Commodities & Energy Sector
Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations
Highlights Asset allocation: Go long industrial commodities versus equities on a 6-month horizon. If an inflationary impulse is dominating, beaten-down industrial commodities have more upside than richly valued equities; and if a disinflationary impulse is dominating, its main casualty will be equities. Currencies: Take profits on long EUR/CNY. Maintain a broadly neutral stance to EUR, with short EUR/JPY counterbalancing long EUR/USD. Equity sectors: overweight basic materials versus the market. And within the basic materials sector, overweight basic resources versus chemicals. Chart of the WeekChina's 6-Month Credit Impulse Provides A Perfect Explanation For Commodity Inflation Feature Equity markets are entering the crossfire between two opposing forces: an inflationary impulse coming from the global economy; and a disinflationary impulse as higher bond yields threaten to deflate the very rich valuations of equities and other risk-assets. As this battle plays out in the coming months a good strategy is to go long commodities versus equities. The logic is simple: if the inflationary impulse from the economy is dominating, then beaten-down industrial commodities have more upside than richly valued equities; and if the disinflationary impulse from higher bond yields is dominating, then commodities have less downside than equities, because commodities have a much weaker valuation link with bond yields. Therefore, going long industrial commodities versus equities on a 6-month horizon should be a good strategy however the battle between inflationary and disinflationary impulses plays out. Inflationary Impulse Battles Disinflationary Impulse Chart I-2 shows the credit impulse oscillations in the euro area, U.S., and China since the start of the millennium, all expressed in dollars to allow a comparison between the three major economies. It is a fascinating chart because the change in the dominant oscillation - the one with the highest amplitude - perfectly illustrates the shift in global economic power and influence from Europe and the U.S. to China. Chart I-2The Shift In Economic Power From Europe And The U.S. To China Through 2000-08 the impulses in the euro area and the U.S. dominated. But during the global financial crisis that all changed: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies were briefly the same size, before China took on the undisputed mantle of dominant impulse, which it has held consistently since 2013. The world's three major economies are now all in 'up' oscillations according to their credit impulses. This means the global economy will experience an inflationary impulse for the next couple of quarters or so. However, battling the inflationary impulse is a disinflationary impulse. As the inflationary impulse pushes up bond yields, it threatens to deflate the very rich valuations of equities (and other risk-assets). Crucially, this disinflationary force is particularly vicious when bond yields are rising from ultra-low levels. We have described this dynamic exhaustively in previous reports, so we will not go into the detail here. But in a nutshell, both parts of an equity's required return - the risk-free component and the risk premium - go up together when bond yields are rising from ultra-low levels. Meaning that rising yields deflate equity valuations exponentially (Chart I-3).1 Chart I-3At Low Bond Yields The Valuation Of Equities Changes Exponentially But Which Inflationary Impulse? At our recent investment conference in Toronto, the three speakers on the China panel gave three different conclusions on China: aggressively bullish, moderately bullish, and bearish! The aggressive bull pointed out that the 3-month credit impulse has gone vertical (Chart I-4); the moderate bull pointed out that the 6-month credit impulse appears to be turning up (Chart I-5); while the bearish argument was that the level of the 12-month credit and fiscal impulse remains depressed. Chart I-4The 3-Month Impulse Is Up Sharply... Chart I-5But The 6-Month Impulse Is Just Turning So which narrative should we use? The answer is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report The Cobweb Theory And Market Cycles, the theory and evidence powerfully identifies the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets - because the 6-month period aligns most closely with the lag between credit demand and credit supply.2 In any case, as we use the 6-month impulse to powerful effect in Europe, consistency demands that we must use the 6-month impulses in U.S. and China too. For the sceptics, the Chart of the Week should finally obliterate any lingering doubts. China's 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle. The important takeaway right now is that if the 6-month impulse is turning up, so will industrial commodity inflation. What Does All Of This Mean For Investors? This brings us to our central message. As we have just seen, an up-oscillation in 6-month impulses, especially in China, will lift industrial commodity inflation. But it will likely have a much smaller influence on developed market equities which, in these circumstances, will be under the strong constraining spell of higher bond yields. On this basis the asset allocation recommendation is to go long industrial commodities versus equities on a 6-month horizon (Chart I-6). Chart I-6Go Long Commodities Vs. Equities Interestingly, technical analysis also supports this recommendation over the next three months or so. Our tried and tested measure of excessive trending and groupthink suggests that the recent underperformance of industrial commodities relative to developed market equities is extreme and at a point which indicates a countertrend move, or at least a trend exhaustion (Chart I-7). Chart I-7The Underperformance Of Industrial Commodities Is Technically Stretched For currencies, the foregoing analysis and charts means it is time to take profits in our long position in the euro versus the Chinese yuan. This leaves us with a broadly neutral exposure to the euro, with a short position versus the yen counterbalancing a long position versus the dollar. As for European equities, many years ago they were a pure play on events in Europe. Today, this might still be true for European 'tail-events' such as the euro sovereign debt crisis, or a potential 'no deal' Brexit. However, for the most part, European equity markets are tightly integrated with global equity markets - at least in direction if not level. Given that industrial commodity inflation takes its cue from the 6-month credit impulse - especially in China - it is hardly surprising that the European basic materials sector follows exactly the same cycle, both in absolute terms (Chart I-8) and relative to the broader equity market (Chart I-9). Therefore the equity sector recommendation is to overweight basic materials versus the market. Chart I-8China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... Chart I-9...And In Relative Terms Interestingly, there is also a play within the basic materials sector. The basic resources sector which represents the miners and extractors of raw materials should fare better than the chemicals sector which uses these raw materials as an input (Chart I-10). Hence, overweight basic resources versus chemicals. Chart I-10Overweight Basic Resources Vs. Chemicals Readers may argue that most of the foregoing charts illustrate the same cycle. But that's precisely the point! Never forget that financial markets follow the Pareto principle: the most important 20 percent of analysis explains 80 percent of the moves across all asset classes across all geographies across all times. The key to successful investing is to find the most important 20 percent of analysis. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Reports 'Trapped: Have Equities Trapped Bonds?' September 13, 2018 and 'The Rule Of 4 For Equities And Bonds' August 2, 2018 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' January 11, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a busy week for our trades. Long basic resources versus chemicals achieved its profit target, but short U.S. telecom versus U.S. autos hit its stop-loss. Meanwhile, short trade-weighted dollar reached the end of its 65 day holding period broadly flat. All three trades are now closed. In line with the main body of the report, this week's trade recommendation is to go long industrial commodities (represented by the CRB industrials index) versus equities (represented by the MSCI World Index in USD). The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
It turns out that what matters for implied volatility of oil is the slope of the crude futures curve. A futures curve in contango, where long-dated futures trade at a higher price than short-dated futures, tends to be associated with high implied volatility.…
Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart of the WeekIncreasing Gas-On-Gas Pricing Will Disrupt Global LNG Markets Growth in the global Liquefied Natural Gas (LNG) market will be fuelled by surging U.S. natural gas production, which will allow consumers in Asian and European markets to diversify away from oil-indexed pricing - with its attendant geopolitical risks - and falling European gas production. As a result, markets will move toward short- and long-term contracts priced in USD/MMBtu (Chart of the Week). This will favor gas producers and LNG merchants with access to U.S. shale-gas supplies, where production is growing at double-digit p.a. rates (Chart 2). Well-developed trading and risk-management markets in the U.S. - centered on Henry Hub, LA - will incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. These markets allow producers and merchants to offer short- and long-term contracts that meet consumer preferences. As the global LNG market grows, shipping companies, along with producers and merchants with worldwide trading and transport capabilities - or access to such capabilities - will grow market share at the expense of exporters tied to the more rigid oil-indexing regime (Chart 3). Energy: Overweight. We remain long call spreads along the Brent forward curve over February - August; these positions are up an average 88.4% since inception, basis Tuesday's close. The long S&P GSCI position we recommended in December is up 21.8%, on the back of higher oil prices and backwardated crude-oil forward curves. Base Metals: Neutral. Copper is holding on to recent gains - up ~ 11% from its mid-August trough, following oil higher. Precious Metals: Neutral. Gold hovers around $1,200/oz, following the Fed's meeting last week, which resulted in a 25bp increase in fed funds to 2.25%. Ags/Softs: Underweight. The trade agreement to be signed by U.S. officials at the end of November with their counterparts in Mexico and Canada removes some of the uncertainty weighing on ag markets. Upward revisions to 2017 carry-out estimates by the USDA continue to pressure corn and beans. Chart 2Surging Production, Market Depth Favor U.S. Gas Producers And Merchants Chart 3Growing LNG Imports Will Favor Shippers, Producers And Merchants Feature Surging U.S. natural gas production will continue to find its way to global LNG markets over the next decade. The persistence of oil-indexing in Asian LNG contracts will fuel the growth of U.S. exports, given the arbitrage between cheaper natural gas - priced basis supply-demand fundamentals for gas - and more expensive oil-indexed contracts.1 Added to this cost advantage, U.S. exports can be linked to hedgeable futures prices, using NYMEX Henry Hub, LA, contracts. These stability-of-supply and pricing advantages also allow LNG buyers in Asia and Europe to diversify away from oil-production disruption risks, which can send prices sharply higher, and being overly reliant on Russian imports. Chart 4U.S. LNG Exports Will Surge This will give global consumers an incentive to continue shortening the tenor of more rigid oil-indexed LNG contracts, and to replace them with hedgeable contracts referencing Henry Hub, LA, futures contracts priced in USD/MMBtu. While a fairly stout increase of U.S. LNG exports already is expected by the EIA and IEA, we believe this dynamic likely results in export volumes that are higher than the ~ 10 Bcf/d expected by 2023, and close to 15 Bcf/d toward the end of the 2020s (Chart 4).2 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so that it does not curtail oil production, will drive a large part of this growth. We expect a significant LNG export center to be developed in South Texas in Corpus Christi over the next five years or so, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.3 Flexible pricing of LNG contracts basis Henry Hub already is supporting the buildout of Gulf Coast exports via take-or-cancel contracts. These contracts are replacing the more restrictive take-or-pay contracts still used in Asia.4 This will continue to evolve, allowing supply development to be hedged via Henry Hub natgas futures. Consumers ultimately benefit from cheaper supplies and hedgeable risks. This is not to say other benchmarks will fall away. There is always room for regional benchmarks - even oil-based benchmarks such as the Japan Crude Cocktail (JCC), or the spot- and swaps-market reference Japan/Korea Marker (JKM).5 The global crude oil market accommodates such regional benchmarks: WTI crude oil futures are the benchmark for oil markets in the Americas, while Brent crude oil futures serve as the benchmark for global markets. Crude oils with different chemical properties can be priced relative to these benchmarks for delivery anywhere in the world. The global LNG market could retain an Asian benchmark, but a lot of work needs to be done in terms of building the supporting infrastructure - pipelines, regasification facilities, deep futures markets, etc. - to make that happen.6 We are inclined to believe the build-out of U.S. LNG export capacity will occur before these pieces fall into place: Scale has never been an issue in the U.S. oil and gas patch. Global Supply - Demand Overview Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations Global LNG demand is expected to rise at an impressive 1.7% p.a. out to 2040 (Chart 5). However, local supply and demand levels are increasingly unbalanced, implying that cross-border pipeline and LNG imports will need to increase as gas demand rises.7 A few key markets lead this trend, as seen in Chart 6, which illustrates the supply-gap in major consuming countries. Supply gaps are poised to grow in Emerging Asia and Europe, due to elevated demand growth in the former and lack of supply growth in the latter. World LNG demand grew by 10% last year, with Europe and Emerging Asia accounting for more than 95% of this increase. However, last year's stellar growth numbers should not be considered as the baseline growth forecast.8 The latest projections show demand increasing by 21 Bcf/d by 2025 - taking LNG imports from 38 Bcf/d at present to 58 Bcf/d by then. This implies a lower annualized growth rate of 5.5%. Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally LNG Supply On Growth Trajectory World LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7), with 53% of the additional capacity coming from the U.S., 18% from Australia, and 15% from Russia.9 Chart 7LNG Export Capacity Growth Our baseline forecast for the LNG market foresees a short-term supply surplus in 2020 (Chart 8), followed by a catch-up in demand and new waves of projects between 2024 and 2030. Among the supply-side developments we are following: Chart 8New LNG Projects In The Pipeline The Australian LNG market has undergone massive change in the last five years. While being a relatively small natural gas producer (8th largest producer, accounting for ~ 3% of world output), in 2015, the country became the second largest LNG exporting country in the world with now over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019 with the completion of new trains at the Wheatstone, Prelude Floating and Ichthys LNG facilities.10 This will bring Australian total LNG export capacity to over 10 Bcf/d. Importantly, most of Australia's LNG trade is with Emerging Asian countries. This region still relies mostly on oil-linked, long-term, and fixed-destination contracts. Absent the OPEC market-share war of 2014 - 2016, when oil prices collapsed, Australia's LNG prices are subject to oil price risks and volatility (Chart 9). Chart 9Asian Oil-Indexed Contracts Trade Above Spot LNG The U.S. currently has ~ 3 Bcf/d liquefaction capacity and is increasingly exporting to Asian countries (Table 1). The present wave of projects under-construction will push capacity to ~ 9 Bcf/d in 2020. Following a two year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized; therefore, final investment decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. If a majority of these projects goes through, U.S. capacity risks being overbuilt for the next decade (Chart 10). Table 1U.S. LNG Exports By Country Chart 10U.S. LNG Capacity Risks Becoming Overbuilt Importantly, U.S. LNG exports already have had a massive impact on the global LNG market. The totality of U.S. export prices are determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. Just as importantly, these contracts are without destination restrictions found in many oil-indexed contacts. In the U.S., the presence of a deep futures market allows flexible long-term contracting.11 According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply.12 An overbuilt U.S. market would increase spot LNG trading. Our own calculations based on EIA data indicate the U.S. could have too much capacity relative to demand in 2018 - 19, but goes into balance in 2020 - 2022.13 Russia's natural gas production is projected to increase from 66.7 Bcf/d in 2017 to 70.1 Bcf/d in 2023. However, the bulk of this increase will cover new pipeline exports. The country's LNG capacity is expected to grow by ~ 2.5 Bcf/d with the completion of trains at the Yamal, Vysotsk and Portovaya export facilities. Despite its low LNG capacity, Russia remains a key player in the LNG market. Its rising pipeline capacity connected to China - the fastest growing market in the world - competes directly with global LNG supplies. For Russia, the rise of natural gas availability on a global basis - in the form of LNG - shakes its foreign relationships and policies to the core. In loosening the once-tight relationship between buyers and sellers, the rise of spot LNG supplies will favor consumers and energy security, and foster the development of longer-term contracting.14 Global LNG Demand Could Outpace Supply By our reckoning, some 62% of additional global gas demand of 160 Bcf/d will be covered by rising domestic production, 12% by rising trans-national pipeline capacity, and the remaining 26% by LNG imports.15 Longer-term, we expect LNG and natural gas demand to keep rising as industry demand expands and major coal consumers build up their natural gas and renewables usage. As a result, LNG consumption will increase at a rate of ~ 3% p.a. until 2040, as overall gas demand grows ~ 1.7%.16 Key demand-side developments: Table 2Natgas Emits Less CO2 China's environmental reforms, supply-side industrial policies and continued economic growth will be the engine of global natural gas and LNG growth in the next decade. The Middle Kingdom's natural gas demand grew 15% to 23 Bcf/d in 2017, of which 54% came from additional LNG. This short-term growth surge required spot and short-term LNG imports, which pushed up North Asian LNG spot prices. Despite our expectation that China will continue leading global LNG growth, we believe 2017 to be an outlier. Two factors contributed to the rise in spot prices: To tackle its massive pollution without significantly altering economic development and growth, China's environmental policies favor natural gas as a bridge to a low-carbon economy, since natgas contains half the carbon content of coal (Table 2). China's supply-side reforms and winter capacity cut led to a spike in spot LNG demand, which had to be covered in global LNG markets. China has an extremely low level of storage to deal with seasonal natgas consumption fluctuations; this forces the country to rely on spot LNG to meet short-term peaks in gas demand (Chart 11). Chart 11China's Minimal Natgas Storage Forces It To Rely On Spot Markets While these factors still dominate Chinese markets, new Russian pipeline capacity is expected to start delivering gas in 2019, the ~ 247 bcf of additional domestic storage capacity and the rise in spot LNG supply will mitigate the effect. In addition, China is limited in its regasification capacity. Data re projects under construction and demand forecasts indicate the average utilization would rise to ~ 90% in 2020. Winter usage would push this to ~ 100% rapidly, constraining its ability to meet winter demand with spot LNG. As a result, we expect Asian spot LNG prices to rise above contracted oil-indexed prices next winter, but less so in 2020 and 2021. Longer term, China's gas consumption is expected to grow 4.6% p.a., outpacing the 4.0% p.a. domestic production growth. Some 23% of the gap will come from Russian and Turkmenistan pipeline imports. Europe's supply-gap rose in the past 3 years, and is expected to continue to widen. Unlike the rest of the world, this gap is growing because of supply depletion instead of strong demand growth. In fact, demand is expected to remain flat, based on the IEA's forecast of Europe's long-term growth. On the other hand, total European gas supply has decreased by 16% since 2010, and is expected to continue decreasing at a similar pace, reaching 21 Bcf/d in 2023 from 25 Bcf/d in 2017. These declines in European natgas supply are due to: The phase-out by 2030 of Netherlands' Groningen field. Continued concerns about the impact of natural gas production on earthquakes in nearby communities pushed the Dutch government to adopt, in March 2018, a plan to gradually stop gas extraction at the Groningen field. Production has been decreasing since 2013 and is expected to decrease by around three quarters between now and end-2023. U.K. natural gas production will decrease by 5% p.a. due to the lack of capex and the large number of fields reaching a mature state. Stagnation in Norway's gas production following its record production level in 2017. Europe's regasification capacity has considerable slack, which will allow it to expand its import volumes. Europe currently has 23 Bcf/d regas capacity, with a very low 27% utilization in 2017. This means it has ~16 Bcf/d capacity available. With the U.S. is expected to raise its exports by ~ 6 - 7 Bcf/d in the next couple of years, Europe could potentially absorb the entire U.S. LNG exports if it desires to diversify its source of energy supply. Pressure Builds For Competitive LNG Markets Chart 12Expect More LNG Spot Trading The movement toward an integrated global market - similar in structure to current oil markets - will be driven by sharply increased U.S. LNG exports, and more competitive pricing of LNG as a function of gas supply-demand fundamentals. This latter effort likely will find support from Japanese and EU regulators. In addition, U.S. exporters already are using futures-based pricing - using Henry Hub contracts - which provide greater flexibility for producers, consumers and merchants to hedge their risk. Either Asian markets will develop viable regional benchmarks, or the global market will increasingly adopt Henry Hub indexing. Again, this is a typical commodity-market evolution: wheat can be priced for delivery anywhere on the planet using Chicago Board of Trade indexing. Asia lacks an integrated pipeline network. Market-based pricing of gas as gas - i.e., based on regional supply-demand gas fundamentals - also has not fully developed. LNG-on-LNG competition is considered a way to promote market-based pricing. Thus, the rise in spot and short-term contracts priced on the basis of natural gas fundamentals in the region already visible in the data likely will continue (Chart 12). In addition, if we see the oil price spike we expect in 1Q19 - driven by the loss of Iranian exports due to U.S. sanctions, continuing losses in Venezuelan exports due to economic collapse, and still-strong global oil demand - LNG priced on gas fundamentals will become even more attractive.17 LNG consumers' exposure to oil prices - via oil-indexed supply contracts - is a disadvantage to consumers with super-abundant natural gas supplies (Chart 13).18 That said, the U.S. export capacity remains limited, thus it cannot completely substitute for the global trade being done basis oil-indexed LNG contracts. Still, higher oil prices will incentivize a shift to contracts with prices determined by natgas fundamentals, which favors continued growth in U.S. exports. If anything, it will push for a faster-than-expected expansion of U.S. LNG export capacity. Chart 13LNG Buyers Will Resist Oil-Indexed Exposure Bottom Line: Growth in global LNG markets likely will be faster than expected, as the U.S. develops its export capacity and continues to offer futures-based pricing. This will further reduce the attractiveness of rigid oil-indexed contracts. Gas producers and LNG merchants with access to U.S. shale-gas supplies, possessing trading and risk-management capabilities that allow them to offer flexible contracts globally, are favored in this quickly evolving market. Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com Pavel Bilyk, Research Associate pavelb@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The LNG cost structure is complex. A recent paper from the Oxford Institute For Energy Studies estimates U.S. breakeven costs for new LNG projects are roughly $7/MMBtu delivered, or ~ $4/MMBtu over current Henry Hub, LA, spot prices. This includes liquefaction costs, and transportation costs from the U.S. Gulf to Asia of ~ $1.50/MMBtu, and ~ $0.70/MMBtu from the U.S. Gulf to northwest Europe. Regasification charges and entry fees likely add ~ $0.70 to $1/MMBtu. Please see "The LNG Shipping Forecast: costs rebounding, outlook uncertain," published by the Oxford Institute For Energy Studies, March 2018. Transport costs are variable, and are only one part of the LNG pricing equation. The benefits of diversifying supplies cannot be overlooked, nor can the benefit of gas-on-gas pricing in a high-priced crude oil market. See also see "US powerhouse in the making," published June 14, 2018, by petroleum-economist.com. 2 Please see the International Energy Agency's Gas 2018 report published in March, particularly the discussion of supply beginning on p. 67. 3 Please see "The Price of Permian gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 4 Take-or-cancel contracts employ option-like features - e.g., cancelation payments that function as an option premium - that give buyer and seller flexibility in cancelling a contract or delivery in a manner that allows the seller to cover fixed costs, not unlike a tolling contact. This is possible because of the hedging latitude provided by the NYMEX natural gas futures market, which has Henry Hub, LA, as its delivery point. Please see "The Shift Away from Take-or-Pay Contracts in LNG," published by the Atlanta-based law firm King & Spalding on its Energy Law Exchange blog September 13, 2017. 5 Platts' JKM spot assessment for November was $11.35/MMBtu, which was down 6% from October assessments. Please see "Platts JKM: Asia November LNG spot prices fall on thin demand," published by S&P Global Platts September 21, 2018. The NYMEX JKM forward curve peaks at $13.50/MMBtu for January 2019 deliveries, and backwardates thereafter. 6 Big LNG consumers' antitrust regulators are increasing pressure on overly restrictive contracts, which could open these markets to further competition over the next three years. Japan's Fair Trade Commission (JFTC) in 2017 concluded a review of term LNG contracts, which raised the possibility heretofore standard term contract features - e.g., limits on destinations and diversions, and take-or-pay provisions - could run counter to its antimonopoly laws. Japan is the largest importer of LNG in the world, taking ~ 11 Bcf/d. Meanwhile, in June of this year, the European Commission opened an investigation into long-term LNG contracts between its member states and Qatar Petroleum. Akin Gump Strauss Hauer & Feld, the Washington, D.C., law firm, expects a ruling on destination and profit-sharing clauses that severely limit re-trading of LNG by purchasers. Akin Gump expects a ruling in the course of the next 3 years. While Japan's FTC did not specify remedies, it is possible buyers gain rights to re-sell and re-direct cargoes, following these reviews. This would make markets more competitive, although indexing the price of LNG to oil-based formulas likely will hinder this process. Please see "Revisiting LNG Resale Restrictions - Implications of Recent EU Decisions," published on the firm's website August 2, 2018. 7 Natural gas demand grew by 16% since 2010, according to the BP 2018 Statistical Review of World Energy, and is expected to grow by a cumulative 47% (1.6% p.a.) by 2040. 8 Many idiosyncratic factors helped Chinese LNG imports reach such an exceptional growth rate, mostly weather-related: China's environmental policy is resulting in widespread substitution of coal for natural gas for space-heating purposes, which, in colder-than-expected winters, results in surging demand. We do not believe this will be a long-term seasonal influence: Physical facilities are being built out to accommodate higher supply and demand. 9 World liquefaction capacity will rise to ~ 61 Bcf/d in 2022, based on our calculations of projects under construction. The bulk of additional capacity will come from the U.S., Australia and Russia. 10 Capacity of 0.6, 0.5 and 1.2 Bcf/d, respectively. 11 Please see U.S. Department of Energy, office of Oil & Natural Gas, LNG Monthly. 12 Like most globally traded commodities, LNG can be traded in USD/MMBtu. The global financial and clearing system already is set up to accommodate commodity transactions denominated in USD, therefore we do not see any impediments to extending it further into the LNG market. 13 Please see Chart 10 footnote for details. 14 We will be exploring the geopolitical dimension of LNG next week in a Special Report written with our colleagues in BCA Research's Geopolitical Strategy. Please see Meghan L. O'Sullivan, Windfall: How the new energy abundance upends global politics and Strengthens America's Power (New York: Simon & Schuster, 2012). 15 From 2017 to 2040, based on BP projections. The bulk of additional pipeline capacity will come from Russia with 12 Bcf/d destined to China and Europe expected to come on line in 2019. 16 Please see the International Energy Agency's GAS 2018 report published in March, BP's BP Statistical Review Of World Energy 2018 report published in June, Shell's Shell LNG Outlook 2018 report published in February, and U.S. the Energy Information Administration's International Energy Outlook 2017 report published in September. 17 Please see our most recent assessment of global oil fundamentals, published September 27, 2018, entitled "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," and our updated forecast, "Odds Of Oil-Price Spike In 1h19 rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published September 20, 2018. 18 Asia LNG prices are usually linked to the JCC according to predetermined formulae. However, the exact formula remains opaque and varies with each contract. Based on our calculations, we concluded that since 2010, the average formula uses a slope of ~14% on JCC prices lagged 4 months, with very low s-curve components and a constant. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Investors who are betting on a quick resolution to the U.S./China trade war following the "new NAFTA" deal and the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months. Consequently, we are closing our long ESG leaders / short benchmark trade. Feature September's PMI releases, both official and private, confirm that China's export outlook is deteriorating rapidly. Chart 1 highlights that the Caixin PMI is about to fall below the boom/bust line, and the new export orders component of the official PMI has sunk to a 2 ½ year low. Somewhat oddly, investors do not seem to be responding negatively to the de-facto announcement of a 25% rate on the second round of U.S. import tariffs against China. Chart 2 shows that domestic infrastructure stocks have actually been rising relative to global stocks since mid-September, and our BCA China Play Index appears to have entered a (so far very modest) uptrend. Chart 1The Export Shock Is Coming... Chart 2...But Investors Have Been Incrementally Upbeat One possible explanation for this is that investors are doubling down on the idea that China will have to aggressively stimulate in response to the shock. We have leaned against this narrative, by arguing in past reports that China's policy response to the upcoming export shock is not likely to be heavily credit-based, and that increases in fiscal spending today will involve more "soft infrastructure" than in the past.1 Chart 3 certainly shows no evidence of a spike in broad money or total credit; adjusted total social financing growth barely accelerated in August, against the backdrop of promises to front-run planned fiscal spending over the coming year. Chart 3No Major Acceleration In Credit Growth Evident Yet Chart 4Americans Support A Tough Stance Against China But a second explanation of recent investor behavior, one that we have been hearing more loudly from some market participants, is that China is waiting until after the midterm elections in the U.S. to make a deal, in anticipation that Republican losses in Congress will weaken Trump and change the political reality in terms of trade policy towards China. There are three reasons why investors holding this view are likely mistaken, and have been taken in by false hope: In the U.S., the actual implementation of tariffs lies within the control of the Presidency. Congress has delegated substantial authority to the president that would take time to be clawed back. Moreover, the president controls the execution of tariffs, and has a general prerogative over national security issues, which certainly includes the trade war with China. Democratic control of the House or Senate may cause President Trump to act even more forcefully against China, as trade will be among the few relatively unfettered policy options left to him. Chart 4 highlights that a sizeable majority of the American public views Chinese trade policy towards the U.S. as unfair, unlike the U.S.' other major trade partners. Reflecting this point, Democrats themselves maintain a hawkish stance on trade with China. This suggests that Trump will have a strong mandate to continue to demand major concessions from China even after the elections. We agree that Chinese stocks have already priced in a sizeable earnings decline, but we would still characterize buying now as an ill-advised case of trying to catch a falling knife. We highlighted in our September 19 Weekly Report that during the 2014-2016 episode Chinese stocks bottomed several months after stimulus began to take effect,2 because of a delayed decline in forward earnings. A similar situation would appear to be developing this time around: the third round of tariffs against China will likely soon be announced, the shock to Chinese export growth will soon manifest itself in the data, and yet Chinese forward earnings have only fallen 5-6% from their June peak. Bottom Line:Investors who are betting on a resolution to the U.S./China trade war following the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. Recent Sector Performance: A Beta Story, And A New Trade Idea Chart 5Last Week We Closed One Of Our Most Successful Calls We recommended closing one of our most successful trades of the past year in a brief Special Report last week.3 The report outlined major changes to the global industry classification standard (GICS) that took effect this week, as well as the implications for China's stock market. One key change is that Alibaba, one of the "BATs", is now part of the consumer discretionary sector and makes up roughly 60% of its market capitalization. Given this fundamental shift in the risk/reward profile of the position, we recommended closing our long MSCI China Consumer Staples / short MSCI China Consumer Discretionary trade for a profit of 47% (Chart 5). With the goal of identifying new trade ideas that are likely to outperform within the context of a trade war, Chart 6 presents the alpha and beta characteristics of 23 industry groups in the MSCI China index (the investable benchmark) from mid-June to the end of September. The x-axis of the chart represents the group's beta versus the benchmark, whereas the y-axis shows standardized alpha over the period. The chart also distinguishes between out/underperforming sectors. Chart 6Since Mid-June, Sector Performance Has Largely Been Beta-Driven Several points are notable: Largely speaking, the relative performance of Chinese industry groups since mid-June has been determined by their beta characteristic (with almost all low-beta industry groups outperforming). This supports our existing position of favoring low-beta sectors within the MSCI China index, a trade that we initiated on June 27.4 Four industry groups that belong to traditionally cyclical sectors have outperformed since mid-June and have had a beta less than 1: energy, capital goods, banks, and consumer durables and apparel. Energy and capital goods have been particularly notable, having outperformed by 24% and 15%, respectively. Technology-related industry groups have underperformed, including the pharma, biotech, and life sciences industry group within health care. Consumer services and retailers have significantly underperformed, due to the heavy influence of travel-related businesses in both indexes. Among the top performing industry groups over the past three months, Chinese energy stocks look like the most compelling trade in absolute terms. While we are normally reluctant to chase performance, several factors support an outright long position: BCA's Commodity & Energy Strategy service is bullish on oil prices, and recently increased their 2019 Brent price forecast to $95/bbl based on both supply and demand factors.5 Despite the recent outperformance of Chinese energy companies within the investable universe, they remain cheap versus global energy companies based on cash flow-based valuation metrics (Chart 7). This is true even after accounting for the fact that they are typically discounted relative to their global peers due to heavy state ownership. Chinese energy companies look reasonably priced relative to the value of global oil production (Chart 8). Chinese energy companies largely receive their revenue in U.S. dollars, which is an attractive hedge in an environment where CNY-USD may decline further. Chart 7Chinese Energy Stocks Are Cheap Versus Their Global Peers... Chart 8...And Versus The Value Of Global Oil Production Given this, we are updating our trade book and recommend that investors initiate an outright long position in Chinese energy stocks as of today. Chart 9Despite Outperforming, Absolute Capital Goods Performance Has Been Lackluster What about Chinese capital goods companies? For now, we are content with relative rather than absolute exposure, which (surprisingly) exists in our low-beta sectors trade. Capital goods companies account for almost 70% of the Chinese industrial sector, and industrial stocks have been less volatile than the broad market over the past year, in large part because they underperformed so significantly in 2017. Given this, they have been included in our low-beta sectors portfolio, despite being typically pro-cyclical. In absolute terms, though, it is far from clear that Chinese capital goods stocks will trend higher (Chart 9). Some investors are hopeful that capital goods producers will benefit from a significant acceleration in infrastructure spending but, as we noted above, the bar is high for the type of stimulus that investors have come to expect. In addition, potential weakness in property construction could be a drag, and could offset gains from a pickup in infrastructure investment.6 We recommend that investors stick with a relative position, until compelling signs of a stimulus overshoot emerge. Bottom Line: The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. A Pause In Broad "Reform" As An Investment Theme Following last November's Communist Party Congress, we noted that China was likely to step up its reform efforts in 2018, and would take meaningful steps to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth Slow or halt leveraging in the corporate/financial sector Eliminate corruption and graft We argued that Chinese policymakers would have to set the pace of reforms to avoid a significant slowdown in the economy, but we noted that a policy mistake (moving too aggressively) could not be ruled out. We introduced the BCA China Reform Monitor as a way of tracking the intensity of the reforms, which was calculated as an equally-weighted average of the four "winner" sectors that emerged in the month following the Party Congress (energy, consumer staples, health care, and technology) relative to an equally-weighted average of the remaining seven sectors (Chart 10). In particular, we argued that a rise in the monitor that was driven by the underperformance of the denominator would be a warning sign that reforms had become too aggressive for the economy to withstand. Chart 10Reform, As A Broad Theme, Will Be Less Relevant In The Year Ahead Chart 10 highlights that the reform monitor rose for the first half of the year, driven by the gains of the numerator rather than losses in the denominator. The message of a sustainable pace of reforms, even against the backdrop of brewing trade tension, was consistent with the relative performance of Chinese stocks and was part of the reason we recommended staying overweight versus the global benchmark in Q1 and the majority of Q2.7 Since mid-June, however, the reform theme has been thrown into reverse: our reform monitor has declined, alongside absolute declines in both "winner" and "loser" sectors. The timing of this inflection point is clearly aligned with President Trump's announcement of the second round of tariffs. Given this, and our view that the U.S./China trade war is likely to get worse over the coming 6-12 months, it is likely that broad "reform" as an investment theme will be less relevant for the foreseeable future, at least relative to policymaker efforts to stabilize the economy. However, for several reasons, we view this as a pause in the theme, rather than an end: On the environmental front, Chart 11 highlights that China continues to pursue a clean air policy, at least in large population centers. Anti-pollution efforts are a signature policy of President Xi Jinping. They affect quality of life and ultimately the legitimacy of the regime, so they cannot be postponed entirely or indefinitely. Chart 11China Continues To Clamp Down On Air Quality Shifting China's growth model away from primary and secondary industry remains a long-term goal of policymakers. Chart 12 highlights that tertiary industry has already risen non-trivially as a share of GDP. This trend is also clearly visible in the electricity consumption data, which shows that residential and tertiary industry consumption has risen quite materially over the past several years. Chinese policymakers will clearly ease up on the brake over the coming year in terms of deleveraging, but it is far from clear that they will aim for another wave of aggressive private sector debt growth. We highlighted one key reason for this in a recent Special Report: comparing adjusted state-owned enterprise (SOE) return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative for these firms (Chart 13). This implies that further aggressive leveraging of SOEs could push them into a debt trap. In fact, if policymakers do refrain from promoting a major private sector credit expansion over the coming year, that restraint will directly reflect the reform agenda. Chart 12Policymakers Continue To Emphasize A Transition Towards Services Chart 13SOEs Now Appear To Have A Negative Financial Gain From Debt Chart 14 highlights that while anti-corruption cases involving gifts and the improper use of public funds are off of their high from early this year, they remain elevated and are not trending lower. As a final point, Chart 15 shows that our long MSCI China environmental, social, and governance (ESG) leaders / short MSCI China trade has been negatively impacted by the pause in reform as an investment theme. While MSCI's ESG indexes aim to generate low tracking error relative to the underlying equity market of each country, technology companies are typically overrepresented in ESG indexes because of the low emissions nature of their business model. In China's case, we noted above that technology industry groups have fared poorly since mid-June, and panel 2 of Chart 15 shows that the underperformance of Chinese investable technology companies since mid-June lines up with the latest leg of ESG underperformance. Chart 14China's Anti-Corruption Drive Is Still In Effect Chart 15Favor ESG Leaders Again When The Reform Theme Reasserts Itself It remains unclear how much of tech's underperformance has been due to rich multiples versus concerns that the U.S. crackdown on Chinese technology transfer and intellectual property theft will negatively impact the market share of China's tech companies (via an opening of the market and a rise in the market share of foreign competitors). But we believe that the latter is a factor, and we recommend closing our long ESG leaders / short benchmark trade until "reform", both environmental and otherwise, reasserts itself as a driving factor for the Chinese equity market. Bottom Line: While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months relative to policymaker efforts to stabilize the economy. We are closing our long ESG leaders / short benchmark trade at a loss of 5.5%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Report "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "GICS Sector Changes: The Implications For China", dated September 26, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com. 5 Pease see Commodity & Energy Strategy Weekly Report "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com. 6 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 7 The rapidly escalating trade war between China and the U.S. caused us to recommended putting Chinese stocks on downgrade watch at the end of March, and we recommended that investors cut their exposure to neutral on June 20. Pease see China Investment Strategy Weekly Report "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, and China Investment Strategy Special Report "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, both available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations