they would get a majority in the senate, as the vice president would break any tie. With a majority, Senate Democrats could use the “nuclear option” to bypass the filibuster and drive through their priority legislation.1 This would set a new precedent with far-reaching consequences. But recent majority leaders have already begun eroding the filibuster and there is no hard constraint preventing a ruling party from removing it entirely. It is perfectly possible, and all the more likely if the nation sweeps a progressive candidate to power in a wave of enthusiasm for dramatic changes like universal health care. In other words, any victory against Trump is likely to entail full Democratic control of government. In this scenario, Democrats would have a very good chance of passing a major piece of legislation. Hence, if a progressive wins the nomination, and makes Medicare for All the policy priority, there is at least a 50/50 chance it will pass, probably more like 60%. The catch is that a progressive may not win the nomination. There is not decisive evidence that Americans really want Medicare for All. First, Americans tend to view their own health costs as “reasonable” (Chart 11). They are not, as a whole, clamoring for a single-payer system. Second, while Americans say they support Medicare for All, that support evaporates when they learn about the various policies that it would necessitate, such as eliminating private health insurance and raising taxes (Chart 12). Third, most Democrats are closer to Biden’s position than Sanders’s – they want to fix Obamacare rather than revolutionize the system (Chart 13). Fourth, Colorado tried to pass its own version of Medicare for All on the state level in 2016. The bill’s advocates were handed a 79% defeat by voters. Colorado is a swing state so it is not an irrelevant experiment. Fifth, independents are not shifting to the left in a way that would validate the sharp leftward shift within the Democratic Party (Chart 14). Nominating Sanders or another progressive is more likely to lead to a loss in the general election than it is to ensure that universal health care gets passed.   Chart 14Independents Not Swinging Dramatically To The Left A simple back-of-the-envelope exercise suggests that odds of universal health care by 2022 are about 10%-15%. Nevertheless, we attempt a conservative, back-of-the-envelope method for estimating the probability of passage. It runs like this: There is a 50% chance a progressive wins the Democratic nomination. We assume that if Biden wins it is because Democratic voters prefer a restitution of Obamacare. There is a 45% chance that Trump loses the presidential election. We assume that for the Democrats to unseat an incumbent is difficult enough that they will also win the Senate. Under these circumstances, there is a 50%-60% chance that universal health care legislation passes – even though it will be very difficult to get it over the line. (Note that the ACA passed very narrowly at a time when the Democrats had a huge tailwind due to voters’ disenchantment after the global financial crisis). With these assumptions, the conditional probability of passage is around 13.5% (0.5 x 0.45 x 0.6 = 0.135) These odds can be moderated by boosting Trump to a 69% chance of reelection (the historical average for sitting presidents), which brings down the odds of ultimate passage to 9%. Note, however, that the bond market is pricing a 27% probability of a recession 12 months from now (Chart 15). If there is a recession, then President Trump is virtually assured to lose reelection and the Democratic victor will have a strong tailwind of public support. This will increase the chance that universal health care passes to 80%. (We still assume in this case that Biden would stick with Obamacare as he would not be committed to Medicare for All and it is not an economic stimulus package). The conditional probability would become 0.5 x 0.27 x 0.8 = 11%. Chart 15Probability Of Recession Is Rising NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low In other words, whether we upgrade Trump’s chances of winning or we upgrade the chances of a recession that kicks him out of office, the odds are roughly the same at 9%-11%. And they could be a bit higher at 14%. Medicare for All has a chance of becoming law, although it is not all that great. Bottom Line: With fairly conservative assumptions the odds range from 10%-15%. that the U.S. could legislate a sweeping overhaul of the health care system and new social entitlement by 2022. This is a serious risk to the industry. Health care equities have recovered the losses suffered since Sanders’s latest push for Medicare for All, which means that it is not pricing in a high probability of passage at present. Additional policy-related selloffs are likely between now and the spring of 2020, if and when the odds increase of Sanders (or another progressive) winning the Democratic nomination. Buy Into Health Care Weakness Regardless of the likelihood of passage, the faintest hint of the winds of change has brought about significant price changes in the relevant equities. In the lead up to the 2016 U.S. presidential election, Hillary Clinton, a health care reformer (though importantly NOT a Medicare for All advocate) was polling well ahead of Donald Trump. Health care stocks underperformed the broad market in anticipation of potential reforms resulting from a Clinton win (Chart 16). Two years after Donald Trump’s election, both S&P health care equipment and S&P managed health care have significantly outperformed with the effect most dramatic in the former. Chart 17 shows the reverse picture: a “blue wave” in the 2018 midterm elections was swiftly followed by the zenith for health care stocks as the market digested the implications of a Democratic House and the resulting higher probability of a similar sweep in 2020 in the Senate and executive branch. Chart 16Election Fear Creates Buying Opportunities... Chart 17...And History Appears To Be Repeating Itself Furthermore, our prior research shows that S&P health care has been the top performer in the last equity market surge to take place between the peak of the ISM manufacturing composite index and the beginning of the subsequent recession.2 This research was confirmed in a report last month analyzing sector returns after a Fed loosening cycle begins. The S&P health care index has historically outperformed from six months before a rate cut all the way to two years after easing policy.3#fn_3 As a reminder, the market has now priced in two rate cuts over the next year. We recommend an overweight position for the broad S&P 500 health care index as well as for health care equipment. BCA’s U.S. Equity Strategy has already moved to an overweight recommendation on the S&P managed health care index, a move that has netted our portfolio 12.4% of alpha. Today U.S. Equity Strategy is raising our recommendations on both the S&P health care equipment and, more importantly, the broad S&P health care index from neutral to overweight. Further, considering U.S. Equity Strategy’s recent portfolio changes, namely moving the S&P materials index to neutral, this upgrade of S&P health care to overweight moves our cyclicals vs. defensives style preference from overweight cyclicals to neutral. This move to the sidelines on the cyclical/defensive portfolio bent has netted modest gains of 2% since its October 2, 2017 inception. Equipping The World’s Hospitals Our upgrade of S&P health care equipment to overweight is not contingent upon earnings outperformance. Rather, it is a combination of overwrought investors having created a buying opportunity, combined with health care’s historic outperformance at the end of the business cycle. Nevertheless, an examination of the sector’s macro environment is revealing. The health care equipment index has recently completed an inventory clear-out cycle, as evidenced both by a slingshot rebound in the shipments-to-inventories ratio (second panel, Chart 18) and a recovery in industry pricing power (bottom panel, Chart 18). This is remarkable in the context of the deceleration in equipment fixed-investment growth that the industry has faced since reaching decade-highs in 2017 (third panel, Chart 18). The upshot is that steady pricing and resilient volume growth should deliver positive top-line growth. The margin picture has also dramatically improved: industrial production has been surging for the past year while hours worked have remained tepid (second and third panels, Chart 19). The combination has driven our productivity proxy to a multi-year high where it has recently diverged from the relative stock price (bottom panel, Chart 19). Chart 18Inventories Have Cleared Chart 19Productivity Is Soaring This underpins our thesis that health care stocks in general and health care equipment stocks in particular have recently suffered based on fear, not fundamentals, amidst a stable domestic demand environment and rosy profit picture. The export channel is at least as important to the S&P health care equipment index as the domestic demand environment. In fact, roughly 60% of sector revenues are generated outside the United States. The news on this front is encouraging. Europe, the other key market for domestically-manufactured health care equipment, has lately seen a pickup in new orders and coupled with the loss of momentum in the trade-weighted U.S. dollar signal that future export growth will remain upbeat (trade-weighted U.S. dollar shown inverted and advanced, bottom panel, Chart 20). The global PMI has historically led exports. While this series has turned down, it has been diverging from export growth for the past year. We believe this is a function of the early stages of a secular trend in health care equipment: the expansion of the EM safety net with health care at its core. The same demographic trend that has been driving the explosion of health care spending in the DM for the last 20 years is rapidly impacting the EM, namely an aging population. The UN projects that the share of the population aged 65 and older in the EMs will rise from roughly 7% this year to 16% in 2060, while population growth slows to below the replacement rate, a tectonic shift in the demographic landscape (Chart 21). Meanwhile, according to IMF data, EM health care spending is approximately 5% of GDP. By contrast, the DMs stand in excess of 14%. Chart 20The Export Valve Is Wide Open A catch-up phase looms, driven by both demographics and an overall global harmonization of standard of care, resulting in a secular outperformance of internationally geared health care equipment manufacturers’ earnings. This bodes well for U.S. health care equipment providers who are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Notwithstanding the bright outlook, fear selling in the S&P health care equipment index has driven a reversal in the two-year valuation rerating that the index has undergone (bottom panel, Chart 22). With the valuation retreating back to its historical range, our main concern that the index is too expensive has eroded. Further, the valuation decline is coming at a time when forward earnings growth has come out of hiding and is now slated to materially outgrow the broad market (middle panel, Chart 22). Chart 22Valuations Have Returned To Earth Bottom Line: Something has to give in this equation and macro tailwinds suggest that a valuation re-rating phase looms. Accordingly, we are moving to an overweight recommendation on the S&P health care equipment index. This move pushes our S&P health care index to an above benchmark allocation and also moves our cyclical vs. defensive preference back to neutral. The ticker symbols for the stocks in the S&P health care equipment index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR. BCA’s Geopolitical Strategy echoes the tenor of these recommendations and is going long the S&P 500 health care index and the health care equipment index versus the broad market. A Word On Pharma Between 1980 and 2000, pharma earnings expanded at a record clip, taking sector share prices into the stratosphere (top panel, Chart 23). Since the zenith in the early 2000’s, margins have been continually under pressure as R&D costs have outpaced volume gains (second panel, Chart 23). However, earnings growth has continued mostly uninterrupted as the industry has raised drug prices. Since 2015, however, price increases have flat lined and now they move at the same pace as overall inflation, though the current convoluted system keeps pricing mostly opaque (bottom panel, Chart 23). We think this is the new normal. The thesis of this report revolves upon a blue vs. red probability outcome. However, as noted, both parties seem united in the fight against high drug costs and Republicans under President Trump are not averse to government intervention to drive down prices. As such, we expect the pharma pricing headwinds to remain a secular trend, driven by outrage from both sides of the aisle and even universal coverage is not enough to bear the pressure. Accordingly, we reiterate our underweight recommendation. Chart 23Pharma Remains Underweight Conclusion Universal health care will be negative for the U.S. budget deficit but positive for economic growth. As for the macroeconomic impact of universal health care, it is complex to assess because much would depend on the extent of any reduction in private health-related sectors. Almost certainly, the U.S. would adopt a parallel system where private health care remains available, but there inevitably would be some job losses in the insurance sector. And drug companies would face downward pressure on pricing. On the other hand, the marked increase in government spending would be stimulative. And we do not see future American administrations exercising a heretofore unknown fiscal discipline once such a new entitlement is established. Many families would enjoy a reduction in health care costs. Overall, it should be positive for economic growth.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy ChrisB@bcaresearch.com Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      The filibuster is a means of prolonging debate and obstructing a vote. It can be defeated if 60/100 senators vote to move to end debate (“cloture”). It effectively ensures that the three-fifths majority is the standard majority needed to pass legislation in the senate. However, it is possible for the senate majority leader, backed with a simple majority, to alter the senate rules and remove the filibuster, so legislation can be passed with a simple majority. But it would be an aggressive move and a historic precedent. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap” dated May 6, 2019, available at uses.bcaresearch.com.   Current Recommendations