Commodities & Energy Sector

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Portfolio Strategy Depressed technicals, compelling valuations, macro tailwinds, improving operating fundamentals and the messages from our relative profit growth models and relative Cyclical Macro Indicators all signal that the time is ripe to initiate a long energy/short utilities pair trade. Pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Recent Changes Initiate a long S&P Energy/short S&P Utilities pair trade today. Table 1 Feature Equities propelled to uncharted territory, celebrating an easy Fed and the US/China détente with a hint of a tariff rollback, overcoming the seasonally difficult months of September and October. Historically, investors chase performance during the end of the year and seasonality will likely favor further flows into equities in the last two months of the year. On the economic front, while manufacturing remains in recession, a resilient labor market is providing a significant offset allaying fears of recession gripping the broad economy. Drilling deeper on the labor front is revealing. The unemployment rate ticked higher to 3.6% last month based on the household survey as the participation rate increased. However, according to the Sahm Rule Recession Indicator (SRRI), courtesy of Fed economist Claudia R. Sahm,1 were the unemployment rate to average 4% for three consecutive months by September 2020, the US economy will enter recession. In other words, based on empirical evidence the SRRI shows that when the three-month average unemployment rate has jumped by 50bps compared with previous twelve month low, the US has entered recession 100% of the time since the end of WWII (Chart 1). Chart 1Watch The Sahm Rule Recession Indicator Meanwhile, the parallels drawn with the mid-to-late 1990s and the current market backdrop have mushroomed, but our view is that the differences could not be wider. Since the history of our reconstructed SPX data going back to the late-1920s, there has never been a five-year period when the S&P 500 rose by at least 20% every year except for the 1995-1999 era. In that five-year period the SPX soared more than threefold, increasing annually by 34%, 20%, 31%, 27% and 20%, respectively. Investors forget that those were manic markets and despite a high and rising fed funds rate that peaked at 6.5% in early 2000 (real rates were over 4%), the forward P/E multiple went to the stratosphere ignoring theory and defying logic (Chart 2). Putting the late-1990s exuberance into perspective is instructive: if 1995 is similar to 2016 (and 1998 is similar to 2019) then the SPX should spike to over 6000 by the end of next year! Moving over to economic green shoots, we turn our attention to the signal the emerging markets are emitting. While both the EM and the Chinese manufacturing PMIs are expanding smartly, leading indicators suggest that the recovery may be running on empty. Chart 2One Of A Kind Chart 3Mixed Signals Chart 3 shows that the Chinese credit impulse is contracting, weighing on EM FX momentum and also signaling that the CAIXIN China manufacturing PMI, that has opened the widest gap with the official China NBS manufacturing PMI since the history of the data, will likely suffer a setback in the coming quarters. In the transportation sector, the Baltic Dry Index is down 33% since the early-September peak and is also losing steam on year-over-year basis, warning that a global trade recovery is skating on thin ice. Moreover, EM sentiment is downbeat. Investor flows into EM equities, according to the most liquid iShares MSCI EM ETF, have been drifting lower since the 2018 peak and have more recently gapped down (bottom panel, Chart 3). Thus, the recent green shoots may prove fleeting. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. With regard to US liquidity, that we have been inundated with client requests recently, we highlight our simple liquidity indicator: industrial production (IP) growth versus M2 money supply growth. In other words, we gauge how fast a unit of currency is translated into IP. Chart 4 highlights that IP/M2 is contracting at an accelerating pace, heralding further earnings growth pain for the S&P 500. US dollar based liquidity is also contracting as we showed in last week’s US Equity Strategy Webcast slides. Chart 4Clogged Pipelines Weighing On Profit Growth Other SPX profit indicators we track continue to suggest that the earnings soft patch is not out of the woods yet (we use forward EBITDA estimates to gauge trend growth, which excludes the one time fiscal easing boost to net EPS). Net forward EBITDA revisions are below zero, the ISM manufacturing new orders-to-inventories ratio has fallen 40% from the 2018 peak and is hovering near parity, momentum in the key ISM manufacturing new orders subcomponent is contracting and BCA’s boom/bust indicator continues to deflate. All of this, suggests that a turnaround in profits remains elusive and is a first half of 2020 outcome, at the earliest (Chart 5). Already, Q4/2019 profit growth estimates have now sunk into negative territory according to the latest FactSet data.2 Finally, the Fed released the last Senior Loan Officer Survey of the year in the past week and demand for C&I loans collapsed. This data series has broken below the 2016 trough and warns that C&I credit origination will continue to contract. Chart 5No Pulse Chart 6Capex Contraction Dampens Need For Credit Such a souring backdrop makes intuitive sense as animal spirits have died down courtesy of the Sino-American trade war. CEO’s are still voting with their feet and are canceling/postponing capital outlays. Absent capex, C&I credit demand runs aground (Chart 6). It remains unclear if a US/China “phase one” trade deal including tariff rollbacks can reverse the ongoing global trade contraction, signaling that caution is still warranted on the prospects of the broad equity market for the next 9-12 months. This week we are initiating a new market-neutral pair trade and reiterate our negative view on a niche defensive sector. Long/Short Idea: Buy Energy/Sell Utilities There is an exploitable opportunity in going long the S&P energy sector/short the S&P utilities sector and we recommend initiating this market-neutral trade today. The top panel of Chart 7 shows that energy stocks have come full circle and are trading at levels last seen two decades ago when WTI oil was fetching less than half of today’s $55/bbl price. Encouragingly, there seems to be long-term support for relative share prices at the current overly depressed level. While utilities have been making headlines all year long given their outperformance, when put in proper perspective this niche defensive sector with a mere 3% weight in the SPX looks like a shipwreck (bottom panel, Chart 7). Taken together, this battle between two diminishing sectors presents a tradable opportunity by favoring energy stocks at the expense of utilities. In fact, this ratio trades at more than two standard deviations below the historical uptrend, and thus offers a lucrative risk/reward profile (Chart 8). Chart 7Buy Energy… Chart 8…At The Expense Of Utilities Beyond depressed technicals and compelling overall valuations with an alluring relative dividend yield (investors are paid an unprecedented 100bps in dividend yield carry to put on this trade, Chart 9), macro tailwinds, improving operating fundamentals, and the messages from our relative profit growth models and relative Cyclical Macro Indicators (CMI), all signal that the time is ripe to initiate a long energy/short utilities pair trade. On the macro front, inflation expectations have tentatively troughed and if oil rebounds further, as our Commodity & Energy Strategy service expects, then given their tight positive correlation with oil prices, rising inflation expectations should put a definitive floor under the relative share price ratio (Chart 10). Chart 9Unloved And Oversold Chart 10Return Of Inflation… However, the real interest rate component (i.e. growth) also explains roughly half of the selloff in the 10-year Treasury yield since early September, which also moves in lockstep with relative share price momentum (bottom panel, Chart 10). Were this budding global growth recovery to gain steam into the first half of 2020, then energy profits would outshine utility sector profits. As a reminder, oil is a global growth barometer and rises with increasing global growth while defensive utilities flourish when growth sputters (Chart 11). The US dollar’s recent appreciation has also dealt a blow to this trade and a grinding lower currency which is synonymous with a modest global growth recovery would also reverse this pair trade’s fortunes (top two panels, Chart 12). Chart 11…And Green Shoots Beneficiary Chart 12Operating Metrics Also… Zooming into the relative operating outlook, the bottom panel of Chart 12 shows that oil price inflation is outpacing natural gas selling prices. This relative underlying commodity backdrop is important as energy stocks move with the ebbs and flows of the oil market, whereas the marginal price setter for utility services is natural gas prices. The upshot is that heading into 2020, bombed out relative share prices should play catch up to the firming relative commodity backdrop. Capital spending outlays also favor energy shares over utilities stocks (top two panels, Chart 13). Surprisingly, the utilities sector net debt-to-EBITDA ratio is above 5x, waving a red flag, but energy indebtedness is coming down fast in the aftermath of the early 2016 oil price collapse and the energy sector’s net debt-to-EBITDA ratio is close to 2x (bottom panel, Chart 13). Our relative CMIs and relative profit growth models do an excellent job capturing all these moving parts and are unanimously sending a bullish message that an earnings-led recovery is in store for the relative share price ratio (Chart 14). Chart 13…Favor Energy Over Utilities Chart 14Green Light From US Equity Strategy Models Bottom Line: Initiate a long S&P energy/short S&P utilities pair trade today. Out Of Power Warning Utilities stocks have been all the rave this year, but given their small weighting in the SPX they only explain a very small part of the broad market’s run (in contrast, the heavyweight tech sector explains most of the S&P 500’s rise as we highlighted in recent research).3 We reiterate our underweight stance in this small defensive sector that has run way ahead of soft profit fundamentals. Worrisomely, utilities trade with a 20 forward P/E handle and command a 20% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 350bps (not shown). Chart 15 shows that our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession. Technicals are also extended (bottom panel, Chart 15), warning that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam.   Chart 15Overbought And Overvalued   In sum, pricey valuations, overbought technicals, the selloff in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. The top panel of Chart 16 shows that relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. Similarly, the recent selloff in the total return bond-to-stock ratio also warns that buying up expensive utilities at the current juncture is fraught with danger (second panel, Chart 16). The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (new export orders shown inverted, bottom panel, Chart 16). Chart 16Budding Recovery Weighing On Utilities Chart 17Sell The Strength Turning over to the sector’s operating metrics reveals that investors piling into utilities is unwarranted. Natural gas prices are contracting at the steepest pace of the past four years (middle panel, Chart 17) and signal that the path of least resistance is lower for relative share price momentum. Meanwhile, electricity capacity utilization is in a multi decade downtrend, warning that the relative profitability will remain under pressure in the coming quarters (bottom panel, Chart 17). In sum, pricey valuations, overbought technicals, the sell-off in the bond market and weak profit fundamentals, all warrant an underweight stance in the S&P utilities sector. Bottom Line: Shy away from the expensive S&P utilities sector. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     https://www.federalreserve.gov/econres/claudia-r-sahm.htm 2       https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q4-2019 3       Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The correlation between oil and petrocurrencies has shifted in recent years. It no longer makes sense going long petrocurrencies versus the US dollar blindly. One of the reasons has been the impressive and prominent output from US shale. We are currently long a basket of petrocurrencies versus the euro, but intend to shift this trade towards a short USD position on more visible signs of a breakdown in the US dollar. Go short CAD/NOK for a trade. Feature Chart I-1Oil And Petrocurrencies Have Diverged Since the middle of the last decade, one of the most perplexing disconnects has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices more than doubled, but the petrocurrency basket has underperformed by a whopping 110% versus the US dollar. This has been a very perplexing result that has surprised many investors on what was traditionally a very sound correlation (Chart I-1).  In general, an increase in oil prices usually implies rising terms of trade, which should increase the fair value of a currency. Throughout our modeling exercises, terms of trade were uncovered as what mattered the most for commodity currencies in general, and petrocurrencies in particular. In theory, this makes sense, given the improvement in balance-of-payment dynamics (that tend to be observed with a lag) and the ability for increased government spending, allowing a resident central bank to tighten monetary policy. In the case of Canada and Norway, petroleum represents over 20% and 50% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast, but it has now become a necessary but not sufficient condition. Oil Demand Should Recover We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt (Chart I-2). Chart I-2Oil Demand Has Been Weak Part of the slowdown in global demand is being reflected through elevated inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-3). Chinese oil imports continue to hold up well, and should easier financial conditions put a floor on the manufacturing cycle, overall consumption will follow suit (Chart I-4). Chart I-3Oil Inventories Are Elevated Chart I-4China Oil Imports Holding Up The increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity is only at 2%. This means that any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints – especially in the face of OPEC production discipline. Second, unplanned outages wiped out about 1.5% of supply in 2018, and should this occur again as oil demand recovers, it will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-5Opec Spare Capacity Is Low Bottom Line: A recovery in the global manufacturing sector will help revive oil demand. This should be positive for oil prices in general. A Necessary But Not Sufficient Condition Rising oil prices are bullish for petrocurrencies, but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. As the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-6). Chart I-6US Has Grabbed Oil Production Market Share This explains why the positive correlation between petrocurrencies and oil has been gradually eroded as the US economy has become less and less of an oil importer. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Meanwhile, falling production in Iran, Venezuela, and even Angola has been a net boon for US production and the dollar.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-7). Since then, that correlation has fallen from around 0.9 to around 0.2. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the US becomes a net energy exporter. Chart I-7Falling Correlation Between Petrocurrencies And The US Dollar Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Oil Consumers Versus Producers Our strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar downleg. We are long an oil currency basket versus the euro, but intend to make the switch once our momentum indicators for the dollar decisively break lower. With bond yields having already made a powerful downward adjustment, the valve for financial conditions to get any looser could easily be via the US dollar (Chart I-8). A loss of global market share has hurt the oil sensitivity of many petrocurrencies. The second strategy is to be long a basket of oil producers versus oil consumers. Chart I-9 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. It is also notable that the correlation has strengthened as that between petrocurrencies and the US dollar has weakened. Chart I-8The Dollar As An Arbiter Of Growth Chart I-9Buy Oil Producers Versus Oil Consumers Sell CAD/NOK The Norges Bank has been quite hawkish in spite of the dovish tilt by most other central banks. As such, the underperformance of the Norwegian krone, especially versus the euro, has been quite perplexing in the face of diverging monetary policies (Chart I-10). Our bias is that speculators have been using the thinly traded krone to play USD upside, but that momentum is now fading. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence, and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. A weak exchange rate will also anchor inflation expectations (Chart I-11). Chart I-10Diverging Monetary ##br##Policies Chart I-11A Weak Exchange Rate Will Anchor Inflation Expectations Higher The underperformance of the Norwegian krone has mirrored that of global oil and gas stocks. Perhaps sentiment towards the environment and climate change has been pushing investor flows out of these markets, but given the central role oil plays in the global economy, we may have reached the point of capitulation (Chart I-12). Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts. Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-13). The CAD/NOK briefly punched through the 7.1 level in October but is now seeing a powerful reversal. Our intermediate-term indicators also suggest the next move is likely lower. The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart I-14) Chart I-12ESG And Global Divestments Chart I-13NOK Will Outperform CAD (I) Chart I-14NOK Will Outperform CAD (II) Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been strong:  The labor market remains tight: nonfarm payrolls increased by 128K in October, well above expectations of 89K. Average hourly earnings continue to grow by 3% year-on-year. Unit labor costs grew by 3.6% year-on-year in Q3. The ISM manufacturing PMI increased to 48.3 from 47.8 in October. The non-manufacturing PMI soared to 54.7 from 52.6 in October, well above expectations. The trade balance narrowed by $2.5 billion to $52.5 billion in September. The DXY index appreciated by 0.8% this week. ISM PMI data points to improvements in both manufacturing and services sectors, mainly supported by production, new orders, and the employment components. It will be interesting to monitor if this signals an improvement in the global manufacturing cycle, or is a US-centric issue. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Markit manufacturing PMI slightly increased to 45.9 from 45.7 in October. The services PMI also improved to 52.2 from 51.8. The Sentix confidence index increased to -4.5 from -16.8 in November.  Retail sales grew by 3.1% year-on-year in September, an improvement from the 2.7% yearly growth rate in the previous month. EUR/USD fell by 0.8% this week. On Monday, Christine Lagarde, the former managing director of the IMF, gave her first speech as the new ECB president where she urged Europe to overcome self-doubt, aiming to boost investor and business confidence in the euro area. However, no comments were given regarding ECB monetary policy. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Vehicle sales shrank by 26.4% year-on-year in October. The monetary base grew by 3.1% year-on-year in October. The services PMI plunged to 49.7 from 52.8 in October. The Japanese yen depreciated by 1% against the US dollar this week. We remain short USD/JPY given global economic uncertainties and domestic deflationary tailwinds. Should the global economy pick up early next year, the yen could still remain bid against the USD, allowing investors time to rotate their short USD/JPY bets. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 49.6 from 48.3 in October. Services PMI increased to 50 from 49.5 in October. Retail sales increased by 0.1% year-on-year in October, compared to a contraction of 1.7% in the previous month. Halifax house prices grew by 0.9% year-on-year in October. GBP/USD depreciated by 1% this week. On Thursday, the BoE decided to leave its interest rate unchanged at the current level of 0.75%. However, unlike a unanimous decision as in previous policy meetings this year, two BoE officials unexpectedly voted to lower interest rates amid signs of deeper economic slowdown and entrenched Brexit chaos. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Retail sales grew modestly by 0.2% month-on-month in September. The Commonwealth composite PMI fell slightly to 50 from 50.7 in October. The services PMI also fell to 50.1 from 50.8. The trade balance increased by A$1.3 billion to A$7.2 billion in September. Both exports and imports grew by 3% month-on-month in September. The Australian dollar has been volatile against the US dollar, but returned flat this week. The RBA has left its interest rate unchanged this Monday, as widely expected. We remain positive on the Australian dollar and went long AUD/CAD last week, which is currently 0.3% in the money. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The participation rate increased marginally to 70.4% from a downward-revised 70.3% in Q3. The labor cost index increased by 2.3% year-on-year in Q3. The unemployment rate however, climbed to 4.2% from 3.9%, higher than expectations of a rise to 4.1%. The kiwi fell by 1.4% against the US dollar, making it the worst performing G-10 currency this week. Despite the rise of the unemployment rate in Q3, the under-utilization rate, a broad measure of labor market spare capacity has fallen to the lowest level in over 11 years, as suggested by the manager of Statistics New Zealand, Paul Pascoe. That said, we remain underweight the kiwi given it will likely lag other commodity currencies in a global growth upswing. We will change this view if New Zealand terms of trade start to inflect meaningfully higher. Stay with our long AUD/NZD and SEK/NZD positions. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI was little changed at 51.2 in October. The trade deficit narrowed marginally from C$1.24 billion to C$0.98 billion in September. Exports and imports both fell in September. Ivey PMI fell to 48.2 from 48.7 in October. USD/CAD increased by 0.3% this week. The recent uptick in oil prices support the Canadian dollar, but the loonie will likely underperform other petrocurrencies. We remain bullish on the oil prices, however, spreads will likely continue to move against the Western Canadian Select blend. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline CPI fell below 0 at -0.3% year-on-year for the first time over the past 3 years in October. On a month-on-month basis, it contracted by 0.2%. Real retail sales grew by 0.9% year-on-year in September. PMI improved to 49.4 from 44.6 in October. FX reserves were little changed at CHF 779 billion in October. The Swiss franc fell by 0.9% against the US dollar this week. Faced with deflationary pressures, the SNB will likely to use its currency as a weapon to stimulate the economy and exit deflation. This will favor long EUR/CHF positions. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Industrial production contracted by 8.1% year-on-year in September, mainly caused by the slowdown in extraction and related services. On the positive side, manufacturing output grew by 2.9% year-on-year. The manufacturing output of ships, boats, and oil platforms in particular, grew by 26.2% year-on-year in September. The Norwegian krone appreciated by 0.3% against the US dollar this week, despite the broad dollar strength. The WTI crude oil price increased by nearly 6% this week, which is a tailwind for petrocurrencies. We maintain a pro-cyclical stance and expect oil prices to increase further. The global growth recovery and a weaker US dollar should all boost the oil demand, and lift the Norwegian krone. Please refer to our front section this week for more detailed analysis on the NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The manufacturing PMI fell marginally to 46 from 46.3 in October. Industrial production growth slowed to 0.9% from 2.1% year-on-year in September. Manufacturing new orders contracted by 1.5% year-on-year in September. The Swedish krona has been flat against the USD this week. The PMI components of new orders, industrial production, and employment all continued to fall. On the positive side, the export component increased marginally. We expect the cheap krona to help improve the trade dynamics in Sweden and put a floor under the krona. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – are experiencing mass unrest. Protesters in both states are calling for the dismantling of sectarian based political systems, economic reforms, and reduced foreign interference. The unrest in Iraq is of greater consequence due to its role as a major global oil supplier. The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary.  We remain tactically long spot crude oil on the back of the geopolitical risks to supply amid an expected revival in global demand. Feature A wave of popular uprisings has swept over Lebanon and Iraq. While the riots are to a large extent a product of long-standing economic and governance failures, the timing is consequential. The Middle East is experiencing a paradigm shift. With the US reducing its strategic commitment to the region, most recently evidenced by the withdrawal of its troops from northeast Syria, a power vacuum has emerged. This opens up the necessity for foreign actors – Russia – as well as regional powers – Saudi Arabia, Iran, and Turkey – to fill the void. The evolution of power could be unsettling given that it will likely generate greater instability in a region that is fertile ground for unrest. Iran has so far emerged a winner in this dynamic. It has expanded its influence in Iraq since the US pullout, it has played a critical role in saving the Assad regime, and it has seen Saudi initiatives fail in Syria, Yemen, Lebanon, and Qatar. It is making progress toward building its ‘land bridge’ to the Mediterranean (Map 1).1 Map 1Iran’s Aspirational ‘Land Bridge’ To The Mediterranean The tensions brought about by the US withdrawal from the JCPOA further illustrate Iran’s growing regional sway. It has hardened its stance. Meanwhile the US and its allies have been vacillating. The Saudi coalition – mired in a war in Yemen and confronting domestic risks – is reluctant to engage in a full-scale confrontation.  Even though Iran has a higher pain threshold, it stands on shaky ground. Just last year it was rocked by domestic protests demanding less foreign adventurism. Lebanon and Iraq are the two countries most entrenched in Iran’s sphere of influence. Protesters in both countries are calling for greater national unity – demanding an overhaul of the political system, and arguing that the sectarian set-up has failed to meet their most basic needs. What occurs in Beirut and Baghdad will be of great consequence for Tehran. Deadlock In Iraq “Out, out, Iran! Baghdad will stay free!” - Chants by Iraqi protesters While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.2 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Chart 1AFertile Ground For Unrest In Iraq The protesters are also united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 1A & 1B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 1BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Where the election results failed to translate into real change for Iraq is in the appointment of the Prime Minister. Abdul-Mahdi – a technocrat – was a compromise candidate that surfaced as a result of a five-month long political standstill between the two rival Shia blocs, each claiming to have gained a majority of seats in parliament. On one end is the Iran-backed bloc led by Hadi al-Amiri head of both the Fatah Alliance and the PMF, and Nouri al-Maliki leader of the State of Law Coalition. On the other end is al-Sadr’s Sairoon coalition, which joined forces with Ammar al-Hakim of the Wisdom Movement, and champions greater unity and less foreign interference. The result has been a weak prime minister who is perceived to be incapable of pushing back against Iraq’s ruling elites and ushering in structural reforms. Instead the Prime Minister is seen as benefiting from a corrupt system. The rift between Iraq’s rival Shia blocks is deepening. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs. Last week Abdul–Mahdi responded to calls by al-Sadr and former Prime Minister Haider al-Abadi to resign by arguing that it is up to the main political leaders to agree to put forward a vote of no confidence in the Iraqi parliament. He agreed to resign, on condition that political parties jointly approve of a replacement. For now, that appears improbable. In a move that has been interpreted as a display of Iranian interference, al-Amiri changed heart after a reported meeting with Iranian Quds Force leader Qassem Suleimani last week in Baghdad. He backed down on his agreement to support al-Sadr to bring down Abdul-Mahdi, and has instead stated Abdul-Mahdi’s resignation will only bring about more chaos. This interference on the part of Iran was likely induced by fears that a crisis-stricken Iraq would weaken its hegemony over the region. Iraq is in a state of deadlock. A vote of no confidence would require a majority of 165 in parliament and would require the support of various Sunni and Kurdish parties (Chart 2). Al-Sadr is likely calculating that a new election is in his best interest. He would be able to capitalize on the movement given that he has aligned himself with the protesters, and will gain seats in parliament. Chart 2A Shia Schism In Iraq’s Parliament This would allow the nationalist bloc to gain a majority and appoint a government that is acceptable to the protesters. However, this scenario would also entail greater meddling from Iran, as it is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.3 Despite the death of over 260 Iraqis, the protesters have yet to be deterred by the violence. This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. The impasse could be resolved if the main actors – the rival Shia blocs – agree to compromise. However, that is precisely what transpired last year and resulted in Abdul-Mahdi’s appointment. It ultimately led to only a temporary resolution of the unrest: a one-year deferral. If a similar compromise is reached in the current environment, it too will result in only a temporary détente. The grievances afflicting Iraqis cannot be resolved easily or swiftly. Iraq is in for an extended period of instability. Bottom Line: Iraqi protesters and authorities are in stalemate. The rift in the Shia bloc is deepening. There does not appear to be a clear path to bridge the demands and desires of the protesters and the leadership. Any détente will be temporary. Even if under a new election the protests translate to greater seats for the nationalist bloc, it will not translate to a de-escalation of domestic tensions. It may resolve the protests, but Iran-backed groups will retaliate. Iraq is in for an extended period of instability. Deadlock In Lebanon “All of them means all of them” “No to Iran – No to Saudi” - Chants by Lebanese protesters Just as Iraqi protesters are expressing national unity in calling for an end to sectarian politics and foreign interference, Lebanon’s protests stand out for crossing religious and regional divides. They have swept across the country, and include the Shia-dominated southern region where anger is even being directed at Hezbollah. Among the protesters’ demands is the removal of all three heads of the pillars of government – the Maronite Christian President Michel Aoun, the Sunni Prime Minister Saad Hariri, and the Shia Speaker of Parliament Nabih Berri. Rather than being a source of division, the unrest is a demonstration of unity among Lebanese of all ideologies against the entire political system. Since Prime Minister Saad Hariri’s resignation on October 29, the movement rages on. Protesters are claiming that they are unwilling to back down until all their demands are met, including a complete overhaul of the sectarian power-sharing system, which has defined the country’s politics since the end of the 1975-1990 civil war.4 Chart 3Economic Deterioration In Lebanon The movement and the protesters’ complaints are not surprising. The government has failed to prevent the economy from moving toward collapse. It has long been in decline, with Lebanese feeling the pinch of corruption, economic stagnation, high unemployment, and the effects of the massive influx of Syrian refugees (Chart 3).The trigger of the uprising, a tax on WhatsApp calls amid clear signs of a domestic liquidity shortage, is a delayed response to what citizens have already known and felt for some time: a deteriorating economic situation. While the protests were caused by these economic grievances, they persist due to a crisis of confidence between the political class and the masses. Neither concessions on the part of the government in the form of a list of reforms nor the prime minister’s resignation convinced protesters to halt the movement. The uprising appears set to remain steadfast so long as the current politicians remain in power. The challenge for Lebanon’s protesters – and political elite all the same – is that while the protesters are united in their demands, they have so far been headless. The protesters have refused to present a list of acceptable replacement leaders, insisting that it is the government’s role to propose potential alternatives to the people. This has led to deadlock and will be a hurdle for the government in negotiating with demonstrators. On the other side of the conflict, the current political class, including Hezbollah leader Hassan Nasrallah, has expressed warnings about the chaos that would ensue with a government resignation. According to the Lebanese constitution, following Hariri’s resignation President Aoun is now tasked with consulting Lebanon’s fractured parliament to determine the next prime minister – a role reserved for a Sunni Muslim. However, if history is any guide, this process could take months and protesters are not that patient. Given that Hariri has sidelined himself and – unlike Parliament Speaker Nabih Berri or Foreign Minister Gebran Bassil – he is not the core target of protesters’ ire, there is a possibility that he may once again be appointed to the post of prime minister. While the outgoing government will take on a caretaker role until a new one is formed, demonstrators are standing their ground. ​​This has generated a political standoff causing Lebanese assets to bear the brunt (Chart 4). The emergence of competing rallies – in the form of support for President Michel Aoun – only complicates and possibly prolongs the situation. For now, the army is staying on the sidelines, allowing the protests to be – for the most part – a peaceful one. However, with Hezbollah also subject to the protesters’ wrath, odds of greater regional tensions have increased. Hezbollah may attempt to regain lost support by provoking Israel. The instability could also prompt Hezbollah to reassert its willingness to use force against domestic enemies, namely any new government that attempts to disarm it. In the meantime, Lebanon’s economy and financial markets will remain under pressure. The economy depends on capital inflows from citizens living abroad to finance the large twin deficit and maintain the dollar peg. Thus, the decline in sentiment will weigh on the economy (Chart 5). While the government has not implemented official capital controls, banks have independently tightened restrictions and raised transaction fees to reduce capital outflow. Chart 4Further Unrest Ahead Chart 5Weak Sentiment Weighs On Lebanon's Economy Bottom Line: Lebanese protesters and the political class are in deadlock. The prime minister’s resignation has done little to ease the tension, and demonstrators are refusing to back down until a new non-sectarian, technocratic government is formed. The domestic economy will remain frail. Earlier this week the central bank asked local lenders to boost their liquidity by raising their capital by 20% or $4 billion in 2020 in anticipation of potential downgrades. A stabilization of the political situation is a necessary precondition to boost confidence and once again shore up capital inflows. Nevertheless, with the protest movement being largely headless, the path toward compromise with the government will be challenging, raising the odds of prolonged tensions. What Of Iran’s Sphere Of Influence? “Not Gaza, Not Lebanon, I Give My Life For Iran” - Chants by Iranian protesters, January 2018 Iran has a strong incentive to preserve the established systems in both Lebanon and Iraq. The protesters’ demands risk weakening its grip on power in the region. In both movements, pro-Iranian forces have taken a stance against the protests with Hezbollah in Lebanon advising against the resignation of Prime Minister Hariri while the Iran-backed bloc in Iraq voiced concern over the chaos that will ensue with the prime minister’s resignation. Meanwhile, Tehran’s position is hardening. Iran is taking further steps away from the nuclear deal, injecting uranium gas into centrifuges at its underground Fordow nuclear complex, making the facility an active nuclear site rather than a permitted research plant. Chart 6Popular Support For Iran’s Hardening Stance Chart 7US-Iran Détente Unlikely This reflects the loss of public support for the JCPOA and the loss of confidence that other countries will honor their obligations toward the nuclear agreement (Chart 6). In a speech on November 3 marking the fortieth anniversary of the 1979 US Embassy takeover, Supreme Leader Ayatollah Ali Khamenei renewed his ban on negotiations with the US. His stance mirrors public opinion, which is moving toward an increasingly unfavorable view of the US (Chart 7). However, this does not mean that President Hassan Rouhani’s administration is immune to popular discontent. Rather, with Iranians living through a continued economic deterioration and assigning the most blame to domestic mismanagement and corruption, there could be cracks forming in Iran as well (Chart 8). Chart 8A Case For Unrest In Iran? Bottom Line: The ongoing US withdrawal from the Middle East opens opportunities for Iran to increase its regional influence. It has been capitalizing on such opportunities by lending support to its proxies in Syria, Yemen, Iraq, and Gaza. However, the escalation of unrest in Lebanon and Iraq pose a risk to Iran’s grip on power in the region. On the one hand, if the movements there result in new governments, Iran will witness its wings clipped. This could incentivize retaliation and violence in Iraq, and provocations by Hezbollah along Lebanon’s southern border in an attempt to regain lost support. On the other hand, a prolonged standstill between protesters and the governments could result in greater Iranian influence over the long term. Other foreign powers are unwilling to wholeheartedly intervene to fill an emergent power vacuum. Investment Implications The risk of a decline in Iran’s control over its sphere of influence and the still unstable state of Iraqi domestic politics suggest that the geopolitical risk premium in oil prices should remain elevated. For now, President Trump is still enforcing sanctions and Iran’s oil exports have largely collapsed (Chart 9). The White House is continuing to add pressure by warning Chinese shipping companies – the largest remaining buyer of Iranian oil – against turning off their ships’ transponders. Chart 9The US Maintains Pressure On Iran News reports indicate that oil workers in Iraq’s southern region have started to join the government demonstrations. Moreover, reports on Wednesday indicate that the 30k b/d of production from the Qayarah oil field has been shut down due to road blockades in Basra that are preventing trucks from transporting crude to the Khor al-Zubair port. The geopolitical risk premium in oil prices should remain elevated. While the impact on the country’s oil production and exports have so far been minimal, a prolonged standoff between protesters and the government could result in supply outages. Today’s environment is notably different than that of the ISIS invasion of Iraq in 2014. Tensions then did not create a geopolitical risk premium in oil as they occurred amid an oil market share war, which kept supply abundant. Similarly, the September attack on Saudi Arabian oil facilities did not result in a lasting price spike as it occurred at a time of weak global demand. Moreover, Saudi Arabia possesses the technology and spare capacity that permitted it to swiftly restore output and maintain export commitments. The same cannot be said today about Iraq. A disruption there would be of greater consequence to oil markets, as illustrated by the 2008 Battle of Basra. Especially given Saudi Arabia's need to maintain high prices and amid the Aramco IPO and the tailwind created by a rebound in global growth. The fall in global economic policy uncertainty as the US and China move toward a trade ceasefire will weaken the dollar and support global demand for oil, which is overall bullish for oil prices. Moreover, US-Iran tensions remain unresolved which pose risks to production and shipping infrastructure in the region. We remain tactically long spot crude oil on the back of the geopolitical risks to supply as well as an expected revival in global demand. We are booking a 4.6% gain on our GBP-USD trade but remain long sterling versus the yen. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1    The ‘land bridge’ is an aspirational route by which Iran would create a strategic corridor to the Mediterranean, stretching through friendly territory. 2   Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 3   Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. 4   Under the current system, Lebanon’s president has to be a Maronite Christian, the parliament speaker a Shiite Muslim and the prime minister a Sunni. Cabinet and parliament seats are equally split between the two Muslims groups and Christians.

Highlights The slowdown in global industrial activity appears to have bottomed. This, along with an apparent shared desire for a ceasefire in the Sino-US trade war, points toward a measured recovery in manufacturing and global trade, which will contribute to higher iron-ore and steel demand beginning in 1H20. A trade-war ceasefire, should it endure, will reduce global economic uncertainty. Along with continued monetary accommodation from systematically important central banks, reduced economic uncertainty will boost global growth and industrial-commodity demand generally by allowing the USD to weaken. We expect Beijing policymakers to remain focused on keeping GDP growth above 6.0% p.a. To that end, we believe a boost in infrastructure spending next year is likely, which also will be bullish for steel demand. Given China’s growing share of global steel production, we expect price differentials for high-grade iron ore – most of which comes from Brazil – to widen as steel demand increases next year. Given this view, we are initiating a strategic iron-ore spread trade at tonight’s close: Getting long December 2020 high-grade (65% Fe) futures traded on the Singapore Exchange vs. short the benchmark-grade (62% Fe) December 2020 futures traded on the CME. We recommend a 20% stop-loss on this recommendation. Feature Iron ore and steel demand will get a lift from the rebound our proprietary Global Industrial Activity (GIA) index has been forecasting for the past few months (Chart of the Week). The GIA index is designed to pick up changes in Chinese industrial activity, given its outsized influence on world industrial output, and also makes use of trade data, FX rates, and global manufacturing data. The rebound we are expecting will get a fillip from an apparent shared desire for a ceasefire in the Sino-US trade war, which, based on media reports, is close to being agreed. Should this ceasefire prove to be durable, it would contribute to a lowering of global economic policy uncertainty (GEPU), which, as we have shown recently, has kept the USD well bid to the detriment of industrial-commodity demand.1 Chart of the WeekBCA GIA Index Pick-Up Points To Higher Global Steel Demand While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. As global economic uncertainty fades, the USD broad trade-weighted index for goods (TWIBG) will fall, which will bolster EM GDP growth, and a recovery in global trade next year (Chart 2). If, as media reports suggest, this so-called “phase-one” agreement includes a relaxation – or complete removal – of tariffs by the US on Chinese imports, we would expect manufacturing activity to pick up as Chinese manufacturers spin-up capacity to meet demand. A reduction in tariffs also will lessen the deadweight loss they imposed on US households, which will support higher consumption.2 Chart 2Reduced Global Economic Uncertainty Bolsters Global Trade Volumes, EM GDP That said, economic uncertainty still remains high. This uncertainty is destructive of demand and will remain a key risk factor in 2020. While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. China’s Steel Demand Holds Up In Trade War China accounts for more than half of global steel production and consumption, and the lion’s share of seaborne iron-ore consumption (Chart 3). This makes its steel industry critically important to the global economy, and a key barometer of industrial activity worldwide. With global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises. China’s apparent steel demand held up fairly well during the slowdown observed in manufacturing and in commodity demand growth globally, averaging 8% y/y growth ytd (Chart of the Week, bottom panel). It now appears to be stalling in the wake of the global manufacturing slowdown. In addition, Chinese credit stimulus remains weak, contrary to expectations. However, with global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises.3 Chart 3China Dominates Global Steel Production and Consumption Chart 4Construction, Real Estate Strength Offset Lower Chinese Auto Production Greater demand for steel by the construction and real estate sectors offset lower consumption by the automobile industry in China this year, as manufacturing and trade slowed globally (Chart 4). Overall, apparent demand is still growing (Chart 5), which will continue to support iron ore imports, even though domestic production of low-grade ore picked up as steelmakers’ margins tightened earlier in the year (Chart 6). Chart 5China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown Chart 6China Iron Ore Imports Remain Stout Chinese imports from Brazil have rebounded following the Brumadinho tailings dam collapse in January at Vale’s Córrego do Feijão iron ore mine, which killed close to 300 people. The collapse in margins from steel mills combined with outages to Brazil and Australia high-grade ore exports led to a rise in imports and domestic production of low-grade iron ore. High-Grade Iron Ore Favored; Policy Uncertainty Persists Our overall view for industrial commodities – iron ore, steel, base metals and crude oil – is constructive but not wildly bullish going into next year. Our oil view, for example, calls for a rally in the average price of crude oil next year of ~ 10% from current levels for Brent crude oil, the world benchmark. While we expect global monetary stimulus to offset much of the tightening of financial conditions brought on by the Fed’s rate hikes last year, and China’s de-leveraging campaign of 2017-18, elevated economic uncertainty will keep the USD better bid that it otherwise would be absent the Sino-US trade war and global economic policy uncertainty. This translates into weaker commodity demand, generally, as a strong USD raises local-currency costs for consumers and lowers local-currency production costs for producers. At the margin, both push commodity prices lower. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. For iron ore and steel in particular, environmental considerations also are important, given the Chinese government's “Blue Skies Policy” aimed at reducing the country’s high levels of air pollution.4 This policy has led to the forced retirement of older, highly polluting steelmaking capacity, which has been replaced with newer, less-polluting technology that favors high-grade iron ore. However, the application of regulations designed to reduce pollution has been uneven, and still relies on local compliance, which has been spotty. We expect demand for high-grade ore will increase as global manufacturing and trade also recovers. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. The restoration of high-grade exports from Brazil means this ore will be available. It is worthwhile noting that these steelmakers account for an increasing share of global capacity. For this reason, we expect demand for high-grade ore will increase as global manufacturing and trade also recovers (Chart 7). Given our view, at tonight’s close we will get long December 2020 high-grade iron-ore futures (65% Fe) traded on the Singapore Exchange vs. short benchmark-grade iron-ore futures (62% Fe) traded on the CME. Both are quoted in USD/MT and settle basis Chinese port-delivery (CFR) indexes in cash. Given the uncertain nature of the durability and depth of the ceasefire currently being negotiated by the US and China, we will keep a stop-loss on this position of 20%. Bottom Line: China’s steel demand has held up relatively well despite the global slowdown in manufacturing and trade. Given our expectation for a pick-up in global growth – in response to global monetary and fiscal stimulus and lower economic uncertainty in the wake of a ceasefire in the Sino-US trade war – we expect Chinese steel demand to resume growing. This will support iron ore prices, particularly for high-grade ores. On the back of this expectation, we are recommending an iron-ore spread trade, going long high-grade futures vs. short benchmark-grade iron ore futures. Chart 7High-Grade Iron Ore Should Outperform Strategically   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up Energy: Overweight. Bloomberg reported China is looking to invest between $5-$10 billion in the Saudi Aramco IPO through various vehicles. Such an investment would give China a deeper stake in the Kingdom’s oil industry, and a hedge to price shocks. In addition, it could open the way for deeper investment in the Saudi oil and petchems industries. For KSA, as we have argued in the past, a deepening of China’s investment and involvement in the Kingdom’s economy would diversify the states that have a vested interest in ensuring its safety.5 We will be updating our analysis of China’s pivot to the Middle East, and KSA’s pivot to Asia next week. Separately, we the last of our Brent backwardation trades – i.e., long December 2019 Brent vs. short December 2020 Brent – was closed last week with a gain of 110.8%. Base Metals: Neutral. Copper prices are up 6% vs. last month, supported by supply-side worries in Chile and, more recently, easing trade tensions. Cyclically, we believe copper prices are turning up – spurred by easy monetary conditions and fiscal stimulus directed at infrastructure and construction spending. Most of our key commodity-demand indicators have bottomed and are suggesting EM demand growth will move up. This supports a year-end base metal rally. Precious Metals: Neutral. A risk-on sentiment fueled by expectation the U.S. and China will sign a trade deal weighs on gold’s safe-haven demand. Prices fell 2% since last week. Additionally, U.S. 10-year bond yields shot higher – pushing gold prices lower – on Tuesday following a stronger-than-expect ISM services PMI data release. Gold-backed ETF holdings reached a new record in September at 2,855 MT (up 377 MT ytd), surpassing the December 2012 peak. A reversal in investors’ sentiment towards gold could send prices down. Ags/Softs: Underweight. The USDA reported that 52% of the U.S. corn has been harvested, a 13 percentage point increase relative to last week, yet the figure came shy of analysts’ expectation and far below the 2014-2018 average of 75%. On a weekly basis, corn prices are still down 2% due to drier weather forecast. Soybean harvest did better reaching 75%, and meeting expectations. Soybean price is almost unchanged on a weekly basis, despite having edged higher earlier in the week on the back of rising expectations the US and China will agree on a ceasefire in the ongoing trade war.   Footnotes 1     We measure this uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related economic uncertainty. Newspapers from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 2    We discuss deadweight losses to US households arising from the tariffs in Waiting To Get Long Copper, In China’s Steel Slipstream, published August 29, 2019. It is available at ces.bcaresearch.com. 3    BCA Research’s China Investment Strategy expects China’s business cycle likely will bottom in 1Q20 of next year, rather than in 4Q19. This aligns with our expectation. Please see China Macro And Market Review, published November 6, 2019. It is available at cis.bcaresearch.com. 4    We examined the implications of China’s “Blue Skies” policy in China's Anti-Pollution Resolve Critical To Iron Ore Markets, published April 4, 2019. It is available at ces.bcaresearch.com. 5    We discuss these issues in our Special Report entitled ضد الواسطة published November 16, 2018. The Arabic title of the report translates as "Against Wasta." Wasta means reciprocity in formal and informal dealings. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

In lieu of our regular weekly report, we are sending you a special report by our colleagues Bob Ryan, Chief Commodity and Energy Strategist, and Hugo Bélanger, Senior Analyst, from BCA Research Commodity & Energy Strategy. The report highlights how global economic policy uncertainty over the past year has enabled gold and the USD unusually to rise together. In the near term, the combination of global economic stimulus and a US-China trade ceasefire should reduce policy uncertainty and encourage global demand for commodities. On a cyclical basis this should allow the dollar to fall back, inflation expectations to revive, and gold to appreciate. We trust you will find this research useful and insightful. All very best, Matt Gertken Geopolitical Strategy Feature The once-reliable negative correlation between gold and the USD was indefinitely suspended beginning in 4Q18 by the pervasive economic uncertainty we identified last week as the culprit holding back global oil demand growth via a super-charged dollar.1 This uncertainty is most pronounced in the US and Europe vis-à-vis gold, and partly explains the performance of safe havens, particularly the USD, which has soared to new heights on a trade-weighted goods basis, and gold (Chart of the Week). So far, gold has held its ground after breaking above $1,500/oz from the low $1,200s in mid-2018, indicating investors are much more concerned about economic risks arising from economic policy uncertainty than inflation and other diversifiable risks gold typically hedges (Chart 2). Cyclically we remain positive on gold prices on the back of a lower dollar and rising inflation pressure in the US. Chart of the WeekDemand For Safe Havens Soars As Economic Policy Uncertainty Rises Economic policy uncertainty in Europe and the US supports gold prices. Chart 2AUS, Euro Economic Uncertainty Correlated With Gold Prices Chart 2BUS, Euro Economic Uncertainty Correlated With Gold Prices Even so, we are putting a $1,450/oz stop-loss on our long gold portfolio hedge to cover tactical risks showing up in our technical indicators. In addition, as is the case with oil demand, if the ceasefire we are expecting in the Sino-US trade war materializes in 1H20 and limited trade – mostly in ags and energy – is forthcoming, demand for safe-haven assets could weaken gold prices at the margin. Fiscal and monetary stimulus globally also could revive economic growth and commodity demand, pushing global yields higher, which would put negative pressure on gold at the margin, as well, given the high correlation between real rates and gold prices. Feature The once-reliable negative correlation between gold and the USD will remain muted over the short-term tactical horizon – 3 to 6 months – as economic policy uncertainty continues to stoke global demand for safe havens.2 This can be seen in the elevated correlations between the USD’s broad trade-weighted goods index with the Baker-Bloom-Davis (BBD) Economic Policy Uncertainty (EPU) indexes for the US and Europe (Chart 3).3 Rising economic uncertainty – particularly since 4Q18 – has created a rare environment in which both the USD and gold trended up simultaneously and continue to move in the same direction. The implication of this is that gold’s correlation with both the USD and EPU is weaker than before because economic policy uncertainty now is positively correlated with the dollar. Chart 3Strong USD, EPU Correlation Chart 4Correlation of Daily Gold, USD Returns Also Moving Sharply Higher   There is a possibility global policy uncertainty could be reduced later this year if the US and China can agree on a trade ceasefire... The typically negative correlation between daily returns of gold and the USD also is weakening, moving toward positive territory (Chart 4), as both the USD and gold trend higher simultaneously (Chart 5). Chart 5Gold and USD Levels Trending Higher ...If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. Our short-term technical indicator is signaling an overbought gold market (Chart 6), and our fair-value model indicates gold should be trading ~ $1,450/oz (Chart 7). The latter signal off our fair-value model is less concerning, given the demand for safe-haven assets like the USD and gold now dominates gold’s typical drivers. Chart 6Gold Technical Indicators Signal Overbought Market Chart 7High USD Correlation Throws Off Fair-Value Model However, to be on the safe side, we are placing a $1,450/oz stop-loss on our long-term gold position, which as of Tuesday’s close was up 21% since inception on May 14, 2017. This is a precautionary measure, which recognizes the possibility global policy uncertainty could be reduced later this year if the US and China can agree on a trade ceasefire, and global fiscal and monetary policy are successful in reviving EM income growth, which would revive commodity demand generally, pushing up global bond yields. If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. During that period, the monetary and fiscal aggregates we track as explanatory variables for gold prices will reassert themselves as the dominant drivers of gold prices (see below). This could produce tension between a falling USD and rising real rates as growth picks up, which would send us to a risk-neutral setting re gold, given the current high correlation between gold and real rates, which should remain strong until the Fed starts hiking rates again, most likely in 2020 (Chart 8). This is part of the reason we are including the stop-loss at $1,450/oz for our existing gold position: During this risky period going into 1H20 economic uncertainty could dissipate, and real rates could rise. Although the USD depreciation would mute these effects, rising real rates would be a risk to gold prices. Chart 8Rising Real Rates Could Weaken Gold Prices Economic Uncertainty Dominates Gold’s Fundamentals At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. In Table 1, we collect the variables we consider when assessing gold’s fair value. At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. This variable broadly falls in the geopolitical risk we regularly account for in our analysis of gold markets. Table 1Fundamental And Technical Gold-Price Drivers If the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Checking off each of these groups, we see: · Demand for inflation hedges remaining muted over the short-term, as inflationary pressures remain weak. In line with our House view, however, we do expect inflation could move higher toward the end of next year and overshoot the Fed’s 2% target for the US. This would support gold prices. · Monetary and financial aggregates are working less well as explanatory variables for gold prices in a market dominated by economic policy uncertainty. The USD-gold correlation continues to be disrupted by strong demand for safe-haven assets. As inflation picks up next year, we expect nominal bond yields to rise. Real rates, however, could remain subdued, as long as the Fed is not aggressively raising rates to get out ahead of a possible revival of inflation (Chart 9). Later in 2020, the correlation between rates and gold should be supportive for gold prices – the correlation fades when the Fed tightens, which creates a demand for safe-haven assets like gold. All the same, an increase in real rates would be a risk to gold prices in 1H20. · At present, demand for portfolio-diversification assets via safe-haven assets is a powerful force in gold’s price evolution. It is worthwhile pointing out, however, that if global economic uncertainty is resolved and global growth does rebound, recession fears will diminish, thus reducing the marginal impact of geopolitical shocks. On the other hand, if the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Should that happen, short-term volatility in gold will rise (Chart 10). Chart 9Bond Yields Should Rise As Inflation Revives In 2H20 Chart 10Investors Expect Large Positive Moves In Gold And Silver Prices Investment Implications Over a tactical horizon – i.e., 3 to 6 months – we expect global economic policy uncertainty to remain elevated. Going into 2020 – and particularly in 2H20 – we expect the USD to weaken on the back of global monetary accommodation policies and increased fiscal stimulus. We also are expecting a ceasefire in the Sino-US trade war, which will revive trade somewhat and support EM income growth and commodity demand. These assumptions, which we’ve laid out in previous research, will be bullish cyclical factors supporting commodities generally. Bottom Line: A ceasefire in the Sino-US trade war, coupled with global fiscal and monetary stimulus, will reduce some of the economic uncertainty dogging aggregate demand. This should be apparent in the data in 1H20. As a result, we continue to expect rising EM income growth to be cyclically bullish for commodities generally. This will allow inflation to revive – again, assuming the Fed does not become aggressive in raising rates. Net, this will be bullish for gold: As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries (Chart 11) Chart 11EM Income Growth Will Support Demand For Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1               Please see “Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth,” published October 17, 2019, available at ces.bcaresearch.com. 2              We expect a ceasefire in the Sino-US trade war to be announced in 1H20, which will defuse – but not eliminate – an important risk for global growth in our analytical framework.  We expect this will allow the relationship between the USD and gold to move back to its previous equilibrium in 1Q20 or 2Q20. 3              For more info on the Baker-Bloom-Davis index, please see policyuncertainty.com