Commodities & Energy Sector
Highlights Before re-capping the performance of our recommendations last year - up 77%, led by oil calls, which posted an average gain of 111% - we take a look at what the re-emergence of financial and monetary factors will mean for commodities this year. Fundamentals - supply, demand, inventories - drove the evolution of industrial commodity prices over the past two years, and will remain supportive for oil and, to a lesser degree, base metals in 1H18. Thereafter, in 2H18, we believe financial and monetary variables will begin to re-assert their importance in the evolution of commodity prices. Forecasting commodity prices becomes more difficult, as a result, as it is not clear the Fed or other systematically important central banks, understand what is driving their principal policy variables - particularly inflation - or how they are evolving. Despite these central-bank uncertainties, we remain long broad commodity exposure via the S&P GSCI (up 6.4% since it was recommended in Dec/17), long call spreads in Brent and WTI across 2018 deliveries (up 78%); and long gold (up 6.7%). 2018 Weightings Energy: Overweight. WTI and Brent crude oil forward curves will become more backwardated as the combination of OPEC 2.0 production discipline and continued strength in demand draws inventories lower. This will boost S&P GSCI returns.1 Base Metals: Neutral. Base metals will continue to be supported through 1Q18 by China's environmental reforms, which are reducing supply in the face of continued strength in global demand. Strong demand ex-China will offset weaker Chinese growth, supporting metals prices. Precious Metals: Neutral. While we expect four rate hikes by the Fed this year, we are wary of policy errors at systemically important central banks, which makes forecasting monetary policy highly uncertain. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Still-high supplies outside the corn market; policy uncertainty re NAFTA; and uncertainty over Fed policy likely keep grain prices weak. A stronger USD would weaken demand for U.S.-sourced grains and softs. Feature Chart of the WeekFundamentals Continue To##BR##Support Commodities That was quick! Oil prices are closely hewing to fundamentals as the year opens. We revised our Brent forecast to $67/bbl in early December (up from a $65/bbl forecast in mid-October 2017), based on our fundamental assessment of the market - supply, demand and inventories - and, voilà, contracts for Mar/18 delivery got there by the end of 2017. Our $63/bbl forecast for WTI is still ~ $2.50/bbl from being realized, but we continue to expect this gap to close. At the moment, fundamentals for industrial commodities - oil and, to a slightly lesser extent, base metals - will support firmer prices in 1H18 (Chart of the Week). For oil, this will be an extension of the fundamental realignment initiated by OPEC 2.0 at the end of 2016. The producer coalition agreed to remove ~ 1.1mm b/d from the market, which, along with another 300k to 400k barrels of natural declines, tightened the supply side considerably. On the demand side, the synchronized global economic upturn that powered consumption up by 1.65mm b/d last year, by our estimation, will push demand higher by 1.67mm b/d this year. Supply-side adjustments in base metals, particularly copper, where strikes and natural disasters combined to tighten markets, will be augmented by the ongoing environmental reforms in China (Chart 2). These supply-side effects in industrial commodities occurred against a backdrop of stronger-than-expected economic growth worldwide last year - the first such upturn since the Global Financial Crisis (GFC) in 2008 (Chart 3). Chart 2Fundamentals Supported Metals Chart 3Global Upturn Powers Commodity Demand We expect this to continue. Part of the recovery in aggregate demand worldwide can be attributed to the massive monetary stimulus by systematically important central banks - led by the Fed, the ECB and BoJ. Lower energy prices last year, which acted like a tax cut, put more discretionary income in consumers' hands and also boosted aggregate demand.2 Monetary Policy Will Re-Assert Itself Chart 4The USD Will Re-Emerge As A##BR##Driver Of Commodity Prices The influence of monetary policy - chiefly how the Fed's actions affect the USD - has been de minimis over the past two years relative to fundamentals, which have driven price formation in industrial commodities (Chart 4). While the Fed raised its policy rate 3 times last year, monetary conditions remained relatively loose in the U.S., which was supportive of commodity prices. Looser monetary conditions kept the USD better offered than other major currencies in 4Q17, which allowed gold prices to recover late in the year. A weaker USD also supported grain markets, which also have staged a somewhat subdued recovery following a mid-2017 sell-off. For at least 1H18, we see commodities generally continuing to be supported by strong fundamentals and relatively accommodative monetary policy globally, even with the Fed lifting its policy rate as many as four times this year, per our House view. Inflation Pressures Could Start Building By 2H18, inflationary pressures could start to build: In the U.S., tax cuts coupled with fiscal stimulus from the federal government in the form of disaster relief and higher discretionary spending - could add ~ 0.5% to GDP growth this year, based on calculations by BCA's Global Investment Strategy team (Chart 5).3 This should, all else equal, increase demand for labor and push the U.S. unemployment rate lower, lifting wages, inflation and inflation expectations in turn (Chart 6). At least that's how it's supposed to work. Our colleagues in BCA Research's U.S. Bond Strategy note, the "dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 5U.S. Inflation Is Ticking Higher Chart 6Still Waiting On The Phillips Curve "... Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995."4 We're inclined to agree with former Fed Chair Ben Bernanke on this. In 2016, he noted that, given the years-long stretch of errors in forecasting key economic variables - output, unemployment and the Fed funds rate - "Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance."5 This is a mixed blessing (or curse) for commodity markets: Increased economic activity raises demand for commodities, so at least in 1H18, and most likely for the second half as well, commodity demand will remain well supported globally. If we do get higher inflation, the Fed likely would feel it could lean into its rate-normalization with greater vigor, and start guiding to more frequent or bigger rate hikes. If we don't see higher inflation - if, as Chicago Fed President Charles Evans fears, inflation expectations have been marked down in a meaningful way - and the Fed cannot justify further rate hikes, we could see the real side of the global economy take another leg higher, lifting commodity demand in the process.6 This is the big issue for the coming year. We cannot say at this point how it plays out, which is why we recommend commodity investors remain in tactical mode, as we did a year ago. Recapping 2017's Recommendations Our trade recommendations were up an average of 77% last year, led by a 111% gain in our oil calls. This was a touch better than the 95% average gain we posted on our oil recommendations in 2016 (Table 1). Table 1Average Quarterly Returns 2017 Without a doubt, most of our recommendations were in the oil markets, as the accompanying tables show, and we maintained an exposure of one sort or another in oil throughout the year (Table 2). Table 2Trades Closed In 2017 The big drivers of our view in oil markets were fundamentals: On the supply side, we maintained the view OPEC 2.0 would not waver in its commitment to draining global storage levels, particularly in the OECD commercial inventories via supply reductions. On the demand side, by mid-2017, it became apparent to us the big data providers - the U.S. EIA and the IEA in Paris - and most of the sell-side analysts were underestimating demand. Information flows during 1H17 were often contradictory, which injected enormous volatility in crude-oil spread markets - particularly the calendar spreads trading markets employ to take a view on the shape of the forward curve (e.g., long a near-term futures contract like Dec/17 Brent, vs. short a deferred delivery contract like Dec/18). This intense volatility drove us toward the relative safety of call-option spreads in 2H17, where the risk of loss is limited to the net premium paid for the call spread. As we did last year, we constructed an information ratio (IR) to determine whether the additional volatility produced by our recommendations was adequately compensated for by the returns (simple percent changes of the opening level for a recommendation vs. the closing level). Our IR uses the S&P GSCI as a benchmark, given it has a relatively high weight in energy-related exposures. Our ratio looks at the average excess return of the active portfolio against this benchmark. This average excess return is divided by its standard deviation (also referred to as the tracking error volatility) in order to generate a risk-adjusted metric to measure returns on our recommendations relative to the risk we took to generate them. BCA's IR thus is calculated as: The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: High returns in the portfolio; low returns in the benchmark, or low tracking error volatility. Hence, this measure provides a numeric value to analyze the risk-reward trade-off; it tells us whether or not the risk assumed in our trades was compensated for by larger returns. Viewing our energy recommendations as a portfolio over the course of 2017, our average return was 111%, while the GSCI return was 5.8%. The tracking error volatility was 112%.7 Using these inputs, the IR of our recommendations was 0.94. While not as stellar as our 2016 IR of 1.47, this risk-adjusted return is still stout, and indicates the consistent positive excess returns of our portfolio relative to passive GSCI exposure compensated for the high volatility of those returns. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is the name we've given the OPEC + non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 For a summary of our 2018 outlooks, please see BCA Research's Commodity & Energy Strategy Weekly Report "Oil Fundamentals Remain Bullish Heading Into 2018," published on December 21, 2017, and "Opposing Forces: Stay Neutral Metals In 2018" in the same issue. It is available at ces.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," published December 22, 2017. It is available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Ill Placed Trust?," published December 19, 2017. It is available at usbs.bcaresearch.com. 5 Please see "The Fed's shifting perspective on the economy and its implications for monetary policy," by Ben S. Bernanke, published by the Brookings Institution on its website August 8, 2016. 6 Please see "All Talk, Few Answers From FOMC for Yellen's Long Inflation Miss," published by bloomberg.com on January 3, 2018. 7 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 224 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking-error volatility. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017
Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in Summary of Trades Closed in
Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.
In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3% and we think the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. The Fed and other G7 central banks are simultaneously tightening monetary policy, either through rate hikes or reduced asset purchases or a combination thereof. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (second panel). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners as global oil majors have returned to profitability in the new era of $50/bbl oil, suggesting that the worst is behind the industry. Notwithstanding the still-supportive context, this was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Should a broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now; see Monday's Weekly Report for more details.
Highlights Portfolio Strategy The easy money has already been made in the liquidity-to-growth theme-levered long S&P energy/short global gold miners pair trade. Lock in profits and move to the sidelines, for now. Similarly, book gains in the long S&P materials/short S&P utilities market-neutral trade. A stealthy macro shift, at the margin, suggests that a more challenging phase lies ahead for this relative share price ratio. Recent Changes Book 18.3% profits in the long S&P energy/short global gold miners pair trade today. Take profits in excess of 8.6% in the long materials/short utilities pair trade today. Table 1 Feature Equities continued to defy gravity last week, vaulting to fresh all-time highs. Seasonality (or the pending Santa rally) appears to have trumped any "buy on rumor sell the tax news" jitters, at a time when macro data continue to surprise to the upside. Heading into 2018, easier fiscal policy will likely offset some of the uneasiness of the Fed's ongoing tightening cycle as we postulated in early October.1 Synchronized global economic and capex growth remain the key macro themes that dominate markets. The latest GDP revisions in the G3 confirm our global capex upcycle bias: U.S., euro area and, especially, Japanese gross fixed capital formation are on fire (Chart 1). Importantly, once the tax bill related dust settles, profits will come back to the forefront as a key stock market driver. In that regard, the news on the EPS front is ebullient and, along with the forward multiple, all that matters. Table 2 shows annual SPX returns going back to 1979, and breaks down the composition of the capital (not total) return into two components: forward earnings growth and the forward P/E multiple (January 1979 is the first IBES data point for forward EPS SPX estimates). Chart 1Synchronized Global Capex Table 2Disentangling SPX Returns Currently, sell side analysts expect 11% EPS growth for 2018, and our sense is that 8-12% EPS growth is achievable next year, a message that our SPX EPS macro model corroborates (Chart 2). Keep in mind that there is no tax cut penciled into our EPS model's numbers. Chart 2SPX EPS Macro Model Flashing Green What is interesting from the multiple/EPS analysis is that over the last four decades when forward profit growth was in this high single-digit / low double-digit range (ten iterations), the multiple expanded modestly (on average, adding 2.6 percentage points to the market's return) and EPS did the heavy lifting (explaining, on average, roughly 80% of the S&P 500's 12.9% average annual return, Table 3). If we consider periods when EPS growth was positive but below 8% (eleven iterations), SPX returns are close to 10%, on average, with EPS and the multiple contributing almost equally to the market's return. One caveat is that two recessionary years and the dot com bust are part of this segment skewing the results to the downside (Table 3).2 Table 3Disentangling SPX Returns Continued Nevertheless, if history at least rhymes, were EPS growth to stay positive next year and hit the 8-12% mark, then a profit driven low double-digit broad equity market return is likely. If profits disappoint and grow between 0-8%, barring recession, empirical evidence suggests that equity returns will still prove healthy. Adding it up, the path of least resistance is higher for equities on a cyclical 9-12 month horizon. Granted, since Brexit the SPX has rallied in a near straight line up and a healthy and temporary pause for breath is likely in Q1/2018. As a result, this week we are booking impressive gains in two tactical market-neutral trades we initiated in late-August and mildly de-risking our portfolio. Lock In Profits In The Long Energy/Short Gold Producers Trade In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3%. It also sports a positive annual dividend carry of 200bps. With the equity market overshoot phase likely going on hiatus sometime in early 2018 is it still prudent to hold this high-octane intra-commodity and market-neutral trade? The short answer is no. Nothing in terms of macro data has changed to trip up this pair trade. If anything, the handoff of global liquidity to economic growth has gained steam in the past few months. Global GDP, IP, manufacturing PMIs, global trade (Chart 3) and gross capital formation are all growing simultaneously across all of the G7 and most of the EMs. Even China's economy seems to have stabilized. The Fed announced its plans to wind down its balance sheet as expected in September and the BoE and BoC have both tightened monetary policy. Even the ECB announced a halving of the size of its monthly purchases in late-October (but extended it for nine months). All these central bank (CB) moves suggest that, at the margin, the global liquidity injection is reversing, with CBs actually mopping up liquidity. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (Chart 4). Chart 3Brisk Global Growth... Chart 4...Higher Rates... Moreover, geopolitical uncertainty is steadily receding, especially now that the Senate also passed a tax bill, and a final bill will likely soon be signed into law.3 Historically in times of duress, safe haven assets are bid up and vice versa, and the current low policy uncertainty backdrop is conducive to additional gains in the relative share price ratio (policy uncertainty shown inverted, Chart 5). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners. The oil and gas rig count has resumed its advance and remains 150% clear of the lows hit during the depths of the global manufacturing recession of late-2015/early-2016. Anecdotes of global oil majors comfortably registering positive EPS, in the new era of $50/bbl oil, and reinstating stock buybacks and eliminating scrip dividends (RDS, BP & ENI) suggest that the worst is behind the industry. In contrast, safe haven asset demand is in retreat and will continue to weigh on global gold ETF flows. Anecdotally, the BITCOIN/ICO/cryptocurrency mania may also steal some of bullion's thunder, as this mania is capturing investor's imagination. Either a flare up in global geopolitical risk or a global growth scare could cause investors to start shifting capital into gold ETFs. Our relative EPS models do an excellent job in capturing this energy positive/gold negative backdrop and continue to suggest that energy profits will outpace gold mining EPS (Chart 6). Chart 5...And Diminishing Uncertainty##br## Still Bode Well For The Trade Chart 6But We Do Not Want To##br## Overstay Our Welcome If these different macro and operational forces all emit an unambiguously bullish signal for S&P energy shares compared with global gold miners, why book profits? Our sense is that there are high odds of a pullback in Q1/2018 and from a portfolio management and risk perspective it is prudent to lock in handsome profits in excess of 18.3% in a four month period. There are high odds that most of these key drivers are reflected in relative share prices versus late-August. Relative valuations are pricier today and technicals are also flashing yellow (bottom panel, Chart 4). We deem that the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. This was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Were the broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now. Take Profits In Materials Vs. Utilities Similar to booking gains in the liquidity-to-growth levered market-neutral long S&P energy/short global gold miners pair trade, we also recommend taking profits in the reflation levered long S&P materials/short S&P utilities pair trade. Since its late-August inception this market-neutral trade has generated returns in excess of 8.6% and added alpha to our portfolio. While overall macro conditions continue to underpin the relative share price ratio, some cracks are appearing on the surface. Global reflation has matured and synchronized global growth is as good as it gets. The ISM manufacturing and services surveys have ticked down in sympathy recently, warning that the easy gains are behind this market neutral trade (Chart 7). Worrisomely, our relative sector Cyclical Macro Indicators are sniffing out this marginal shift in the macro backdrop and suggest that a more challenging phase lies ahead for the relative share price ratio (Chart 8). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018. This is one of our key themes for next year, and given that this trade typically moves in lockstep with interest rates, the path of least resistance is higher. Nevertheless, the fact that this ratio has not kept up with the slingshot recovery in the stock-to-bond (S/B) ratio is slightly disconcerting. The top panel of Chart 9 shows that the gap between the S/B and the materials/utilities ratios has widened further since late-August. Chart 7As Good As It Gets? Chart 8Fatigue Signs Chart 9More Balanced Backdrop=Move To The Sidelines On the operating front, our relative EPS models are also showing signs of fatigue. Materials profits cannot expand indefinitely at the breakneck pace observed since the 2016 trough, at a time when utilities EPS have stabilized. Currently, the relative earnings models suggest that materials are on an even keel with utilities (Chart 9). Tack on rising odds of a healthy broad market pullback in Q1/2018, and from a risk management perspective we would rather de-risk the portfolio a notch by locking in near double-digit gains since inception in this volatile pair trade. Bottom Line: Book gains of 8.6% in the long S&P materials/short S&P utilities pair trade. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 For reference and completion purposes Table 3 also tabulates the results during EPS contractions (nine iterations) and in profit boom times, i.e. forward EPS growth north of 12% (nine iterations). 3 Please see BCA U.S. Equity Strategy & Geopolitical Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Recommended Allocation Highlights We are late cycle. Strong growth could turn in 2018 from a positive for risk assets into a negative. More risk-averse investors may thus want to turn cautious. But the last year of a bull run can be profitable, and we don't expect a recession until late 2019. For now, therefore, our recommendations remain pro-risk and pro-cyclical. We may turn more defensive in 2H 2018 if the Fed tightens above equilibrium. We expect inflation to pick up in 2018, which will lead the Fed to hike maybe four times. This will push long rates to 3%, and strengthen the U.S. dollar. Equities should outperform bonds in this environment. We prefer euro zone and Japanese equities over U.S., and remain underweight EM. Late-cycle sectors such as Financials and Industrials, should do well. We also favor corporate bonds and private equity. Feature Overview Fin de cycle Global economic growth in 2017 was robust for the first time since the Global Financial Crisis (Chart 1). Forecasts for 2018 put growth slightly lower, but are likely to be revised up. However, as the year rolls on, the strong economic momentum may turn from being a positive for risk assets into a negative. U.S. output is now above potential, according to IMF estimates. As Chart 2 shows, historically recessions - and consequently equity bear markets - have usually come within a year or two of the output gap turning positive. With the economy operating above capacity, inflation pressures force the Fed to tighten monetary policy, which eventually causes a slowdown. Chart 1Growth Finally On A Firm Footing Global Growth Has Accelerated Chart 2Recessions Follow Output Gap Closing That is exactly how BCA sees the next couple of years panning out, leading to a recession perhaps in the second half of 2019. U.S. inflation was soft in 2017, but underlying inflation pressures are picking up, with core CPI inflation having bottomed, and small companies saying they are raising prices (Chart 3). Add to that wage pressures (with unemployment heading below 4% in 2018), tax cuts (which might boost growth by 0.2-0.3% points in their first year) and a higher oil price (we expect Brent to average $67 a barrel during the year), and core PCE inflation is likely to rise to 2%, in line with the Fed's expectations. This means the market is too sanguine about the risk of monetary tightening in the U.S. It has priced in less than two rates hikes in 2018, compared to the Fed's three dots, and almost nothing after that (Chart 4). If inflation picks up as we expect, four rate hikes in 2018 could be on the cards. Chart 3Inflation Pressures Picking Up Chart 4Market Still Underpricing Fed Hikes The consequences of this are that bond yields are likely to rise. Despite a significant market repricing since September of Fed behavior, long-term rates have not risen much, leading to a flattening yield curve (Chart 5). The market has essentially priced in that inflation will not rebound and that, consequently, the Fed will be making a policy mistake by hiking further. If, therefore, we are correct that inflation does reach 2%, the yield curve would be likely to steepen over the next six months, with the 10-year U.S. Treasury yield reaching 3% by mid-year. Other developed economies, however, have less urgency to tighten monetary policy and we, therefore, see the U.S. dollar appreciating. The only other major economy with a positive output gap currently is Germany (Chart 6). However, the ECB will continue to set policy for the weaker members of the euro area, and output gaps in France (-1.8% of GDP), Italy (-1.6%) and Spain (-0.7%) remain significantly negative. In the absence of inflation pressures, the ECB won't raise rates until late 2019. Japan, too, continues to struggle to bring inflation up the BOJ's 2% target and the Yield Curve Control policy will therefore stay in place, meaning that a rise in global rates will weaken the yen. Chart 5Is Fed Making A Policy Mistake? Chart 6Still A Lot Of Negative Output Gaps This sort of late-cycle environment is a tricky one for investors. The catalysts for strong performance in equities that we foresaw a few months ago - U.S. tax cuts and upside surprises in earnings - have now largely played out. Global earnings will probably rise next year by around 10-12%, in line with analysts' forecasts. With multiples likely to slip a little as the Fed tightens, high single-digit performance is the best that investors should expect from equities. The macro environment which we expect, would be more negative for bonds than positive for equities. That argues for the stock-to-bond ratio to continue to rise until closer to the next recession (Chart 7). And, for now, none of the recession indicators we have been consistently monitoring over the past months is flashing a warning signal (Chart 8). Chart 7Stock-To-Bond Ratio Likely To Rise Further Chart 8Recession Warning Signals Still Not Flashing More risk-averse investors might chose to reduce their exposure to risk assets now, given how close we are to the end of the cycle. But this would be at the risk of leaving some money on the table, since the last year of a bull run can often be the most profitable (remember 1999?). We, therefore, maintain our recommendation for pro-cyclical and pro-risk tilts: overweight equities versus bonds, overweight credit, overweight higher-beta equity markets and sectors, and a preference towards riskier alternative assets. We may move towards a more defensive stance in mid to late 2018, when we see clearer signs that the Fed has tightened above equilibrium or that the risk of recession is rising. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Be The Impact Of The U.S. Tax Cuts? It is not a done deal, but it still seems likely (notwithstanding the Democratic victory in Alabama) that the U.S. House and Senate will agree a joint tax bill to pass before the end of the year. Since the two current bills have only minor differences, it is possible to make some estimates of the macro and sector impacts of the tax reform. The Joint Committee on Taxation estimates that the cuts will reduce government revenue by $1.4 trillion over 10 years - or $1 trillion (5% of GDP) once positive effects on growth are accounted for. The Treasury argues that tax reform (plus deregulation and infrastructure development) will push GDP growth to 2.9% and therefore government revenues will increase by $300 billion. BCA's estimate is that GDP growth will be boosted by 0.2-0.3% in 2018 and 2019.1 For businesses, the key tax changes are: 1) a reduction in the headline corporate rate from 35% to 21%; 2) immediate expensing of capital investment; 3) a limit to deduction of interest expenses to 30% of taxable income; 4) a move to a territorial tax system from a worldwide one, with a 10% tax on repatriation of past profits held overseas; 5) curbs for some deductions, such as R&D, domestic production and tax-loss carry-forwards. Corporate tax cuts will give a one-off boost to earnings, since the effective tax rate is currently over 25% (Chart 9, panel 1), with telecoms, utilities and industrials likely to be the biggest beneficiaries. This is not fully priced into stocks, since companies with high tax rates have seen their stock prices rise only moderately (Chart 9, panel 2). BCA's sector strategists expect that capex will especially be boosted: they estimate that the one-year depreciation increases net present value by 14% (Table 1).2 This should be positive for the Industrials sector (supplying the capital goods) and for Financials (which will see increased demand for loans). We are overweight both. Chart 9Tax Cuts Should Boost Earnings Table 1 Is Bitcoin A Bubble, And What Happens When It Bursts? The recent surge in prices (Chart 10) of virtual currencies has pushed Bitcoin and aggregate cryptocurrency market cap to $275 billion and $500 billion respectively. The recent violent run-up certainly bears a close resemblance to classic bubbles, but the impact of a sharp correction should be minimal on the real economy and traditional capital markets. As mentioned above, the market cap of cryptocurrencies has reached $500 billion. Globally, there is about $6 trillion in currency3 outstanding, so the value of virtual currencies is now 8% that of traditional fiat currency. Additionally, an estimated 1000 people own about 40% of the world's total bitcoin, for an average of about $105 million per person. At the moment, the macro impact has been constrained by the fact that most people are buying bitcoins as a store of value (Chart 11) or vehicle for speculation, rather than as a medium of exchange. However, when the public begins to regard them as legitimate substitutes for traditional fiat currencies, their impact will be felt on the real economy. Chart 10A Classic Bubble Chart 11Bitcoin Trading Volume By Top Three Currencies That would raise the issue of regulation. The U.S. government generates close to $70 billion per year as "seigniorage revenue." Governments across the world have no intention of losing this revenue, and would most likely introduce their own competitors to bitcoin. Until then, the biggest potential impact of these private currencies might be to spur inflation in the fiat currencies in which their prices are measured. That would be bad for government bonds, but potentially good for stocks. A further risk - and a similarity with the real estate bubble of 2007 - is the use of leverage. The news of a Tokyo-based exchange (BitFyler) offering up to 15x leverage for the purchase of bitcoins has spooked investors. However, the U.S. housing market is valued at $29.6 trillion, almost 60 times that of cryptocurrencies. Finally, the 19th century free banking era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Why Did The U.S. Dollar Weaken In 2017, And Where Will It Go In 2018? Chart 12Positioning And Relative Rates Supportive For USD We were wrong to be bullish on U.S. dollar at the start of 2017. We think the dollar weakness during most of the year can be attributed to the fact that investors were massively long the dollar at the end of 2016 (Chart 12, panel 2), which made the market particularly vulnerable to surprises. Several surprises did come: inflation softened in the U.S. but strengthened in the euro area. There were also positive geopolitical surprises in Europe - for example the victory of Emmanuel Macron in the French presidential election - while the failure to repeal Obamacare in the U.S. raised investors' concerns on the administration's ability to undertake fiscal stimulus. As a result, the U.S. dollar depreciated against euro despite widening interest rate differentials (Chart 12 panel 4) in 2017. Chart 13late Cycle Outperformance Since investors are now aggressively short the dollar, the hurdle for the greenback to deliver positive surprises is much lower than a year ago. Since the Senate passed the Republican tax bill in early December, we have already seen some recovery in the dollar (Chart 12, panel 1). As the labor market continues to firm, with GDP running above potential, U.S. inflation should finally start to pick up in 2018, which will allow the Fed to hike rates, possibly as many as four times during the year. This will contrast with the macro situation overseas: Japan and Europe are likely to continue loose monetary policy to maintain the momentum in their economies. All this should be supportive of the dollar. Are Convertible Bonds Attractive Over The Next 12 Months? With valuations for traditional assets expensive and investors' thirst for yield continuing, the market is in need of alternative sources of return. Convertible bonds offer a hybrid credit/equity exposure, giving investors the option to participate in rising equity markets but with less risk. An allocation to convertibles could prove attractive for the following reasons: Convertible bonds typically outperform high-yield debt in the late stages of bull markets, because of their relatively lower exposure to credit spreads. Junk spreads have a history of starting to widen before equity bear markets begin. Fifty percent of the convertibles index comprises issuance from small-cap and mid-cap firms. Although equity valuations are expensive, prices should continue to rise as long as inflation stays low. Additionally, our U.S. Investment Strategy service thinks that small-cap equities will outperform large caps in the coming months, partly because the likely cuts in U.S. corporate taxes will disproportionately benefit smaller companies. Convertible bonds do appear somewhat cheap relative to equities (Chart 13, panel 3) but, on balance, there is not a strong valuation case for the asset class. Equities appear fairly valued relative to junk bonds, and convertibles are trading at an elevated investment premium. However, valuation is not likely to be a significant headwind to the typical late-cycle outperformance of convertibles versus high yield. biggest near-term risk for convertibles relative to high yield stems from the technology sector, which makes up 35% of the convertibles index. Technology convertible bonds have strongly outperformed their high-yield counterparts in recent months (Chart 13, panel 4), and are possibly due for a period of underperformance. We recommend investors stay cautious on technology convertibles. Other Than U.S. Tips, What Other Inflation-Linked Bonds Do You Like? Our research shows that inflation-linked bonds (ILBs) are a good inflation hedge in a rising inflationary environment.4 With our house view of rising inflation in 2018, we have been overweight U.S. Tips over nominal Treasury bonds as the U.S. is the most liquid market for inflation-linked bonds, with a market cap of over US$ 1.2 trillion. Outside the U.S., we favor ILBs in Japan and Australia, while we suggest investors to avoid ILBs in the U.K. and Germany (even though the U.K. linkers' market is the second largest after the U.S.), for the following two key reasons: First, even though inflation is below target in Japan, Australia and the euro area, while above target in the U.K., in all of these markets, inflation has bottomed, as shown in Chart 14. Second, our breakeven fair-value models, which are based on trade-weighted currencies, the Brent oil price in local currencies, and stock-to-bond total-return ratios, indicate that ILBs are undervalued in Japan and Australia, while overvalued in the U.K. and Germany, as shown in Chart 15. Chart 14Inflation Dynamics Chart 15Where to Buy Inflation? The shorter duration (in real terms) of ILBs are an added bonus which fits well with our overall underweight duration positioning in the government bond universe. Global Economy Overview: Growth in developed economies remains strong and there is little in the data to suggest it will slow. This is likely to push up inflation and interest rates, especially in the U.S., over the next six to 12 months. Prospects for emerging markets, however, are less encouraging given that China is likely to slow moderately as it pushes ahead with reforms. U.S.: U.S. growth momentum remains very strong. GDP growth in the past two quarters has come in over 3%, and NowCasts for Q4 point to 2.9-3.9%. The Citigroup Economic Surprise Index (Chart 16, panel 1) has surged since June, and the Manufacturing ISM is at 53.9 and the Non-Manufacturing at 57.4 (panel 2). The worst that can be said is that momentum will be unable to continue at this rate but, with business confidence high, wage growth likely to pick up in 2018, and some positive impacts from tax cuts, no significant slowdown is in sight. Euro Area: Given its stronger cyclicality and ties to the global trade cycle, euro zone growth has surprised on the upside even more strongly than in the U.S. The Manufacturing PMI reached 60.6 in December (its highest level since 2000), and GDP growth in Q3 accelerated to 2.6% QoQ annualized. The euro's strength in 2017 seems to have done little to dent growth, and even weaker members of the euro zone such as Italy have seen improving GDP growth (1.7% in Q3). With the ECB reining back monetary easing only slightly, and banking problems shelved for now, growth should remain resilient in early 2018. Japan: Retail sales saw some weakness in October (-0.2% YoY), probably because of bad weather, but elsewhere data looks robust. Q3 GDP came in at 1.3% QoQ annualized and export growth remains strong at 14% YoY. There are even some signs of life in the domestic economy, with wages finally picking up a little (+0.9% YoY), driven by labor shortages among part-time workers, and consumer confidence at a four-year high. Inflation has been slow to rise, but at least core core inflation (the Bank of Japan's favorite measure) is now in positive territory at +0.2%. Emerging Markets: Chinese credit and monetary series, historically good lead indicators for the real economy, continue to decline (M2 growth in October of 8.8% was the lowest since data started in 1996). But, for now, economic growth has held up, with the Manufacturing and Non-Manufacturing PMIs both stably above 50 (Chart 17, panel 3). Key will be how much the government's moves to deleverage the financial system and implement structural reform in 2018 will slow growth. Elsewhere in emerging markets, economic growth remains sluggish, with GDP growth in Brazil barely rebounding to 1.4% YoY, Russia to 1.8%, and India slowing to 6.3% (down from over 9% in early 2016). Chart 16Growth Momentum Very Strong Chart 17Will China And EM Slow in 2018? Interest rates: We expect U.S. inflation to pick up in 2018, as the lagged effects of 2017's stronger growth and the weak dollar start to come through, amid higher oil prices and rising wages. We, along with the Fed, expect core PCE inflation to rise to 2% during the year. This means the Fed is likely to raise rates four times, compared to market expectations of twice. Consequently, we see the 10-year Treasury yield over 3% by mid-year. In the euro zone, the still-large output gap means inflation is less likely to surprise on the upside, allowing the ECB to keep negative rates until well into 2019. The Bank of Japan is unlikely to alter its Yield Curve Control, given the signal this would send to the market when inflation expectations are still well below its 2% target (Chart 17, panel 4). Chart 18Equities: Priced for Perfection Global Equities Still Cautiously Optimistic: Our pro-cyclical equity positioning in 2017 worked very well in terms of country allocation (overweight euro zone and Japan in the DM universe) and global sector allocation (favoring cyclicals vs defensives). The two calls that did not pan out were underweight EM equities vs. DM equities, which was partially offset by our positive stance on China within the EM universe, and the overweight of Energy, which was the worst performing sector of the year. The stellar equity performance in 2017 was largely driven by strong earnings growth. Margins improved in both DM and EM; earnings grew in all sectors, and analysts remained upbeat (Chart 18). Another important contributor to 2017 performance was the extraordinary performance of the Tech sector, especially in China: globally, tech returned 41.9%, outperforming the MSCI all country index by 18.9%. GAA's philosophy is to take risk where it is mostly likely be rewarded. In July, we took profits in our Tech overweight and used the funds to upgrade Financials to overweight from neutral. Then in October we started to reduce tracking risk by scaling down our active country bets, closing our overweight in the U.S. to reduce the underweight in EM. BCA's house view is for synchronized global growth to continue in 2018, but a possible recession in late 2019. We are a little concerned that equity markets are priced for perfection, given that our earnings model indicates a deceleration in the coming months mostly due to a base effect. As such, our combination of "close to shore" country allocation and "pro-cyclical" sector allocation is appropriate for the next 9-12 months. Country Allocation: Still Favor DM Over EM Chart 19China: From Tailwind to Headwind for EM ? Our longstanding call of underweight EM vs. DM since December 2013 was gradually reduced in scale, first in March 2016 (to -5 percentage points from -9) and then in October 2017 (further to -2 points). Going forward, investors should continue to maintain this slight underweight position in EM vs. DM. First, our positive stance on China proved to be timely as shown in Chart 19, panel 4, with China outperforming EM by 54.1% since March 2016, and by 18.8% in 2017. Back then our positive stance on China was supported by attractive valuations (bottom panel) and our view that Chinese politics would be supportive for global growth in the run up to the 19th Party Congress. Now BCA's Geopolitical Strategists think that "China politics are shifting from a tailwind to a headwind for global growth and EM assets".5 In addition, Chinese equities are no longer valued at a discount to the EM average (bottom panel). Second, BCA's currency view is for continued strength in the USD, especially against emerging market currencies. This does not bode well for EM/DM performance in US dollar terms (Chart 19, panel 1). Third, EM money growth leads profit growth by about three months (Chart 19, panel 2). The rolling over in money growth indicates that the currently strong earnings growth may lose steam going forward, while relative valuation is in the fair-value zone (Chart 19, panel 3). Sector Allocation: Stay Overweight Energy Our pro-cyclical sector positioning has worked well in aggregate as the market-cap-weighted cyclical index significantly outperformed the defensive index in 2017. This positioning is also in line with BCA's house view of synchronized global growth and higher inflation expectations, which translates into two major sector themes: capex recovery and rising interest rates. (Please see detailed sector positioning on page 24.) Within the cyclical space, however, the Energy sector did not perform as expected in 2017 (Chart 20). It returned only 3.4%, underperforming the global aggregate by 19.6%. For the next 9-12 months, we recommend investors to stay overweight this underdog of 2017. Chart 20Energy Stocks Lagging Oil Price First, the energy sector is a major beneficiary from a capex recovery. There are already signs of a recovery in basic resources investment in the U.S.6 Second, the energy sector's relative return lagged oil price performance in 2017. Given the generally close correlation between earnings and the oil price, and between analyst earnings revisions and OECD oil inventory growth, earnings in the sector should outpace the broad market. Third, based on price-to-cash earnings, the energy sector is still trading at about a 30% discount to the broad market, and offers a much higher dividend yield (about 1.2 points higher) than the broad market. Even though these discounts are in line with historical averages, they are still supportive of an overweight. Government Bonds Maintain Slight Underweight Duration. One important theme for 2018 will be a resumption of the cyclical uptrend in inflation.7 The implications are that both nominal bond yields and break-even inflation rates will be higher in 2018. We have been underweight duration in government bonds since July 2016. Now with the U.S. 10-year Treasury yield at 2.35%, much lower than its fair value of 2.81%, there is considerable upside risk for global bond yields from current low levels. Investors should continue to underweight duration in global government bonds Maintain Overweight Tips Vs. Treasuries. The base-case forecast from our U.S. bond strategists is that the Tips breakeven rate will rise to 2.4-2.5% as U.S. core PCE reaches the Fed's 2% target, probably sometime in the middle of 2018. Compared to the current level of 1.87%, 10-yr Tips would have upside of 33-38 bps, an important source of return in the low-return fixed-income space (Chart 21, bottom panel). In terms of relative value, Tips are now slightly cheaper than nominal bonds, also supportive of the overweight stance. Underweight Canadian Government Bonds. BCA's Global Fixed Income Strategy has taken profits in their short Canada vs. U.S. and U.K. tactical position, as the market has become too aggressive in pricing in more rate hikes in Canada. Strategically, however, the underweight of Canada (Chart 22) in a hedged global portfolio is still appropriate because: 1) the output gap has closed in Canada, according to Bank of Canada estimates, and so any additional growth will translate into higher inflation; and 2) the rising CAD will not deter the BoC from more rate hikes if the oil prices remain strong. Chart 21U.S. Bond Yields Have Further To Rise Chart 22Strategic Underweight Canadian Bonds Corporate Bonds Our overweights through most of 2017 on spread product worked well: U.S. investment grade (IG) bonds returned around 290 bps over Treasuries in the year to end-November, and high-yield bonds almost 600 bps. Returns over the next 12 months are unlikely to be as attractive. Spreads (Chart 24) are now close to historic lows: the U.S. IG bond spread, at 90 bps, is only about 30 bps above its all-time record. High-yield valuations look a little more attractive: based on our model of probable defaults over the next 12 months, the default-adjusted spread over U.S. Treasuries is likely to be around 240 bps (Chart 25). In both cases, however, investors should expect little further spread contraction, meaning that credit is now no more than a carry trade. However, in an environment where rates remain fairly low and investors continue to stretch for yield, that pick-up will remain attractive in the absence of a significant turn-down in the economic cycle. The key to watch is the shape of the yield curve. An inverted yield curve in history has been an excellent indictor of the end of the credit cycle. We expect the yield curve to steepen somewhat in H1 2018, before flattening again and then inverting late in the year. Spread product is likely, therefore, to produce decent returns until that point. Thereafter, however, the deterioration of U.S. corporate health over the past three years (Chart 23) could mean a sharp sell-off in corporate bonds. This might be exacerbated by the recent popularity of open-ended mutual funds and ETFs: a small widening of spreads could be magnified by a panicked sell-off in such funds. Chart 23Rising Leverage May Worsen Sell-Off Chart 24Credit Spreads Close To Record Lows Chart 25But Default - Adjusted, Junk Still Looks Attractive Commodities Energy: Bullish Energy prices performed strongly in H2 2017, and we expect bullish sentiment to continue. OPEC 2.0 is likely to maintain production discipline, and will maintain its promised 1.8mm b/d production cuts through the end of 2018. Our estimates for global demand growth are higher than those of other forecasters. This, along with potential unplanned production outages in Iraq, Libya and Venezuela (together accounting for 7.4mm b/d of production at present), drives our above-consensus price forecast of $67 a barrel for Brent crude during 2018. Industrial Metals: Neutral Since China accounts for more than 50% of world base-metal consumption, prices will continue to be highly dependent on developments there. (Chart 26, panel 4). Since the government is trying to accelerate environmental and supply-side reforms, domestic production capacity for base metals will shrink, which will be a positive for global metals prices. However, a focus on deleveraging in the financial sector and restructuring certain industries could slow Chinese GDP growth, reducing base-metal demand. Precious Metals: Neutral Gold has risen by 12% in 2017, supported by an uncertain geopolitical environment coupled with low interest rates. We believe that geopolitical uncertainties will persist and may even intensify, and that inflation may rise in the U.S., which would be positives for gold (Chart 26, panel 3). Based on BCA's view that stock market could be at risk from the middle of 2018,8 a moderate gold holding is warranted as a safe-haven asset. However, rising interest rate and a potentially stronger U.S. dollar are likely to limit the upside for gold. Currencies USD: The currency is down over 6% on a trade-weighted basis over the past 12 months (Chart 27). Looking into 2018, the USD is likely to perform well in the first half. U.S. inflation should gather steam in the first two to three quarters, and the Fed will be able at least to follow its dot plot - something interest rate markets are not ready for. As investors remain short the USD, upside risk to U.S. interest rates should result in a higher dollar. Chart 26Bullish Oil, Neutral Metals Chart 27Dollar Likely To Appreciate EM/JPY: Carry trades are a key mechanism for redistributing global liquidity, and they have recently begun to lose steam. A crucial reason for this has been the policy tightening in China which has been the key driver of growth in EM economies. Additionally, Japanese flows have been chasing momentum into EM assets. Further tightening in EM could reverse the flows and initiate a flight to safety, favoring the yen relative to EM currencies. CHF: The currency continues to trade at a 5% premium to its PPP fair value against the euro. However, after considering Switzerland's net international investment position at 130% of GDP, the trade-weighted CHF trades in line with fair value. The CHF will continue to behave as a risk-off currency, and so long as global volatility remains well contained, EUR/CHF will experience appreciating pressure. GBP: Sterling continues to look cheap, trading at an 18% discount to PPP against the USD. However, Brexit remains a key problem. If future immigration is limited, the U.K. will see lower trend growth relative to its neighbors, forcing its equilibrium real neutral rate downward. Consequently, it will be more difficult to finance the current account deficit of 5% of GDP. Until negotiations with the EU come closer to completion, the pound will continue to offer limited reward and plenty of volatility. Alternatives Chart 28Favor Private Equity and Farmland Alternative assets under management (AUM) have reached a record $7.7 trillion in 2017. Lower fees and a broader range of investment types have helped attract more capital. Private equity remains the most popular choice,9 driven by its strong performance and transparency. Many investors have also shifted part of their allocations toward potentially higher-return private debt programs. Return Enhancers: Favor Private Equity Vs. Hedge Funds In 2017 so far, private equity has returned 12.1%, whereas hedge funds have managed only a 5.9% return (Chart 28). We expect private-equity fund-raising to continue into 2018, but with a larger focus on niche strategies with more favorable valuations. Additionally, deploying capital gradually not only provides for vintage-year diversification, but also creates opportunities for investors to benefit from potential market corrections. We continue to favor private equity over hedge funds outside of recessions. During a recession, we recommend investors take shelter in hedge funds with a macro mandate. Inflation Hedges: Favor Direct Real Estate Vs. Commodity Futures In 2017 to date, direct real estate has returned 5.1%, whereas commodity futures are down over 3.7%. Direct real estate as an asset class continues to provide valuable diversification, lower volatility, steady yields and an illiquidity premium. However, a slowdown in U.S. commercial real estate (CRE) has made us more cautious on the overall asset class. With regards to the commodity complex, the long-term transition of the global economy to a more renewables-focused energy base will continue the structural decline in commodity demand. We continue to stress the structural and long-term nature of our negative recommendation on commodities. Volatility Dampeners: Favor Farmland & Timberland Vs. Structured Products In 2017 to date, farmland and timberland have returned 3.2% and 2.1% respectively, whereas structured products are up 3.7%. Farmland continues to outperform timberland. The slow U.S. housing recovery has added downward pressure to timberland returns. Investors can reduce the volatility of a traditional multi-asset portfolio with inclusion of farm and timber assets. For structured products, low spreads in an environment of tightening commercial real estate lending standards and falling CRE loan demand, warrant an underweight. Risks To Our View We think upside and downside risks to our central scenario for 2018 - slowing but robust economic growth, and continuing moderate outperformance of risk assets - are roughly evenly balanced. On the negative side, perhaps the biggest risk is China, where the slowdown already suggested in the monetary data (Chart 29) could be exacerbated if the government pushes ahead aggressively with structural reforms. Geopolitical risks, which the market over-emphasized in 2017, seem under-estimated now.10 U.S. trade policy, Italian elections, and North Korea all have potential to derail markets. Also, when the U.S. yield curve is as flat as it is currently, small risks can be blown up into big sell-offs. This is particularly so given over-stretched valuations for almost all asset classes. Chart 29China Monetary Conditions Suggest A Slowdown Table 2How Will Trump Try To Influence The Fed? The most likely positive surprise could come from a dovish Fed. New Fed chair Jay Powell is something of an unknown quantity, and the White House could use the three remaining Fed vacancies to push the Fed to keep rates low, so as not to offset the positive effect of the tax cuts. Without these new appointees, the Fed would have a slightly more hawkish bias in 2018 (Table 2). The intellectual argument for hiking only slowly would be, as Janet Yellen said last month: "It can be quite dangerous to allow inflation to drift down and not to achieve over time a central bank's inflation target." The Fed has missed its 2% target for five years. It is possible to imagine a situation where the Fed increasingly makes excuses to keep monetary policy easy (encouraged, for example, by a short-lived sell-off in markets or a slowdown in China) and this causes a late-cycle blow-out, similar to 1999. 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017 available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Insight Report, "Tax Cuts Are Here - Sector Implications," dated December 12, 2017, available at uses.bcaresearch.com. 3 CBNK Survey: Monetary Base, Currency in Circulation. Source: IMF - International Financial Statistics. 4 Please see Global Investment Strategy Special Report, "Two Virtuous Dollar Circles," dated October 28, 2016, available at gis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 6 Please see U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 7 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com. 8 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 9 Source: BNY Mellon - The Race For Assets; Alternative Investments Surge Ahead. 10 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. GAA Asset Allocation
Highlights The stellar performance in metals over the past year resulted from a combination of favorable demand- and supply-side developments, propelled along, as always, by China's outsized effect on fundamentals. On the demand side, robust global growth is keeping metals consumption strong. On the supply side, environmental reforms in China and the shuttering of mills - as well as supply-side shocks in individual markets - continues to bolster prices. A weak U.S. dollar - which lost 6% of its value in broad trade-weighted terms - further supports these bullish conditions for metal markets. We expect China's winter supply cuts to dominate 1Q18 market fundamentals. As we move toward mid-year, we expect a soft and controlled slowdown in China, brought about by the Communist Party's goals of reducing industrial pollution and pivoting toward consumer-led growth. Although this will moderate demand from the world's top metal consumer, strong growth from the rest of the world will neutralize the impact of this slowdown. Energy: Overweight. Pipeline cracks in the critical Forties system in the North Sea highlight the unplanned-outage risk to oil prices we flagged in recent reports. We remain long Brent and WTI $55/bbl vs. $60/bbl call spreads in 2018, which are up an average of 47%, respectively, since they were recommended in September and October 2017. Base Metals: Neutral. Following a strong 1Q18, a moderate slowdown in China will be offset by growth in the rest of the world (see below). Precious Metals: Neutral. We continue to recommend gold as a strategic portfolio hedge, even though we expect as many as three additional Fed rate hikes next year. Ags/Softs: Underweight. The U.S. undersecretary for trade and foreign agricultural affairs warned farmers this week they "need to have a backup plan in the event the U.S. exits the North American Free Trade Agreement," in an interview with agriculture.com's Successful Farming. No specifics were offered. Canada and Mexico - the U.S.'s NAFTA partners - are expected to account for $21 billon and $19 billion of exports, respectively, based on USDA estimates for FY 2018. These exports largely offset imports of $22 billion and $23 billion, respectively, from both countries. The U.S. runs an ag trade surplus of ~ $23.5 billion annually. Feature Metals had another extraordinary year in 2017. The LME base metal index rallied more than 20% year-to-date (ytd) bringing the index up more than 50% since it bottomed in mid-January 2016 (Chart Of The Week). Chart of the WeekA Great Year For Metals Steel, zinc, copper, and aluminum led the gains. In fact, of the metals we track, iron ore is the only one in negative territory - having lost almost 8% ytd. Nonetheless, it has been on the uptrend recently - gaining ~ 24% since it bottomed at the end of October. Capacity reductions in China, where policymakers mandated inefficient and highly polluting mills and smelters in steel- and aluminum-producing provinces be taken offline, continue to affect the supply side in those metals most. As China churns out less of these commodities, competition for the more limited supply will pull prices for them higher. Nevertheless, a stronger USD - brought about by a more hawkish Fed - likely will cap significant upside gains, and prevent a repeat of this year's exceptional performance. Strong Global Demand Will Neutralize China Slowdown The Chinese economy is beginning to show signs of a slowdown. The Li Keqiang Index - a proxy for China's economic activity - has rolled over. Furthermore, the manufacturing PMI has plateaued following last year's rapid ascent (Chart 2). This deceleration is also evident in China's infrastructure data. Annual growth in infrastructure spending in the first three quarters of the year are below the four-year average. And, although spending grew 15.9% year-on-year (yoy) in the first 10 months of this year, the rate of growth is slower than the four-year average of 19.6% (Chart 3). Chart 2A China Slowdown Is In The Cards... Chart 3...Threatening A Pull Back In Metals Demand That said, it is important to point out that this is due to a significant decline in utilities spending growth, which accounts for ~ 20% of infrastructure investments. Investment in utilities grew a mere 2.3% in the first ten months of the year, in contrast with the average 15.7% yoy increase of the previous four years. In any case, the slowdown in China's reflation reflects President Xi Jinping's resolve to shift gears and emphasize quality over quantity in future growth strategies. Now that Xi has consolidated his power, we expect policymakers to build on the momentum from the National Communist Party Congress, and be more effective in implementing reforms going forward. As such, Beijing should be more willing to tolerate slower growth than it has in the past. Nonetheless, we do not anticipate a significant slowdown. More likely than not, policymakers will resort to fiscal stimulus if the economy is faced with notable risks. Consequently, a hard landing in China is not our base case scenario. In any case, strong global demand will neutralize a slowdown in China's metal consumption in 2018. Despite a deceleration in China, the IMF expects global growth to pick up in 2018 (Table 1). The Global PMI is at its highest level since early 2011, supported by strong readings in the Euro Area and the U.S. (Chart 4). In all likelihood, conditions for global metal demand will remain favorable in 2018. Table 1IMF Economic Forecasts Chart 4Strong Global Demand Will Neutralize##BR##Impact Of China Slowdown China Real Estate Will Slow; Major Downturn Not Expected Chart 5Slowing Real Estate Investment Is A Mild Risk We do not foresee significant risks to China's real estate market, which is the big driver of base-metals demand in that economy. Total real estate investment is up 7.8% in the first 10 months of the year - the strongest growth for the period since 2014 (Chart 5). Even so, it is important to note the slowdown in that sector. After growing 9% yoy in 1Q17, growth rates fell to 8% and 7% in 2Q and 3Q17, respectively. In fact, growth in October, the latest month for which data are available, came in at 5.6% yoy - significantly slower than the average monthly yoy rate of 8% in the first nine months of the year. The slowdown in floor-space-started is more pronounced. The area of floor space started grew 5% in the first 10 months of the year, down from an 8% expansion in the same period in 2016. October data showed a yoy as well as month-on-month contraction - 4.2% for the former, and 12.1% for the latter. This is the second yoy contraction in 2017, with July experiencing a 4.9% reduction in floor area started. Similarly, quarterly data shows a significant slowdown from almost 12% yoy growth rates registered in 4Q16 and 1Q17 to the mere 0.4% yoy growth in 3Q17. In addition, the growth rate in commodity building floor-space-under-construction has slowed down to 3.1% yoy in the first 10 months of 2017, down from almost 5% for the same period in the previous two years. Although the data are a reflection of Xi's resolve to tighten control of the real estate market, we do not expect a major downturn that will weigh on metal demand. As BCA Research's China Investment Strategy desk notes, strong demand in the real estate sector, coupled with declining inventories, will prevent a major slowdown in construction activity, even in face of tighter policies.1 A Stronger Dollar Moderates Upside Price Pressures In our modeling of the LME Base Metal Index, we find that currency movements are important determinants of the evolution of metals prices. More specifically, the U.S. dollar is inversely related to the LME base metal index. While U.S. inflation has remained stubbornly low, we expect inflation to start its ascent sometime before mid-2018, allowing the Fed to proceed with its rate-hiking cycle. Given our view that too few hikes are currently priced in for 2018, there remains some upside to the USD. Thus, while dollar weakness has been supportive for metal prices in 2017, a stronger dollar will be a headwind in 2018. A Look At The Fundamentals In terms of supply/demand dynamics in individual metal markets, idiosyncrasies in their current states, and variations in how China's environmental reforms manifest themselves will mean the different metals will follow different trajectories next year. Muted Consumption Mitigated Impact Of Supply Disruptions In Copper Copper production had a bumpy 2017, rocked by sporadic supply disruptions in some of the world's top mines.2 This led to a contraction in world refined production ex-China, which was offset by an increase in Chinese output (Chart 6). Although Chinese refined copper output grew a healthy 6% yoy in the first three quarters, this was nonetheless a slowdown from the 8% yoy expansion for the same period in 2016. Even so, increased Chinese copper production more than offset declines from other top producers. Refined copper production in the rest of the world contracted by 1.5% in the first three quarters, bringing world production growth to 1.3% - significantly slower than the average 2.6% yoy increase witnessed in the same period in the previous two years. The supply-side impact on the overall market was mitigated by a slowdown in consumption. Chinese consumption, which accounts for 50% of global refined copper demand, remained largely unchanged in the first three quarters of the year compared to last year. This follows a yoy increase of ~ 8% in Chinese demand vs. the same period in 2016. Demand from the rest of the world contracted by 0.6% yoy, down from a 2.5% yoy expansion in the same period last year. So, despite supply disruptions, the copper market remained balanced - registering a 20k MT surplus in the first three quarters of this year, following a 230k MT deficit in the same period in 2016. Recently, there is news of capacity cuts in Anhui province - where China's second-largest copper smelter will be eliminating 20 to 30% of its capacity during the winter.3 If the copper market is the next victim of China's environmental reforms, global balances may be pushed to a deficit. Although copper remains well stocked at the major warehouses, an adoption of these winter cuts by other copper producing provinces would weaken refined copper supply and support prices (Chart 7). Chart 6Copper Rallied On Back Of Supply-Side Fears Chart 7Copper Warehouses Are Well Stocked Steel Prices Will Remain Elevated Throughout Q1 China's steel sector has undergone significant reforms this year. In addition to the 100-150 mm MT of capacity cuts to be implemented between 2016 and 2020, Beijing has also eliminated steel produced by intermediate frequency furnaces (IFF).4 Even so, Chinese steel production - paradoxically - is at record highs. This comes down to the nature of IFFs, which are illegal and thus not reflected in official crude steel production data. However, growth in steel products - which reflect output from both official as well as illegal steel mills - has been flat (Chart 8). In addition, China's steel exports have come down significantly since last year, reflecting a domestic shortage in the steel industry. November data shows a 34% yoy contraction, and exports for the first 11 months of the year are down more than 30% from the same period last year. We expect Chinese steel production to remain anemic until the end of 1Q18, as mandated winter capacity cuts cap production in major steel-producing provinces. The near-term cutback in production will keep steel prices elevated. The spread between steel and iron ore prices during this period will remain wide as lower steel production translates into muted demand for the ore. This is also consistent with China's inventory data which shows that after falling since August, iron ore stocks have been building up since mid-October - in conjunction with the start of winter steel-capacity cuts. Indonesian Nickel Exports Bearish In Long Run, Not So Much In Near Term Ever since Indonesia's ban on nickel ore exports in 2014, worldwide production has been on the downtrend. In the previous two years, shrinking supply from China - which makes up about a quarter of global output - was the culprit of reduced world output, offsetting increases from the rest of the globe, and causing global production to contract by 0.2% and 0.5%, respectively (Chart 9). Chart 8Falling Exports And Flat Steel Products##BR##Output Reflect Closures In Steel Chart 9Deficit And Inventory##BR##Drawdowns Dominate Nickel... However, at 2.5%, the contraction in global output is significantly larger for the first three quarters of this year. What is noteworthy is that it is caused by shrinking production both from China - down ~ 7.5% - as well as from the rest of the world, where output is down ~ 1%. Nevertheless, a decline in demand from China - which accounts for almost half of global consumption - has softened the impact of withering production. Chinese demand for semi refined nickel shrunk 22% in the first three quarters of the year, more than offsetting the 9% growth in demand from the rest of the world. However, there has been a recovery in global demand since June. A 15% yoy growth in the third quarter from consumers ex-China drove a 5% yoy gain in global growth. Despite weak demand in 1H17, the nickel market recorded a deficit in the first three quarters of the year. In fact, nickel has been in deficit for the past two years. Going forward, Indonesia's gradual lifting of the export ban will prop up production. In fact, global yoy production growth has been in the green since June. However, while Indonesian ores are slowly returning to the global market, they remain a fraction of their pre-ban levels. Thus, prices will likely remain under upside pressure in the near term. Record Deficit And Significant Inventory Drawdowns Dominate Aluminum... Aluminum has been in deficit for the past three years. In fact, at 100k MT, the deficit in the first three quarters of 2017 is the largest on record for that period. This is reflected in LME inventory data which has been experiencing drawdowns since April 2014 - Falling from more than 5mm MT to ~ 1mm MT (Chart 10). Strong growth from Chinese producers - which account for more than half the world's primary production - kept global output growth strong, despite a decline from other top producers. However, falling Chinese production in August and September compounded the fall in output from the rest of the world, leading to a 3.5% yoy decline for those two months. In fact, September's Chinese output data marks the lowest production figure since February 2016. On the demand side, global consumption is up 6.2% yoy in the first seven months of 2017, reflecting a general uptrend in both Chinese consumption and, to a lesser extent, a greater appetite for the metal from the rest of the world. However, there has been some weakness from China recently. Chinese demand contracted by 2.9% and 9.6% yoy in August and September. While an 8.2% yoy increase in consumption from the rest of the world offset the August weakness from China, global demand shrunk by 5.8% in September. As with steel, supply-side reforms will dominate and keep aluminum prices elevated in the near term. ... Along With Zinc Demand Global zinc production has been more or less flat this year. The 2.7% decline from Chinese producers, which supply 46% of global zinc slab, was offset by a 2.4% increase in production from the rest of the world. On the demand side, although Chinese consumption - which accounts for almost half of global zinc slab demand - has been flat, strength from the rest of the world supported global demand, which is up 2.3% yoy for the first three quarters of the year (Chart 11). Chart 10...As Well As Aluminum... Chart 11...And Zinc Static supply coupled with increased demand has led the zinc market to a deficit of 500k MT - a record for the first three quarters of 2017. The deficit has continued to eat up zinc stocks, which have been in free-fall, since early 2013. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," published on December 7, 2017, available at Bloomberg.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Slow-Down in China's Reflation Will Temper Steel, Iron Ore in 2018,' dated September 7, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Chart 6Party Identifications##BR##Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Chart 8Trump Is Not A U.S. Dollar Paradigm Shift If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America Chart 10No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.