Commodities & Energy Sector

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights The U.S. oil market has always been dynamic, but, over the past couple of years, profound changes have been occurring at increasingly rapid rates. In Part 1 of this two-part Special Report, we presented our forecasts for U.S. independent E&P companies’ crude oil production.1 We concluded that U.S. producers would increase production by 15% and 10% yoy this year and next, roughly in line with guidance. We argued that this could be done with flat/higher capex this year, and that current guidance for more than a 10% yoy decrease in capex would not allow for the estimated production increase. This week, we publish Part 2 of our Special Report and look at some of the larger changes occurring in the U.S., and assess the big factors we believe could significantly impact the evolution of oil production: The Majors’ increasing presence in the Permian Basin; Rising U.S. Gulf of Mexico (GOM) production; and Bottlenecks at U.S. Gulf Coast export facilities. Feature The world’s largest privately held energy companies – the "Majors" – have committed to the U.S. in a big way – mostly in the Permian Basin in Texas – directing their formidable technology, scale, and, most importantly, strong balance sheets to expanding U.S. production. Guidance from supermajors2 indicates capital expenditures increased by 11.6% in 2018, and will increase by 17.3% in 2019 (Chart of the Week). U.S.-directed capex for the group has been in a steep upward trend since 2016. In 2018, Chevron, Exxon and BP increased their U.S upstream capex by ~ 50% y/y. Additionally, Exxon’s and Chevron’s U.S. upstream capex represented 30% and 36% of each company’s total capex vs. an average 22% and 23%, respectively, over the past 5 years. This is not exclusively related to tight-oil developments in the major shale basins. Nonetheless, it corroborates comments from these companies re the expansion of their activity in the U.S. tight oil market.3 The major oil companies are expected to invest more than $10 billion in the Permian this year, according to IHS Markit.4 The supermajors could add close to 1mm b/d by 2021 and ~ 2mm b/d of production from U.S. shales alone by 2024, most of it in the Permian and at the lower end of the shale production cost curve. Adding this to the guidance from the E&Ps highlighted in Part 1 of our Special Report motivates our positive U.S. crude production outlook. We expect U.S. onshore production will increase by close to 1.3mm b/d in 2019, and ~ 1mm b/d in 2020. Longer term, the presence of these major integrated oil companies in the U.S. shale patch will reduce production’s price-elasticity. This is because, for some of these companies with all-in sustaining costs close to $40/bbl, tight-oil production out of the Permian will become baseload production, which higher-cost producers will be forced to adjust to going forward.5 These major oil producers focus mainly on the medium- to long-term, on sustainable and stable production, and dividend growth versus short-term production in response to higher – and often transient – prices. The latter production strategy – i.e., ramping production as prices rise – can only be sustained by outspending cash flow (Chart 2). Chart 2E&Ps Have Outspent Their Cash flow Since 2011 Moreover, large integrated oil companies can sustain extended periods of low prices from their shale projects, because their focus is on being the lowest-cost producers wherever they operate. This is the strongest risk-management policy an oil producer can pursue, because it minimizes revenue and profit exposure to low and volatile prices. In addition, these firms develop a presence in midstream and downstream operations to diversify revenues, which reduces direct exposure to E&P activity, thus benefiting balance sheets and income statements. Our updated full-cycle breakeven price for our group of independent E&P companies – arguably the marginal light-tight-oil producer – suggests shale production’s average breakeven (excluding land acquisition costs) is around $50.10/bbl.6 Chart 3 illustrates the impact of this new wave of low cost supply – coming from the supermajors’ focus on Permian production – on our estimated full cycle cost breakeven. Assuming a constant breakeven for independent E&P companies, this could significantly lower the average breakeven cost for shale production by 2021. These operating features brought to the shales by the supermajors have important implications for how we model U.S. onshore production. In our current methodology, we estimate the rig count elasticity with respect to variation in oil prices based on the historical relationship between realized prices, the forward curve (its level and slope), and rig counts. Subsequently, we use these rig count estimates – along with our own estimates of production decline rates and productivity per rig by basin – as an input to forecast oil production.7 Rig count is a core input to our U.S. production estimates. It is a straightforward metric entirely driven by the E&Ps’ willingness to increase capex. Thus, the ongoing capital discipline evident in the E&Ps and the Majors, combined with rising production from the supermajors, could affect our estimated rig count elasticity.8 This in turn, would increase the uncertainty of forecasts obtained from models estimated on historical data over the short run, as we – and the market – become accustomed to a less-elastic production profile in the U.S. shales. Over the short term, this will not have a material effect to our 2019 production estimates. As shown in Part 1 of this report, our modeling based on historical rig count price-elasticity is in line with E&P’s production guidance. If we are right that the current capital discipline theme will remain a top priority for independent U.S. E&P companies in the future, this will gradually affect our forecasting methodology starting next year. U.S. Gulf Production Since 3Q18, our modeling of U.S oil production has focused mainly on onshore production ex GOM. We’ve relied largely on the U.S. EIA‘s estimates of GOM production, given that our own assessment did not differ materially from the EIA’s during that period. Going forward, we believe GOM production could surprise to the upside and surpass the EIA’s estimates in the short term. The EIA recently revised down its GOM forecasts for 2020 (Chart 4). Since the 2014 global oil prices collapse, producers in the Gulf have been increasingly leveraging existing infrastructure with short-cycle field developments using subsea tie-backs to boost production at reduced costs. Previously omitted locations – i.e. smaller fields not profitable enough to support the massive investment required for their own infrastructure – can now be tied in to existing infrastructure using subsea flowlines connected to existing platforms that have surplus production-carrying capacity. GOM producers’ business model is evolving to prosper in volatile oil price environments and sustained lower oil prices. The shorter cycle time and lower capex requirements for subsea tie-backs allow for more flexible production at costs that come close to Permian shale plays. Flowlines can reach wells more than 25 miles away from the main platform; this could be extended to reach 30 miles by 2020, allowing for more field to be profitably developed.9 Chart 4EIA GOM Production Forecasts Are Too Low The theme of subsea tie-backs and low-risk development will remain in place going forward, according to IHS Markit.10 Producers are favoring these projects to limit their exposure to oil price fluctuations. BP and Shell signaled they are expanding development at existing GOM fields.11 However, production at most sites will most probably start towards the end of next year, or slightly after our end-2020 forecast horizon. Chart 5Medium Term, Large Scale Investments Are Needed In the medium term, the risk of stagnating GOM production remains elevated due to a lack of large investments and decline rates at newer fields (2014-2017) (Chart 5). Furthermore, as the majors and large E&Ps continue to focus on increasing their free cash flow, the aggressive shift toward onshore-shale projects risks starving the development of large fields in the GOM of much-needed capex. Future expansions in the Permian and GOM could increasingly be competing for funding by major oil companies. In fact, recent cost-reduction measures could allow for the development of greenfield projects at competitive costs. The recent completion of Shell’s giant Appomattox field – one quarter earlier at a cost 40% lower than initially expected – came in with a breakeven cost between $40-50/bbl, something that could signal a bright future for this type of development.12 U.S. Gulf Export Capacity Buildout Combining our production forecasts for independent E&Ps, majors and GOM projections, we expect total U.S. crude oil production to increase by 1.43mm b/d to 12.38mm b/d in 2019 and 1.16mm b/d to 13.55mm b/d in 2020. However, much of the new shale production, which will represent the bulk of the output growth in the U.S., will have to be sold in export markets, given U.S. refiners still run mostly medium and heavy crude oil slates. This is a problem, taking into account the speed at which Gulf Coast export facilities can be expanded. We believe current export facilities will reach full capacity sometime next year (Chart 6). We will be exploring this topic in greater depth next month. Over the short-term, this implies production bottlenecks likely will move from the Permian Basin to the Gulf Coast. U.S. refineries cannot absorb these large volumes of new light sweet oil in such a short period. Hence, the bulk of additional production will have to be exported to foreign buyers. Additionally, Permian production is becoming lighter as the supply of West Texas Light (WTL) increases – recently reaching more than 10% of the basin’s total production.13 Gulf Coast refiners’ crude slate has become lighter and sweeter as shale-oil production has expanded in the U.S (Chart 7). However, this trend cannot continue without large investments in new capacity, especially with the rising domestic supply of ultra-light WTL-type crude. Chart 6U.S. Crude Exports Are Trending Higher Chart 7Gulf Coast Refiners Crude Slate Has Become Lighter In fact, since 2007, the abundant domestic light-sweet supply has mainly been absorbed through (1) the blending of lighter crude with heavier imported crude, (2) the rising utilization rate of atmospheric distillation units, and (3) declining light oil imports, which have fallen from more than 1.6mm b/d in 2009 to 0.36mm b/d – and close to zero at PADD 3 (Gulf Coast) – as of April 2019. These strategies are at or close to their limits (Chart 8). On the other hand, imports of the heavy crude U.S. refiners continue to need remained constant, reflecting refiners’ stable demand for these grades. Chart 8Domestic Absorption Of Light Crude Is Close To Maximum Chart 9Crude Price Spreads Starting To Signal Export Constraints Historically, logistical imbalances have been resolved quickly in the U.S. shale sector. The price mechanism incentivizes investment where it’s needed the most, and we believe this is already happening in the U.S. Gulf with planned deep-water harbor expansions (Chart 9). In the medium-term – i.e., over the next 2 – 5 years – these export-capacity issues will be fixed. In fact, there already are plenty of projects proposed to alleviate the bottlenecks. We estimate up to 12mm b/d of export capacity increase have been proposed so far. This would be a massive overbuild of Gulf export facilities. We estimate ~ 500k b/d of additional export capacity will be needed by end-2020, which implies only one offshore or a few onshore projects would have to be built. By 2023, the U.S. would need new capacity to reach around 5mm b/d (Chart 10).14 Nonetheless, the buildout of U.S. Gulf coast hydrocarbon-export infrastructure could be a bumpy ride. Risks remain, as these large projects require complicated permitting and massive funding which can drastically increase construction time. The LLS-Brent spread will probably be volatile in 2020 until the first project receives its Final Investment Decision, and markets are able to assess the timeline these new investments are on. Given the number of projects in the pipeline, however, export capacity could significantly expand by end-2020 or 2021. This evolution will be most visible in the different price spreads we follow, which offer a market-based assessment of these developments. First, we track the WTI- and Midland- LLS prices to grasp the evolution of Cushing and Permian pipeline debottlenecks toward the Gulf Coast – i.e. the domestic constraints. Second, we use the LLS-Brent spread as a gauge for the Gulf Coast export buildout – i.e. the external constraints (Chart 11). Bottom Line: Independent U.S. E&Ps will manage to increase production in line with current guidance while remaining profitable. This will be supported by completion of excess DUCs and rising WTI prices. Moreover, the emergence of the supermajors in the Permian and other prolific shale regions will contribute to increasing total U.S. onshore production in line with our current forecasts. Our base case suggests the U.S. Gulf Coast export capacity buildout will allow the excess production to reach foreign buyers. Nonetheless, risks remain re potential delays in these massive projects. The LLS-Brent spread could be volatile this year and next   Chart 11Tracking Domestic And External Constraints With Crude Price Spreads Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity And Energy Strategy Special Report titled “Shale-Oil E&Ps Turning A Corner?” published June 13, 2019. It is available at ces.bcaresearch.com. 2      Supermajors include XOM, CVX, RDS/Shell, BP AND TOTAL. 3      Please See ExxonMobil to increase, accelerate Permian output to 1 million barrels per day by 2024 published March 5, 2019 by exxonmobil.com. Please see Chevron eyes 900,000 b/d from Permian by yearend 2023 published March 6, 2019 by ogj.com. 4      Please see The ‘Monster’ Texas Oil Field That Made the U.S. a Star in the World Market published February 3, 2019 by nytimes.com. 5      For instance, Exxon communicated it could sustain double-digit returns in the Permian with prices falling to $35/bbl. Please see ExxonMobil to increase, accelerate Permian output to 1 million barrels per day by 2024 published March 5, 2019 by exxonmobil.com. 6              Our analysis is based on a sample of selected public independent U.S. E&P companies. As a group, these companies represent ~3.0mm b/d of production (or close to 35% of U.S. onshore production). Our full cycle cost breakeven represents oil price that provides a ~10%+ return on the incremental capital plus the cost of overhead and the capital cost of the drilling right acquisition. 7              Our production estimate is equal to [rig count X estimate of new production per rigs] – [estimate of decline rates X legacy production]. 8              In Part 1, we discussed the likelihood independent E&P companies will deliver on investors’ demand for fiscal discipline. In our view, this will contribute, at the margin, to lowering the supply price-elasticity of U.S. shale development. In periods of high oil prices, these companies will increase production within the limit of their growing cash flow (i.e. without raising external financing via debt or equity). This implies production will have less upside as prices increase or remain elevated. On the other hand, in periods of declining or low prices, the healthy balance sheets of fiscally disciplined companies keeps the external financing window open in case of reduced cash flow. Moreover, the larger the share of companies that manage to improve their balance sheets, the lower the number of bankruptcies when prices decline. This limits the production decline. Hence, on average, production will grow at more steady pace than in the past, decreasing its price-elasticity. 9              Please see “Take a Look at Me Now – Gulf of Mexico Crude Output Is Approaching 2 MMb/d,” published May 7, 2019 by RBN Energy. 10     Please see Subsea tie-backs de-risk Deepwater Gulf of Mexico published June 4, 2019 by ihsmarkit.com. 11     BP plans to increase its production in the GoM by ~400k boe/d through expansion using existing facilities at its Atlantis, Thunder Horse and Na Kika fields. Please see BP plans for significant growth in deepwater Gulf of Mexico published January 8, 2019 by bp.com. Shell signaled it would leverage its new Appomattox infrastructure to tie-back adjacent fields -- e.g. production from Vicksburg and Fort Sumter. Shell's upstream director mentioned “Appomattox creates a core long-term hub for Shell in the Norphlet through which we can tie back several already discovered fields as well as future discoveries.” Please see Appomattox field comes on stream in GOM published May 23, 2019 by ogj.com. 12     Please see Shell starts production at giant Appomattox field in Gulf of Mexico published May 23, 2019 by reuters.com. 13     Please see As Permian oil production turns lighter, price outlook darkens published June 6, 2019 by reuters.com. West Texas Light (WTL) is a newly available crude grade from the Permian basin with an API of 44.1 to 49.9 and maximum sulfur of 0.4% vs. an API of ~ 40 for WTI. Most of the growth in WTL production comes for the Delaware basin within the Permian. The API is a measure of the density of a petroleum liquid. The higher the API, the lighter the crude is. This will determine the complexity of refining a certain crude input into finished products. 14     Please see BCA Research’s Commodity and Energy Strategy Weekly Report titled “Oil Price Diffs: Global Convergence,” published March 7, 2019. It is available at ces.bcaresearch.com.

Highlights The breakout in financial asset prices stands at odds with a deteriorating profit outlook. This suggests a high probability of a coiled-spring reversal in one of the two variables as we enter the thin summer trading months. We are maintaining a pro-cyclical currency stance, but are making a few portfolio tweaks in case we are caught offside during what could be a volatile summer. Maintain very tight stops on cable at 1.25, but look to sell EUR/GBP between 0.92 and 0.94. Our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso, and Colombian peso versus the euro. The latest RBA interest rate cut might be the ultimate insurance backstop needed to jumpstart the Australian economy. Remain long the Aussie dollar versus both the greenback and the kiwi, but with tight stops on the former. Any “flash crashes” are likely to favor the currencies of countries where tradeable bonds are in short supply. Remain short USD/JPY. Also, tactically sell gold bullion versus the yen. Feature Chart I-1The Markets And Data Diverge Financial markets are at an important crossroads as we head into the thin summer trading months. Asset prices have been reflated by plunging bond yields, with the S&P 500 hitting fresh highs this week. On the other hand, incoming manufacturing data across the major economies continue to deteriorate, suggesting the profit cycle remains in a downtrend. Either markets get better visibility into an improving profit outlook, or stock prices will succumb to the pressure of incoming data weakness (Chart I-1).    For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets flip the switch towards risk aversion. Our recommendations this week are threefold. First, maintain tight stops on tactical positions, especially those susceptible to summer volatility. Topping this list is our long position in the British pound. Second, our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Finally, maintain portfolio insurance by being short the USD/JPY. Also, sell gold against the yen, given that relative sentiment has shifted in extreme favor of the former. A Summer Attack On The Pound? The episodes leading to the collapse of the pound in 1992 have important lessons for today.1 Britain entered the Exchange Rate Mechanism (ERM) in October of 1990 in an attempt to find a stable nominal anchor. In the years preceding entry into the ERM, inflation in the U.K. had been high and rising, leading to an appreciation in the real exchange rate. The rationale was that by adopting German interest rates, inflation would finally be tempered, and the real exchange rate would eventually be realigned. Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit.  During the ensuing years, pressure on the pound was relatively short-lived and could be quickly reversed by foreign exchange interventions or modest increases in interest rates. Meanwhile, the prospect of a European Monetary Union (EMU) also provided an anchor for expectations, since it would allow for more sound domestic policies. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. This led to severe doubts about the progress made towards a union, especially as the outcome of the French referendum in September was expected to be close. Investors began to question where the shadow exchange rate for ERM currencies lay, especially where the Italian lira or the Spanish peseta were concerned. In August of that year, Britain began to massively step up interventions in the foreign exchange market, having to borrow excessively through the Very Short Term Financing facility (VSTF) to increase reserves. It also promised to raise interest rates from 10% to 12%, and later to 15%. But as an overvalued exchange rate had generated extremely sluggish GDP growth going into the 1990s, markets were not convinced the U.K. would tap into its unlimited borrowing facility or raise interest rates sufficiently to defend the pound. On black Wednesday in September 1992, Britain suspended membership to the ERM. There are a few important lessons that stand in stark contrast to a hard Brexit: Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly, usually with overshoots or undershoots. From its peak, GBP/USD depreciated by 24% by the end of October 1992. It subsequently fell to a low of 1.418 in February 1993 (Chart I-2). Peak to trough, cable has already fallen by 28%. Judging from the real effective exchange rate adjusted for consumer prices, the pound was overvalued as the U.K. entered the ERM. A persistent inflation differential between the U.K. and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-3). Chart I-2The Pound Drop During ERM Was Quick And Violent Chart I-3Not Much Misalignment In##br## U.K. Prices Today The overvaluation of the pound meant that domestic growth was under tremendous pressure. Growth was already at recessionary levels entering into the ERM. Meanwhile, a bursting real estate bubble necessitated lower, not higher interest rates. This put to test the credibility of the peg. Today, U.K. growth is outpacing that of Germany, and will only improve if the pound drops further (Chart I-4). Productivity in the U.K. has kept pace with that of Germany over the last several years, suggesting the fall in the pound has been unwarranted. The Tory government runs a balanced budget and the Bank of England has much foreign exchange reserves to intervene in the market should confidence in the pound collapse. More importantly, the British currency is freely floating meaning there are less “hidden sins” compared to the fixed exchange rate period when it had to use the VSTF facility to boost reserves (Chart I-5). Chart I-4The U.K. Is Growing Faster Than The Eurozone's Engine Chart I-5Britain Has Lots Of ##br##FX Reserves A new conservative leadership is, at the margin, more negative for the pound (the assessment of our geopolitical strategists is that the odds of a hard Brexit have risen to 21% from 14%). However, our simple observation is that the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union (Chart I-6). The pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union. This dichotomy might be the reason why in a speech this week, BoE Governor Mark Carney continued to highlight the growing divergence between market interest rate expectations (almost a 50% probability of a cut this year) and the central bank’s more hawkish bias. The experience of the ERM suggests it will be extremely destabilizing for the pound if the BoE is unable to anchor market interest rate expectations. This is especially true since the second quarter is likely to be a very weak one, leaving little time for data improvement until the October 31st Brexit deadline. Chart I-6More People In Favour Of The Union Chart I-7Cable Valuation Reflects Brexit Risk   Putting it all together, our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. The real effective exchange rate of the pound is now lower than where it was after the U.K. exited the ERM in 1992, with a drawdown that has been of similar magnitude (24% in both episodes) (Chart I-7). In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its (or above) historical real effective exchange rate range, which will pin it 15-20% higher, or at around 1.50. As for EUR/GBP, U.K. gilt yields stand at 108-basis-point over German bunds, an attractive spread should carry trades return in favor. Historically, such a spread has usually pinned the EUR/GBP much lower (Chart I-8). Yes, incoming data in the U.K. has softened, but employment growth has been holding up, wages are inflecting higher and the average U.K. consumer appears in decent shape. Investment and construction have been the weak spot in the U.K. economy, but may marginally improve on lower rates. Meanwhile, from a technical perspective, the pound is also oversold versus the euro (Chart I-9). Chart I-8EUR/GBP Is A Sell Long-Term Chart I-9EUR/GBP Is Overbought Bottom Line: Stay long the pound as we enter volatile summer trading, but maintain tight stops at 1.25. Sell EUR/GBP if 0.94 is touched. Buy A Speculative Basket Of Petrocurrencies Rising geopolitical tensions between the U.S. and Iran continue to support oil prices. Meanwhile, at its latest meeting, OPEC agreed to extend its production cuts to the first half of 2020. This will put upward pressure on forward curves, nudging oil near our Commodity & Energy Strategy service’s target of $75 per barrel.2 Should demand pick up later this year, it will supercharge the uptrend. More importantly, the risk of escalation between Iran and the U.S. is high, given that the former has been backed up into a corner on falling oil exports. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. In our currency portfolio, we are long the NOK versus both the SEK and CAD as exposure to both crude oil prices and the Brent premium. This week, we are adding a speculative basket of the Colombian peso, Mexican peso and Russian ruble to benefit from any surge in the oil geopolitical risk premium. This basket is attractive for two reasons. First, the currencies are trading at a discount to what is implied by the oil price (Chart I-10). This discount could rapidly close if it becomes evident that oil supplies are at major risk. It is also beneficial that the shipping routes these supplies take categorically avoids the Straits of Hormuz, or the epicenter of the conflict. Second, the carry from the trade is attractive at 5%, which provides some cushion against downside risks. The risk of escalation between Iran and the U.S. is high. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. The positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Meanwhile, Norwegian production has been falling for a few years. This is why it may be increasingly more profitable to be long a basket of petrocurrencies versus oil-consuming nations rather than the U.S. Going long versus the euro is also a cushion against a knee-jerk rally in the dollar. Also going long a basket of higher-yielding EM petrocurrencies versus DM ones is a good bet (Chart I-11). Chart I-10Petrocurrencies Are Attractive Chart I-11EM Versus DM Oil Basket Bottom Line: Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso and Colombian peso versus the euro. Investors should also consider a basket of EM petrocurrencies versus DM ones. A Final Note On Gold The short-term technical picture for gold has become unfavorable. This suggests that investors could be caught offside in the interim holding gold as a hedge. We recommend swapping some gold bullion for yen to insure against this risk for three reasons: As both are safe-haven proxies, yen in gold terms has tended to mean revert since 2012, so as to maintain a stable ratio of 138,000 JPY per ounce of gold. Today, the yen is sitting at two standard deviations below this range (Chart I-12). Open interest for gold is surging towards new highs, while that of the yen is making fresh lows. In the case of a rush towards safe havens, the liquidity squeeze is likely to favor appreciation in the yen (Chart I-13). Chart I-12Sell Some Bullion For Yen Paper Chart I-13A Liquidity Squeeze Could Favor The Yen   Speculators are long gold but short the yen, which is attractive from a contrarian standpoint (Chart I-14). Chart I-14Speculators Are Long Gold And Short Yen Bottom Line: Remain short USD/JPY and sell a basket of gold versus some yen.    Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). 2 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Volatility Will Abate As Financial Conditions Ease,” dated July 4, 2019, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: Headline PCE fell to 1.5% year-on-year in May. Core PCE was unchanged at 1.6% year-on-year. Personal income growth was unchanged at 0.5% month-on-month in May, while personal spending fell to 0.4% month-on-month. Markit composite and manufacturing PMI both increased to 51.5 and 50.6 in June. However, ISM manufacturing and non-manufacturing PMI both decreased to 51.7 and 55.1 in June. Chicago purchasing managers’ index fell to 49.7 in June. Trade deficit widened to $55.5 billion in May. Factory orders contracted by 0.7% month-on-month in May. Also, durable goods orders fell by 1.3% month-on-month in May. DXY index increased by 0.4% this week. Our bond-to-gold indicator continues to point towards a weaker dollar. We believe that the combination of Chinese stimulus and the lagged effects from easing financial conditions should lift the global growth later this year, which would be a headwind for the dollar. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation was unchanged at 1.2% year-on-year in June, while core inflation increased to 1.1% year-on-year in June. Money supply (M3) grew by 4.8% year-on-year in May. Markit composite PMI increased to 52.2 in June. Manufacturing PMI fell to 47.6, while services PMI increased to 53.6. Unemployment rate fell to 7.5% in May. Producer price inflation fell to 1.6% year-on-year in May. Retail sales growth fell to 1.3% year-on-year in May. EUR/USD fell by 0.8% this week. IMF managing director Christine Lagarde was nominated to replace Mario Draghi as European Central Bank president this week. Analysts believe that she will likely maintain the ECB’s accommodative stance. This was confirmed by the plunge in 10-year bund yields to -40bps. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The Tankan survey for Q2 was a mixed bag. The index for large manufacturers fell from 12 to 7. That for non-manufacturers increased from 21 to 23. Importantly, capex intentions rose from 1.2% to 7.4%. Housing starts contracted by 8.7% year-on-year in May. Construction orders continue to fall by 16.9% year-on-year in May. Nikkei composite PMI increased to 50.8 in June. Manufacturing PMI fell to 49.3, while services PMI increased to 51.9. Consumer confidence fell to 38.7 in June. USD/JPY has been flat this week. While Trump and Xi agreed to delay the trade talks during the G20 summit last weekend, there is no real progress toward a final trade agreement that could alleviate the tariffs. We continue to recommend the yen as a safe-haven hedge. Report Links: Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been negative: GDP growth was unchanged at 1.8% year-on-year in Q1. Current account deficit widened to £30 billion in Q1. Markit composite PMI fell to 49.7 in June. Manufacturing PMI decreased to 48; Construction PMI fell to 43.1; Services PMI fell to 50.2. Mortgage approvals fell to 65.4 thousand in May, while the Nationwide house price index was up 0.5% year-on-year. GBP/USD fell by 1% this week. BoE governor Carney warned in a speech this week that “a global trade war and a no deal Brexit remain growing possibilities not certainties.” Moreover, he stated that monetary policy must address the consequences of such uncertainty for the behavior of business, household, and financial markets. The probability of a BoE rate cut by the end of this year has thus increased from 21% to 46% following his speech. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: The Markit manufacturing PMI increased from 51.7 to 52.0 Terms of trade remain in a powerful uptrend. HIA new home sales increased by 28.8% month-on-month in May. This is beginning to put a floor under building approvals. Trade surplus increased to A$5.8 billion in May, the highest on record. Retail sales increased by 0.1% month-on-month in May. AUD/USD increased by 0.3% this week. Following the rate cut last month, the RBA again cut interest rates by another 25 basis points to a historical low of 1% this week. During the policy statement, Governor Philip Lowe stated that this should support employment growth and provide greater confidence to achieve the inflation target. We continue to favor the Australian dollar from a contrarian perspective. 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 positive: Consumer confidence increased by 2.8% month-on-month in June. Building permits increased by 13.2% month-on-month in May. NZD/USD fell by 0.3% this week. With its policy rate 50 basis points higher than its antipodean counterpart, the RBNZ is now under pressure to cut rates in the coming weeks. The market is currently pricing an 84% probability of a rate cut for the next policy meeting in August, and 94% chance rates will be cut before year-end. Should data disappoint in the interim, additional cuts could be priced in. Hold on to our long AUD/NZD and SEK/NZD positions. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: GDP growth increased to 1.5% year-on-year in Q1. Bloomberg Nanos confidence continues to rise to 58.3 last week. This tends to lead GDP growth by a quarter or two. Markit manufacturing PMI increased to 49.2 in June. Exports and imports both increased to C$53.1 billion and C$52.3 billion in May. The trade balance turned positive to C$0.8 billion on surging exports to the U.S. USD/CAD fell by 0.5% this week. The BoC Business Outlook Survey published last Friday highlighted that business sentiment has slightly improved, and that hiring intentions continue to be healthy. This should underpin the loonie in the near-term. ­­­Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 93.6 in June. Real retail sales contracted by 1.7% year-on-year in May. Manufacturing PMI fell to 47.7 in June. Headline inflation was unchanged at 0.6% year-on-year in June, while core inflation increased to 0.7% year-on-year in June. USD/CHF increased by 0.4% this week. The CHF/NZD cross has been correcting in recent weeks, and could eventually trigger our limit buy order at 1.45. Stay tuned. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing PMI fell from 54.1 to 51.9 in June. Registered unemployment was unchanged at 2.1% in June. House prices are inflecting higher, to the tune of 2.6% year-on-year in June. USD/NOK fell by 0.5% this week. This week’s OPEC meeting extended the production cuts into 1Q20. Easing global financial conditions and Chinese stimulus should help revive oil demand. Our Commodity & Energy Strategy team continues to expect Brent to average $75/bbl by the end of this year. Stay long NOK/SEK and short CAD/NOK. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Retail sales fell by 0.5% year-on-year in May. Composite PMI fell to 50.5 in June. Manufacturing and services PMI both fell to 52 and 49.9. USD/SEK increased by 0.4% this week. The Riksbank held its interest rate unchanged at -0.25% this week as widely expected. However, the tone in the communique was hawkish. That said, the trade disputes between U.S. and China, and the Brexit chaos remain downside risks to the European economy, and the Riksbank might push the planned rate hike further down the road. Report Links: Where To Next For The U.S. 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

Oil prices will remain volatile as markets work through the lingering effects of tighter financial conditions prevailing last year, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand growth (Chart of the Week). In 2H19, globally accommodative monetary policy and fiscal stimulus will revive demand for industrial commodities, particularly in EM economies. This will be most apparent in oil markets, where we continue to expect demand growth to strengthen going into 2020, aided in part by a weaker USD. On the supply side, this week’s extension of OPEC 2.0’s production cuts into 1Q20 means growth will remain constrained. Prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand.1 We continue to expect Brent to average $73/bbl this year and $75/bbl next, respectively. We expect WTI to trade $7/bbl and $5/bbl below that this year and next. Chart of the WeekEasing Financial Conditions Will Spur Oil Demand Highlights Energy: Overweight.  Venezuela’s oil production reportedly recovered to 1.1mm b/d in June.  Most of the increased production found its way to China, which accounted for just under 60% of crude and product exports.2  Given its modus operandi, we believe OPEC 2.0 likely will accommodate higher production in Venezuela by reducing production in other member states, keeping overall output relatively constant. Base Metals: Neutral.  Copper treatment and refining charges fell to new lows at the end of last week, with Fastmarkets MB’s Asia – Pacific TC/RC index recording its lowest level on record at $52.40/MT ($0.0524/lb).3  TC/RC levels fall when supplies are low, as refiners have to discount their services to attract concentrate supplies.  Elsewhere, workers at Codelco’s Chuquicamata copper mine agreed to a new contract last week, ending a brief strike.  Precious Metals: Neutral.  Gold’s rally resumed this week, reflecting investors’ expectations for expanded central-bank accommodation globally, which, all else equal, will keep interest rates lower for longer. The Fed's dovish turn, in particular, will weaken the USD later this year, which will be positive for EM commodity demand, the engine for commodity demand growth globally. Ags/Softs: Underweight.  The USDA reported 56% of corn in the ground was in good to excellent condition last week, vs. 76% of the crop last year.  For soybeans, 54% of the U.S. crop was in good or excellent condition, vs. 71% last year.  The USDA’s Crop Progress reports cover 92% and 95% of total acreage planted in the U.S., respectively. Feature Oil prices will remain volatile over the short term, as markets transition from tighter monetary conditions to a more accommodative global backdrop (Chart 2). Based on our research into the drivers of oil-price volatility, this should translate into a less stressful pricing environment for industrial commodities generally, base metals and oil in particular (Chart 3).4 Chart 2Volatility Indicators Are Moderating Chart 3Signaling Oil Price Volatility Will Fall Much of the current oil-price volatility is being driven by worries over damage to aggregate global demand and growth expectations in the wake of the Sino-U.S. trade war, and by what now appears to be a too-aggressive posture by central banks implementing rates-normalization policies last year. Both of these can affect consumption and investment locally and globally.5 Fear That Real Demand Will Weaken At present, any indication real demand is faltering – e.g., weaker manufacturing PMIs – gives industrial commodities an excuse to sell off (Chart 4). In the case of the Sino-U.S. trade war, presidents Xi and Trump appear to have agreed to re-start trade negotiations. Markets are not going to be terribly concerned with the specifics of a trade deal between the U.S. and China, but it does appear some rollback in U.S. tariffs will be necessary for a trade deal – perhaps in exchange for greater access to Chinese markets. However, our geopolitical strategists make the odds of a trade deal by the time U.S. elections roll around 1:3. Our colleagues in BCA Research’s Global Investment Strategy note, “The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a ‘small’ trade war and a ‘moderate’ trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system.”6 As for monetary policy, major central banks are embarked on a coordinated effort to reverse falling inflation expectations, and will be vigorously stimulating their money supply and credit growth over the balance of the year. In addition, fiscal stimulus globally – in the U.S. and China most prominently – will boost real demand for industrial commodities, particularly oil and base metals.7 Monetary and fiscal stimulus operates with a lag, which is why we continue to expect its more visible for commodity demand to become apparent in commodity prices later in 2H19 and next year. This lagged effect can be seen in our expectation for the evolution of EM import volumes to year end, which we estimate using data compiled the CPB World Trade Monitor (Chart 5). EM import volumes are closely tied to the evolution of EM income, which drives global commodity demand.8 Chart 4Globally, The Real Economy Has Slowed Chart 5EM Imports and Income Will Rebound In our modeling of supply-demand balances and prices, we accounted for the reduced EM GDP growth brought about by more restrictive monetary policy last year and the slowdown in global trade in our most recent forecast. In our base case, we took our expected global oil-demand growth this year down to 1.35mm b/d from 1.5mm b/d earlier, and to 1.55mm b/d next year from 1.6mm b/d previously. These adjustments reduced our price expectation for Brent crude oil slightly to $73/bbl this year and $75/bbl next year, with WTI trading $7/bbl and $5/bbl below those respective levels (Chart 6). Chart 6Our Forecasts Reflect Lower Demand, Tighter Supply Oil Markets Will Get Tighter   For all of the concern over real demand, prompt demand remains stout relative to available supply, as can be seen in the backwardations for global benchmark crude oil prices (Chart 7). This week’s extension of OPEC 2.0’s production cuts into 1Q20 means supply growth will remain constrained, which, given our demand expectation, will tighten balances globally (Chart 8).9 Chart 7Global Oil Benchmarks Remain Backwardated Chart 8Oil Supply Demand Balances Will TightenChart 9Oil Inventories Will Fall, As Supply Is Constrained As balances tighten in the wake of global fiscal and monetary stimulus, oil prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand (Chart 9). For this reason we remain long September – December 2019 Brent vs. short September – December 2020 Brent, expecting backwardation to increase.10 Bottom Line: We remain constructive toward oil markets, as they transition to a more accommodative monetary backdrop globally. Combined with fiscal stimulus in the U.S. and China in particular, demand will remain supported in 2H19 and 2020. The extension of OPEC 2.0’s production-cutting deal will tighten markets, forcing refiners to draw down inventories.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1      OPEC 2.0 is a name we coined for the OPEC/non-OPEC oil-producing coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Their agreement to extend production cuts of 1.2mm b/d into 1Q19 was announced this week in Vienna. Please see OPEC/non-OPEC rolls over oil output cuts for 9 months published by S&P Global Platts on July 2, 2019. Compliance with these cuts has been higher by ~ 400k b/d in 1H19 by our reckoning. 2      Please see Venezuela's June oil exports recover to over 1 million bpd: data published July 2, 2019, by reuters.com. 3      Please see Copper concs TCs drop marginally on traders purchase; Cobre Panama’s fresh supply hits market published by Fastmarkets MB June 28, 2019. 4      We are using “volatility” in the technical sense here – i.e., the standard deviation of per-annum returns. We have shown this can be explained by different variables, including EM volatility; U.S. financial conditions – as seen in the St. Louis Fed’s financial-stress index; and by speculative positioning, which tends to follow the evolution of prices as news flows change. For discussions of our volatility modeling, including the construction of Working’s T index, please see Specs Back Up The Truck For Oil, published April 26, 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility, published May 10, 2018, by BCA Research’s Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. 5      Please see The economic implications of rising protectionism: a euro area and global perspective published by European Central Bank April 24, 2019. 6      Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah, BCA Research’s global macro outlook for 3Q19, published June 28, 2019, by our Global Investment Strategy. It is available at gis.bcaresearch.com.  The larger issues that will have to be addressed at some point in the future are non-tariff barriers to trade, exemplified by Huawei’s exclusion from access to U.S. technology on national security grounds.  An expansion of such non-tariff barriers would strand huge amounts of capital globally, which likely would lead to a global recession. 7      Our chief global strategist, Peter Berezin, notes in the above-cited BCA Research third-quarter outlook that Fed policy is expected to remain ultra-accommodative into late 2021, which will push the USD lower later this year, and will support commodity demand generally. 8      We use an FX-based model to estimate EM import volumes to year end off the CPB data. 9      We will be updating our Venezuela and OPEC 2.0 production estimates to reflect this development in our July global oil market balance publication later this month. 10     We have been long 2H19 Brent vs. short 2H20 Brent since February 28, 2019.  The July and August pieces of this position returned 222.7% and 273% since inception. We remain long the September – December exposure. Investment Views and Themes Recommendations Strategic Recommendations TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Portfolio Strategy Business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. The souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature The SPX fell from all-time highs last week on the eve of the G20 Trump-Xi meeting, the outcome of which will dominate trading this week. The “three hopes” rally, as we have coined it predicated upon a U.S./China trade deal, Chinese massive reflation and a fresh Fed easing cycle, is at risk of disappointment as all the good news is likely already priced into stocks. Stocks may suffer a buy the rumor sell the news setback as they did back in early-December right after the Argentina G20 meeting. Following up from last week’s charts 3-6 that generated higher-than-usual responses from clients, we were encouraged to broaden out these eighteen indicators and try to include some positive ones as it appeared that we may be cherry picking the data.1 Put differently, there must be some economic data series that would offset the grim U.S. macro backdrop we painted and likely aid the Fed in its looming easing cycle. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. With regard to the 2018 stock market related fiscal easing boost, neither corporate tax rates would drop further in 2019 nor would buybacks hit the $1tn mark this year. Already, the Standard & Poor’s reported preliminary data that showed buybacks contracted sequentially by 7.7% in Q1/2019 (top panel, Chart 1).2 Retail sales and personal consumption expenditures (PCE) are indeed expanding, however retail sales have decelerated lately (top & second panels, Chart 2). In contrast, consumer sentiment and consumer confidence are contracting on a year-over-year (yoy) basis and the U.S. leading economic indicator is steeply decelerating near 2%/annum from almost 7% at the beginning of the year (middle, fourth & bottom panels, Chart 2). Chart 1Buybacks Are Decelerating Chart 2Retail Sales And PCE Are Expanding   The mortgage application purchase index is gaining momentum courtesy of the 125bps drop in interest rates over the past eight months. But, equity market internals suggest that some of these applications may not convert into home sales: relative homebuilders share price momentum is contracting (Chart 3). As a reminder we recently monetized relative gains of 10% in the S&P homebuilding index, since inception.3  Sticking with housing, new median single family home prices remain 10% below their 2017 zenith, and the Case-Shiller 20-city index growth rate hit the zero line recently on a month-over-month basis. New home sales are in contraction territory (Chart 4). Chart 3Are Cracks Forming… Chart 4…In The Housing Market?   On the labor front, while the unemployment rate and unemployment insurance claims are both at generationally low levels, it will be extremely difficult for either of these labor market series to fall significantly from current levels. In contrast, there are rising odds that the deteriorating credit quality backdrop will soon infect the labor market (top & second panels, Chart 5). Already, “jobs are hard to get” confirming that the unemployment rate cannot fall much further from current levels (middle panel, Chart 5). Not only is credit quality deteriorating at the margin, but also loan growth is decelerating with our credit impulse diffusion indicator falling below the boom/bust line (fourth & bottom panels, Chart 5). U.S. manufacturing, the most cyclical part of the U.S. economy, is under intense pressure. The U.S./China trade tussle is the culprit. Industrial production and capacity utilization petered out last year in September and November, respectively (top & second panels, Chart 6). Chart 5Could The Labor Market Sour Next? Chart 6Manufacturing Has No…   Chart 7…Pulse Durable goods orders are not showing any signs of a turnaround with overall orders flirting with the zero line and core orders contracting (third panel, Chart 6). Total business sales-to-inventories are stuck in the contraction zone (bottom panel, Chart 6). Manufacturing survey data series are all in a synchronous meltdown. Seven regional Fed manufacturing surveys are all sinking (Chart 7). Such broad-based weakness bodes ill for the upcoming ISM manufacturing survey print (we went to print on Friday after the market close, and as a reminder we observed Canada Day yesterday).   The ISM manufacturing new orders-to-inventories ratio sits right at one, warning that more profit trouble looms for the SPX (bottom panel, Chart 1). Keep in mind that typically the ISM manufacturing survey pulls down the ISM services one, as the former represents the most cyclical parts of the U.S. economy. Both are currently contracting on a yoy basis (Chart 8). Adding it all up, the negative economic data clearly dominate and only a handful of data series remain standing. The final tally on these indicators is fifteen negative and five positive (Chart 9). We are still awaiting a turn in the majority of the data to confirm the economy is on a solid footing. Chart 8ISM Services Survey Is Contracting Chart 10Heed The Message From The GS Current Activity Indicator Goldman Sachs’ Current Activity Indicator (GSCAI, a first principal component of 37 weekly and monthly data series) does an excellent job in capturing all these forces. Currently, the GSCAI is steeply decelerating, warning that SPX profit growth will surprise to the downside in coming quarters (top panel, Chart 10).  Thus, we reiterate that a cyclically (3-12 month horizon) cautious equity market stance is still warranted. This is U.S. Equity Strategy’s view, which stands in contrast to the sanguine equity BCA House View. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. Corporate Pricing Power Update U.S. Equity Strategy’s corporate sector pricing power proxy has sunk further since our last update three months ago, and is now deflating 1.1%/annum. Chart 11 shows that the last time the business sector was mired in deflation was during the 2015/16 manufacturing recession. Chart 11Profit Margin Trouble To Persist However, the big difference between now and 2015/16 is that wages are currently expanding at a healthy clip, warning that the corporate sector margin squeeze will not abate any time soon. Granted, unit labor costs are indeed contracting on the back of a surge in productivity, and may thus provide a partial offset. SPX margins have been contracting for two consecutive quarters and sell-side analysts forecast that they will contract for another two. Our margin proxy corroborates this grim sell-side profit margin expectation, and similar to the 2015/2016 episode is firing a margin squeeze warning shot (bottom panel, Chart 11). Digging beneath the surface, our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Two thirds of the industries we cover are lifting selling prices, but only a quarter are raising prices at a faster clip than overall inflation. On a selling price inflation trend basis, 81% of the industries we cover are either flat or in a downtrend (Table 2). Table 2Industry Group Pricing Power There is only one commodity-related industry in the top ten, a sea change from our late-March update when the commodity complex dominated the top ranks occupying six spots (Table 2). Interestingly, industrials have a healthy showing in the top sixteen spots with five entries. On the flip side, energy-related industries continue to populate the bottom of the ranks as WTI crude oil is still deflating from the October 2018 peak. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. Glittering Gold On March 4th, 2019 we reiterated our view that it still made sense to hold an above benchmark allocation to gold equities as a portfolio hedge.4 While our overweight position is in the red since inception, it has recouped 15% versus the broad market since our early-March update, and more gains are in store in the coming months. When global growth is in retreat investors bid up the price of the safe-haven shiny metal which in turn pulls global gold miners higher. The opposite is also true. Chart 12 shows this inverse relationship gold mining equities have with global growth. In more detail, relative share prices move inversely with the global manufacturing PMI (PMI shown inverted, Chart 12). Chart 12Gold Miners Benefit From… Currently, economists, tracked by Bloomberg, have been aggressively decreasing their estimates for 2019 global real GDP growth, down 50bps year-to-date to 3.3% (bottom panel, Chart 13). Similarly, the global ZEW economic sentiment survey has collapsed to levels last hit during the great recession (top panel, Chart 14). Chart 13…Global Growth… Chart 14…Slowdown   Tack on the sustained increase in global policy uncertainty with trade wars, Iranian sanctions, Brexit and Italian politics to name a few, and global gold miners are in the pole position (top panel, Chart 13). As a result, global equity risk premia have come out of hibernation and signal that the gold mining rally has more legs (middle panel, Chart 14). This souring global macro backdrop has dealt a blow to global real yields that are melting. Given that gold equities sport a low dividend yield, they are primary beneficiaries of this disinflationary global economic backdrop (real yield shown inverted, middle panel, Chart 13). Chart 15Negative Yielding Bonds Boost Global Gold Miners Meanwhile, investors have been piling into global bonds and currently negative yielding bonds have surpassed the $13tn mark. Such a stampede into negative yielding bonds has been a boon to global gold mining stocks (Chart 15). This investor risk aversion is also evident in the total return stock-to-bond (S/B) ratio: bonds have been outperforming equities since late-September 2018. Since the early 1990s, relative share prices have been moving in the opposite direction of the S/B ratio, and the current message is to expect more gains in the former (S/B ratio shown inverted, Chart 16). Chart 16When Bonds Outperform Stocks, Buy Gold Miners Chart 17A Tad Overbought, But Still Cheap Meanwhile, the Fed is about to embark on an easing cycle courtesy of a softening economic backdrop and any insurance interest rate cuts will likely put a further dent in the dollar. The upshot is that gold is priced in U.S. dollars similar to the broad commodity complex and tends to rise in price when the greenback depreciates and vice versa. A lower trade-weighted dollar will also boost relative share prices (U.S. dollar shown inverted, bottom panel, Chart 14). Finally, while relative share prices are slightly overbought, relative valuations remain in the neutral zone (Chart 17). In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Bottom Line: We remain overweight the global gold mining index. The ticker symbol for the global gold mining exchange traded fund is: GDX: US. Defense Delivers Recent M&A news in the aerospace & defense sector with UTX bidding for RTN was initially cheered by investors, but President Trump signaled that such a deal would decrease competition in the sector and U.S. regulators would block it. Irrespective of the outcome of this deal, we remain overweight the pure-play BCA Defense Index on a structural basis and also reiterate its high-conviction overweight status. Three key pillars will sustain the upbeat sales and profit backdrop for defense stocks. In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (Chart 18). Defense capital goods orders have taken off and backlogs are at the highest level since 2012. The industry’s shipments-to-inventories ratio is also probing decade highs and weapons exports are near all-time highs (Chart 19). Chart 18Defense Spending Remains Upbeat Chart 19Healthy Operating Metrics   Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. With regard to the financial health of the sector, balance sheets are pristine with net debt-to-EBITDA registering below the broad non-financial equity market and below 2x. Interest coverage is sky high at over 10x, again trumping the broad market. On the return on equity (ROE) front, defense stocks have the upper hand trading at an all-time high ROE of 39% or more than twice the broad market ROE (Chart 20). Looking at the valuation backdrop, relative valuations have corrected recently and defense equities no longer command a premium versus the overall market on both an EV/EBITDA and P/E basis (second & bottom panels, Chart 21). Chart 20Excellent Financial Standing Chart 21Valuations Have Corrected   Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com          Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/index-news-and-announcements/2019062… 3      Please see BCA U.S. Equity Strategy Insight Report, “Locking In Homebuilder Gains” dated May 22, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “The Good, The Bad And The Ugly,” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession?   Recommendations Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up   Chart 5No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 16Downgrade Japan To Underweight   It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy?   For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com   GAA Asset Allocation

Highlights Fed policy is likely to proceed in two stages: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage, which will end in late 2021, will be heaven for risk assets. The subsequent stage, which will feature a global recession, will be hell. In the end, we expect the fed funds rate to reach 4.75%, representing thirteen more 25-basis point hikes than implied by current market pricing. For the time being, investors should maintain a pro-risk stance: Overweight global equities and high-yield credit relative to government bonds and cash. Regardless of what happens to the trade negotiations, China is stimulating its economy, which will benefit global growth. As a countercyclical currency, the dollar will weaken over the next 12 months. Cyclical stocks will outperform defensives. We expect to upgrade European and EM stocks this summer. Feature Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, July 3rd at 10:00 AM EDT, where I will be discussing the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist Macro Outlook Right On Stocks, Wrong On Bonds We turned structurally bullish on global equities following December’s sell-off, having temporarily moved to the sidelines last June. This view has generally played out well. In contrast, our view that bond yields would rise this year as stocks recovered has been one gigantic flop. What went wrong with the bond view? The answer is that central banks are reacting to incoming news and data differently than in the past. As we discuss below, this has monumental implications for investment strategy. A Not So Recessionary Environment If one had been told at the start of the year that investors would be expecting the fed funds rate to fall to 1.5% by mid-2020 – with a 93% chance that the Fed would cut rates at least twice and a 62% chance it will cut rates three times in 2019 – one would probably have assumed that the U.S. had teetered into recession and that the stock market would be down on the year (Chart 1). Instead, the S&P 500 is near an all-time high, while credit spreads have narrowed by 145 bps since the start of the year. Outside the manufacturing sector, the economy continues to grow at an above-trend pace and the unemployment rate is below most estimates of full employment. According to the Atlanta Fed, real final domestic demand is set to increase by 2.8% in Q2, up from 1.6% in Q1. Real personal consumption expenditures are tracking to rise at a 3.7% annualized pace (Chart 2). So why is the Fed telegraphing rate cuts when real interest rates are barely above zero? A few reasons stand out: Global growth has slowed (Chart 3). The trade war has heated up again following President Trump’s decision to further increase tariffs on Chinese goods. Inflation expectations have fallen in the U.S. as well as around the world (Chart 4). Chart 3Global Growth Has Slowed Chart 4Inflation Expectations Have Fallen Around The World   There’s More To The Story As important as they are, these three factors, even taken together, would not be enough to justify rate cuts were it not for an additional consideration: The Fed, like most other major central banks, has become increasingly worried that the neutral rate of interest – the rate consistent with full employment and stable inflation – is extremely low. This has resulted in a major shift in its reaction function. Nobody really knows exactly where the neutral rate is. According to the widely-cited Laubach Williams (L-W) model, the nominal neutral rate stands at 2.2% in the United States. This is close to current policy rates (Chart 5). The range for the longer-term interest rate dot in the Summary of Economic Projections is between 2.4% and 3.3%, which is higher than the L-W estimate. However, the range has trended lower since it was introduced in 2014 (Chart 6). Chart 5The Fed Thinks Rates Are Close To Neutral A Fundamental Asymmetry Given that inflation expectations are quite low and there is considerable uncertainty over the level of the neutral rate, it does make some sense for policymakers to err on the side of being too dovish rather than too hawkish. This is because there is an asymmetry in monetary policy in the current environment. If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always raise rates. In contrast, if the neutral rate turns out to be very low, the decision to hike rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by over five percentage points during recessions (Chart 7). At the present rate of inflation, the zero-lower bound on interest rates would be quickly reached, at which point monetary policy would become largely impotent. Chart 7The Fed Is Worried About The Zero Bound The asymmetry described above argues in favor of letting the economy run hot in order to allow inflation to rise. A higher inflation rate going into a recession would let a central bank push real rates deeper into negative territory before the zero bound is reached. In addition, a higher inflation rate would facilitate wage adjustments in response to economic shocks. Firms typically try to reduce costs when demand for their products and services declines, but employers are often wary of cutting nominal wages. Even though it is not fully rational, workers get more upset when they are told that their wages will fall by 2% when inflation is 1% than when they are told their wages will rise by 1% when inflation is 3%. More controversially, a modestly higher inflation rate could improve financial stability. In a low-inflation, low-nominal-rate environment, risky borrowers are likely to be able to roll over loans for an extended period of time. This could lead to the proliferation of bad debt. Chart 8Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher inflation can also cushion the blow from a burst asset bubble. For example, the Case-Shiller 20-City Composite Index fell by 34% between 2006 and 2012, or 41% in real terms. If inflation had averaged 4% over this period and real home prices had fallen by the same amount, nominal home prices would have declined by only 26%, resulting in fewer underwater mortgages (Chart 8). A New Reaction Function It is usually a mistake to base market views on an opinion about what policymakers should do rather than what they will do. On rare occasions, however, the opposite is true. And, where our Fed call is concerned, this seems to be the case. Where we fumbled earlier this year was in assuming the Fed would follow a more traditional, Taylor Rule-based monetary framework, which calls for raising rates as the output gap shrinks. Instead, the Fed has adopted a risk-based approach of the sort described above, reminiscent in many ways of the optimal control framework that Janet Yellen set out in 2012. The New Normal Becomes The New Consensus If one is going to conduct monetary policy in a way that errs on the side of letting the economy overheat, one should not be too surprised if the economy does overheat. Yet, the implied rate path from the futures curve suggests that investors are not taking this risk seriously. Chart 9 shows that investors are assigning a mere 5% chance that U.S. short-term rates will be above 3.5% in mid-2022. Why isn’t the market assigning more of a risk to an inflation overshoot? We suspect that most investors have bought into the consensus view that the real neutral rate is zero. According to this view, U.S. monetary policy had already turned restrictive last year when the 10-year Treasury yield climbed above 3%. If this view is correct, the recent decline in yields may stave off a recession, but it will not be enough to cause the economy to overheat. Many of the same investors also believe that deep-seated structural forces ranging from globalization, automation, demographics, to the waning power of trade unions, will all prevent inflation from rising much over the coming years even if the unemployment rate continues to fall. In other words, the Phillips curve is broken and destined to stay that way. But are these views correct? We think not.  Where Is Neutral? There is a big difference between arguing that the neutral rate may be low – and taking preemptive steps to remedy it – and arguing that it definitely is low. We subscribe to the former view, but not the latter. Our guess is that in the end, we will discover that the neutral rate is lower than in the past, but not nearly as low as investors currently think. Probably closer to 1.5% in real terms than 0%. As we discussed in detail two weeks ago, while a deceleration in trend growth has pushed down the neutral rate, other forces have pushed it up.1 These include looser fiscal policy (especially in the U.S.), a modest revival in private-sector credit demand, and dwindling labor market slack.  Since the neutral rate cannot be observed directly, the best we can do is monitor the more interest rate-sensitive sectors of the economy to see if they are cooling in a way that would be expected if monetary policy had become restrictive. For example, housing is a long-lived asset that is usually financed through debt. Hence, it is highly sensitive to changes in mortgage rates. History suggests that the recent decline in mortgage rates will spur a rebound in home sales and construction later this year (Chart 10). The fact that homebuilder confidence has bounced back this year and purchase mortgage applications have reached a cycle high is encouraging in that regard. The same goes for the fact that the vacancy rate is near an all-time low, housing starts have been running well below the rate of household formation, and the quality of mortgage lending has been quite strong (Chart 11). Chart 10Declining Yields Bode Well For Housing Chart 11U.S. Housing: No Oversupply Problem, While Demand Is Firm     Nevertheless, if the rebound in housing activity fails to materialize, it would provide evidence that other factors, such as job security concerns among potential homebuyers, are overwhelming the palliative effects of lower mortgage rates.  Have Financial Markets “Trapped” Central Banks? An often-heard argument is that central banks can ill-afford to raise rates for fear of unsettling financial markets. Proponents of this argument often mention that the value of all equities, corporate bonds, real estate and other risk assets around the world exceeds $400 trillion, five times greater than global GDP. There are at least two things wrong with this argument. First, an increase in financial wealth should translate into more spending, and hence a higher neutral rate of interest. Second, as we discussed earlier this year, the feedback loop between asset prices and economic activity tends to kick in only when monetary policy has already become restrictive.2  When policy rates are close to or above neutral, further rate hikes threaten to push the economy into recession. Corporate profits inevitably contract during recessions, which hurts risk asset prices. A vicious spiral can develop where falling asset prices lead to less spending throughout the economy, leading to lower profits and even weaker asset prices. In contrast, when interest rates are below their neutral level, as we believe is the case today in the major economies, an increase in policy rates will simply reduce the odds that the economy will overheat, which is ultimately a desirable outcome. U.S. Imbalances Are Modest Chart 12U.S. Corporate Debt (I): No Cause For Alarm Recessions usually occur when rising rates expose some serious imbalances in the economy. In the U.S. at least, the imbalances are fairly modest. As noted above, housing is on solid ground, which means that mortgage rates would need to rise substantially before the sector crumbles. Equities are pricey, but far from bubble territory. Moreover, unlike in the late 1990s, the run-up in stock prices over the past five years has not led to a massive capex overhang. Corporate debt is the weakest link in the financial system, but we should keep things in perspective. Even after the recent run-up, net corporate debt is only modestly higher than it was in the late 1980s, a period where the fed funds rate averaged nearly 10% (Chart 12). Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above its long-term average, while the ratio of debt-to-assets is below its long-term average (Chart 13). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Every recession during the past 50 years has begun when the corporate sector financial balance was in deficit (Chart 14). Chart 13U.S. Corporate Debt (II): No Cause For Alarm Chart 14U.S. Corporate Debt (III): No Cause For Alarm     The Dollar, The Neutral Rate, and Global Growth In a globalized economy, capital flows can equalize, at least partially, neutral rates across countries. If any one central bank tries to raise rates – while others are standing pat or even cutting rates – the currency of the economy where rates are rising will shoot up, causing net exports to shrink and growth to slow.  In the case of the U.S. dollar, there is an additional issue to worry about, which is that there is about $12 trillion in overseas dollar-denominated debt. A stronger greenback would make it difficult for external borrowers to service their debts, leading to increased bankruptcies and defaults. Since financial and economic imbalances are arguably larger outside the U.S., a rising dollar would probably pose more of a problem for the rest of the world than for the United States. Although this is a serious risk, it is unlikely to materialize over the next 12-to-18 months, given our assumption that the dollar will weaken over this period. The U.S. dollar trades as a countercyclical currency, which is another way of saying that it tends to weaken whenever global growth strengthens (Chart 15). While the U.S. benefits from faster global growth, the rest of the world benefits even more. This stems from the fact that the U.S. has a smaller manufacturing base and a larger service sector than most other economies, which makes the U.S. a “low beta” economy. Hence, stronger global growth tends to cause capital to flow from the U.S. to the rest of the world, putting downward pressure on the greenback. Right now, China is stimulating its economy. The stimulus is a reaction to both slowing domestic growth, as well as worries about the potential repercussions of a trade war. It also reflects the fact that Chinese credit growth had sunk to a level only modestly above nominal GDP growth late last year. With the ratio of credit-to-GDP no longer rising quickly, the authorities had the luxury of suspending the deleveraging campaign (Chart 16). Chart 15The Dollar Is A Countercyclical Currency Chart 16Chinese Deleveraging Campaign Has Now Been Put On The Backburner   The combination of Chinese stimulus, the lagged effects from lower bond yields, and a turn in the global manufacturing cycle should all lift global growth in the back half of this year. This should cause the dollar to weaken. Trade War Worries Needless to say, this rosy outlook is predicated on the assumption that the trade war does not get out of hand. Our baseline envisions a “muddle through” scenario, where some sort of deal is hatched that allows the U.S. to bring down existing tariffs over time in exchange for a binding agreement by the Chinese to improve market access for U.S. companies and better secure intellectual property rights. The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a “small” trade war and a “moderate” trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system. What is less familiar, and much more dangerous to global finance, are nontariff barriers that effectively bar countries from accessing critical inputs and technologies. Most global trade is in the form of intermediate goods (Chart 17). If a company cannot access the global supply chain, there is a good chance it may not be able to function at all. The current travails of Huawei is a perfect example of this. A full-blown trade war would create a lot of stranded capital. The stock market represents a claim on the existing capital stock, not the capital stock that would emerge after a trade war has been fought. Stocks would plunge in this scenario, with the U.S. and most other economies succumbing to a recession. Enough voters would blame Donald Trump that he would lose the election. While such an outcome cannot be entirely dismissed, it is precisely its severity that makes it highly unlikely. Inflation: Waiting For Godot? Global monetary policy is highly accommodative at present, and will only become more so if the Fed and some other central banks cut rates. Provided that the trade war does not boil over, global growth should accelerate, putting downward pressure on the U.S. dollar. A weaker dollar will further ease global financial conditions. In such a setting, global growth is likely to remain above trend, leading to a further erosion of labor market slack. Among the major economies, the U.S. is the closest to exhausting all remaining spare capacity (Chart 18). The unemployment rate has fallen to 3.6%, the lowest level since 1969. The number of people outside the labor force who want a job as a share of the working-age population is below the level last seen in 2000. The quits and job opening rates remain near record highs. Given the erosion in slack, why has inflation not taken off? To some extent, the answer is that the Phillips curve is “kinked.” A decline in the unemployment rate from say, 8% to 5%, does little to boost inflation because even at 5%, there are enough jobless workers keen to accept what employment offers they get. It is only once the unemployment rate falls well below NAIRU that inflation starts to kick in. In the 1960s, it was not before the unemployment rate fell two percentage points below NAIRU that inflation broke out (Chart 19). Chart 18U.S. Is Back To Full Employment Chart 19Inflation Took Off In The 1960s Amid An Overheated Economy   Wage growth has picked up. However, productivity growth has risen as well. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 20).  Chart 20No Imminent Threat Of A Wage-Price Inflationary Spiral As the unemployment rate continues to drop, wage growth is likely to begin outstripping productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue thereafter. Could structural forces related to globalization, automation, demographics, and waning union power prevent inflation from rising even if labor markets tighten significantly further? We think that is unlikely. Globalization Regardless of what happens to the trade war, the period of hyperglobalization, ushered in by the fall of the Berlin Wall and China’s entry into the WTO, is over. As a share of global GDP, trade has been flat for more than ten years (Chart 21).  Chart 21Globalization Has Peaked Granted, it is not just the change in globalization that matters for inflation. The level matters too. In a highly globalized world, excess demand in one economy can be satiated with increased imports from another economy. However, this is only true if other economies have enough spare capacity. Even outside the United States, the unemployment rate in the G7 economies is approaching a record low (Chart 22). Chart 22The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows In any case, for a fairly closed economy such as the U.S., where imports account for only 15% of GDP, relative prices would need to shift a lot in order to incentivize households and firms to purchase substantially more goods from abroad. In the absence of dollar appreciation, this would require that the prices of U.S. goods increase in relation to the prices of foreign goods. In other words, U.S. inflation would still have to rise above that of the rest of the world. Automation Everyone likes to think that they are living in a special age of technological innovation. Yet, according to the productivity statistics, U.S. productivity has grown at a slower pace over the last decade than during the 1970s (Chart 23). As we argued in a past report, this is unlikely to be the result of measurement error.3  Perhaps the recent pickup in productivity growth will mark the start of a new structural trend. Maybe, but it could also just reflect a temporary cyclical revival. As labor has become less plentiful, companies have started to invest in more capital. Chart 24 shows that productivity growth and capital spending are highly correlated over the business cycle. Chart 24U.S. Productivity Growth And Capex Move In Lock-Step   It is less clear whether total factor productivity (TFP) growth — which reflects such things as technological know-how and business practices – has turned the corner. Over the past two centuries, TFP growth has accounted for over two-thirds of overall productivity growth. Recent data suggests TFP growth in the U.S. and around the world has remained sluggish (Chart 25). Chart 25ATotal Factor Productivity Remains Muted Across Developed Markets Chart 25BTotal Factor Productivity Remains Muted Across Developed Markets     Even if TFP growth does accelerate, it is not obvious that this will end up being deflationary. Increased productivity means more income, but more income means more potential spending. To the extent that stronger productivity growth expands aggregate supply, it also has the potential to raise aggregate demand. Thus, while faster productivity growth in one sector will cause relative prices in that sector to fall, this will not necessarily reduce the overall price level. Chart 26Rising Labor Share Of Income Occurring Alongside Labor Market Tightening True, faster productivity growth has the ability to shift income from poor workers to rich capitalists. Since the former spend more of their income than the latter, this could slow aggregate demand growth. However, the recent trend has been in the other direction, as a tighter labor market has pushed up labor’s share of income (Chart 26). Among workers, wage growth is now higher at the bottom end of the income distribution than at the top (Chart 27). Demographics For several decades, slower population growth has reduced the incentive for firms to expand capacity. Population aging has also shifted more people into their prime saving years. The combination of lower investment demand and higher desired savings pushed down the neutral rate on interest. Chart 28The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, they are moving from being savers to dissavers. Chart 28 shows that ratio of workers-to-consumers globally has begun to decline as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The Waning Power Of Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 29). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 30). Chart 29Inflation Fell In Canada, Despite A High Unionization Rate Chart 30Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around   Ultimately, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Unions have influence over wages, but in the long run, central banks play the decisive role. Alt-Right Or Ctrl-Left, The Result Is Usually Inflation In a speech to the Council on Foreign Relations this week, Jay Powell noted that “The Fed is insulated from short-term political pressures – what is often referred to as our ‘independence’.”4 The operative words in his remarks were “short-term”. Powell knows full well that the Fed’s independence is not cast in stone. Even if Trump cannot legally fire or demote him, the President can choose who to nominate to the Fed’s Board of Governors. Early on in his tenure, Trump showed little interest in the workings of the Federal Reserve. He even went so far as to nominate Marvin Goodfriend – definitely no good friend of easy money – to the Fed board. Trump’s last two candidates, Stephen Moore and Herman Cain, were both political flunkies, happy to ditch their previous commitments to hard money in favor of Trump’s desire to see lower interest rates. Neither made it as far as the Senate confirmation process. Recent media reports have suggested that Trump will nominate Judy Shelton, a previously unknown economist whose main claim to fame is the promulgation of a bizarre theory about why the Fed should not pay interest on excess reserves (which, conveniently, would imply that overnight rates would need to fall to zero immediately).5  It is not clear whether Trump’s attempt to stack the Fed with lackeys will succeed. But one thing is clear: Countries with independent central banks tend to end up with lower inflation rates than countries where central banks are not independent (Chart 31). Whether it be Trump-style right-wing populism or left-wing populism (don’t forget, MMT is a product of the left, not the right), the result is usually the same: higher inflation. Investment Recommendations Overall Strategy The discussion above suggests the Fed will proceed along a two-stage path: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage will be heaven for risk assets. The subsequent stage will be hell. The big question is when the transition from stage one to stage two will occur. Inflation is a highly lagging indicator. It usually does not peak until a recession has begun and does not bottom until a recovery is well under way (Chart 32). While some measures of U.S. core inflation such as the Dallas Fed’s “trimmed mean” have moved back up to 2%, this follows a prolonged period of sub-target inflation. For now, the Fed wants both actual inflation and inflation expectations to increase. Thus, we doubt that inflation will move above the Fed’s comfort zone before 2021, and it will probably not be until 2022 that monetary policy turns contractionary. It will take even longer for inflation to rise meaningfully in the euro area and Japan. Recessions rarely happen if monetary policy is expansionary. Sustained equity bear markets in stocks, in turn, almost never happen outside of recessionary periods (Chart 33). As such, a pro-risk asset allocation, favoring global equities and high-yield credit over safe government bonds and cash, is warranted at least for the next 12 months. Chart 33Recessions And Equity Bear Markets Usually Overlap The key market forecast charts on the first page of this report graphically lay out our baseline forecasts for equities, bonds, currencies, and commodities. Broadly speaking, we expect a risk-on environment to prevail until the end of 2021, followed by a major sell-off in equities and credit. Equities Stocks tend to peak about six months before the onset of a recession. In the 13-to-24 month period prior to the recession, returns tend to be substantially higher than during the rest of the expansion (Table 1). We are approaching that party phase. Table 1Too Soon To Get Out Global equities currently trade at 15-times forward earnings. Unlike last year, earning growth estimates are reasonably conservative (Chart 34). Chart 34Global Stocks Are Not That Expensive Outside the U.S., stocks trade at a respectable 13-times forward earnings. Considering that bond yields are negative in real terms in most economies – and negative in nominal terms in Japan and many parts of Europe – this implies a sizable equity risk premium.  We have yet to upgrade EM and European stocks to overweight, but expect to do so some time this summer, once we see some evidence that global growth is accelerating. International stocks should do especially well in common-currency terms over the next 12 months, if the dollar continues to trend lower, as we expect will be the case.  We are less enthusiastic about Japanese equities. First, there is still the risk that the Japanese government will needlessly raise the consumption tax in October. Second, as a risk-off currency, the yen is likely to struggle in an environment of strengthening global growth. Investors looking for exposure to Japanese stocks should favor the larger multinational exporters. At the global sector level, cyclicals should outperform defensives in an environment of stronger global growth, a weaker dollar, and ongoing Chinese stimulus. We particularly like industrials and energy. Financials should catch a bid in the second half of this year. According to the forwards, the U.S. yield curve will steepen by 38 bps over the next six months (Chart 35). Worries about an inverted yield curve will taper off. Curves will also likely steepen outside the U.S. as growth prospects improve. A steeper yield curve is manna from heaven for banks. Euro area banks trade at an average dividend yield of 6.4% (Chart 36). We are buying them as part of a tactical trade recommendation. Chart 36Euro Area Banks Are A Buy     Fixed Income The path to higher rates is lined with lower rates. The longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. The Fed’s dovish turn means that rates will stay lower for longer, but will ultimately go higher than we had originally envisioned. As a result, we are increasing our estimate of the terminal fed funds rate for this cycle by 50 bps to 4.75% and initiating a new trade going short the March 2022 Eurodollar futures contract. Our terminal fed funds rate projection assumes a neutral real rate of 1.5% and a peak inflation rate of 2.75%. Rates will rise roughly 50 basis points above neutral in the first half of 2022, enough to generate a recession later that year. The 10-year Treasury yield will peak at 4% this cycle. While the bulk of the increase will happen in 2021/22, yields will still rise over the next 12 months, as U.S. growth surprises on the upside. Thus, a short duration stance is warranted even in the near-to-medium term. The German 10-year yield will peak at 1.5% in 2022. We expect the U.S.-German spread to narrow modestly through to end-2021 and then widen somewhat as U.S. inflation accelerates relative to German inflation. The spread between Italian and German yields will decline in the lead-up to the global recession in 2022 and widen thereafter. U.K. gilt yields are likely to track global bond yields, although Brexit remains a source of downside risk for yields. Our base case is either no Brexit or a very soft Brexit, given that popular opinion has turned away from leaving the EU (Chart 37). Chart 37U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Chart 38U.S. Default Losses Will Remain In Check   We expect only a very modest increase in Japanese yields over the next five years. Japanese long-term inflation expectations are much lower than in the other major economies, which will require an extended period of near-zero rates to rectify. We expect corporate credit to outperform government bonds over the next 12 months. While spreads are not likely to narrow much from present levels, the current yield pickup is high enough to compensate for expected bankruptcy risk. Our U.S. fixed-income strategists expect default losses on the Bloomberg Barclays High-Yield index on the order of 1.25%-1.5% over the next 12 months (Chart 38). In that scenario, the junk index offers 224 bps – 249 bps of excess spread, a solid positive return that is only slightly below the historical average of 250 bps.  Currencies And Commodities The two-stage Fed cycle described above will govern the trajectory of the dollar over the next few years. In the initial stage, where global growth is accelerating and the Fed is falling ever further behind the curve in normalizing monetary policy, the dollar will depreciate. Dollar weakness will be especially pronounced against the euro and EM currencies. Commodities and commodity currencies will see solid gains. Our commodity strategists are particularly bullish on oil, as they expect crude prices to benefit from both stronger global demand and increasingly tight supply conditions. The Chinese yuan will start strengthening again if a detente is reached in the trade talks. Even if a truce fails to materialize, the Chinese authorities will likely step up the pace of credit stimulus, rather than trying to engineer a significant, and possibly disorderly, devaluation.   In the second stage, where the Fed is desperately hiking rates to prevent inflation expectations from becoming unmoored, the dollar will soar. The combination of higher U.S. rates and a stronger dollar will cause global equities to crash and credit spreads to widen. The resulting tightening in financial conditions will lead to slower global growth, which will further turbocharge the dollar. Only once the Fed starts cutting rates again in late 2022 will the dollar weaken anew. Gold should do well in the first stage of the Fed cycle and at least part of the second stage. In the first stage, gold will benefit from a weaker dollar. In the initial part of the second stage, gold prices will continue to rise as inflation fears escalate. Gold will probably weaken temporarily once real interest rates reach restrictive territory and a recession becomes all but inevitable. We recommended buying gold on April 17, 2019. The trade is up 10.8% since then. Stick with it.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 26, 2016. 4      Please see “Powell Emphasizes Fed’s Independence,” The New York Times, June 25, 2019. 5      Heather Long, “Trump’s potential Fed pick Judy Shelton wants to see ‘lower rates as fast as possible’,” The Washington Post, June 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades