Developed Countries

The price differential at which Canadian heavy-sour crude trades to the North American benchmark WTI will be pushed to -$20/bbl into 1Q20, as transportation constraints continue to slow the marginal barrel’s egress from Alberta. Increasing demand for low-sulfur distillate fuels as global marine-fuel standards tighten under IMO 2020 regulations next year also will contribute to weaker Canadian crude oil prices. Over the next three to five years, domestic politics will determine whether the Canadian oil industry will be able to attract the investment needed for growth. And that will depend on how uncertainty around pipeline expansion is resolved. Allowing pipeline capacity to expand so that more crude can be shipped south could lead to a significant rebound in Canadian producers’ equity valuations. The industry’s breakeven costs now are on either side of $50/bbl for heavy oil delivered at Cushing, OK. As light-sweet production in the U.S. shales rises, the demand for the relatively scarce, heavier crude likely will pick up, redounding to the benefit of Canadian producers. Highlights Energy: Overweight. Operations at Saudi Aramco’s Abqaiq crude oil processing facility and the Khurais oil field were largely restored by the end of September, in line with management guidance. Capacity in the Kingdom is at 11.3mm b/d, while production is running at 9.9mm b/d. Abqaiq and Khurais were attacked by drone and cruise missiles, an operation the U.S. and Saudi Arabia believe was orchestrated by Iran. On Sunday, Crown Prince Mohammad bin Salman, speaking on CBS News’s 60 Minutes, agreed with U.S. Secretary of State Mike Pompeo’s characterization of the attack as an act of war by Iran, and warned, “If the world does not take a strong and firm action to deter Iran, we will see further escalations that will threaten world interests. Oil supplies will be disrupted and oil prices will jump to unimaginably high numbers that we haven't seen in our lifetimes.” In the interview with Norah O’Donnell, he followed that up with a declaration that the Kingdom prefers “a political and peaceful solution” to resolve its issues with Iran. The crown prince, striking a conciliatory tone, said President Donald Trump and the Kingdom are seeking peace, but that “the Iranians don’t want to sit down at the table.”1 Base Metals: Neutral. China’s steel output rose 9.3% y/y in August to 87.3k MT, according to the World Steel Association (WSA). This was 56% of global output, based on WSA data. Chinese output reached a record 89.1k MT in May. Precious Metals: Neutral. Precious metals' prices collapsed as the broad trade-weighed USD surged earlier this week. Platinum prices were down 5.5% from Friday's close by Tuesday, while gold and silver were down 1.3% and 2%, respectively. Ags/Softs: Underweight. Corn and soybean prices surged earlier in the week in the wake of a bullish USDA stocks report.  December corn was up 5.7%, while beans were up 4.1%.  Feature Canadian heavy oil demand is running strong in Asia, as seen in the surge of exports via the U.S. Gulf over the May-to-mid-September period. By ClipperData’s reckoning, 16mm barrels of Canadian crude were shipped over that period, more than doubling the entire volume shipped to Asia in 2018.2 Canadian demand is being boosted by the collapse of Venezuela’s oil industry, which has removed some 1.5mm b/d of heavy crude from the market since 2016. While Canadian exports into Asia markets are surging, the pick-up in this demand hints at an even greater opportunity if north-to-south pipeline capacity is expanded. Year-to-date exports of Canadian crude to the U.S. are up ~ 2.5% y/y to an average 3.5mm b/d, according to the U.S. EIA. This growth is restrained by slowly expanding export capacity.3 Canadian Oil Takeaway Constraints From 2010 to 2017, Western Canadian oil production grew by an impressive 6.5% p.a., pushing pipeline and storage infrastructure to maximum utilization (Chart of the Week). The development of supporting infrastructure failed to produce the required takeaway capacity, locking bitumen production within the Western Canadian Sedimentary Basin (WCSB). Consequently, Alberta crude oil inventories grew above normal levels and the Western Canadian Select (WCS) discount to Cushing WTI exploded, reaching -$50/bbl in 3Q18. While this incentivized crude-by-rail (CBR) shipments, prices received by Albertan producers fell below $20/bbl, a level significantly below breakeven levels required to sustain investment. Chart of the WeekHeavy Crude Output Surges ... Facing multiple delays in pipeline developments, then-Premier Rachel Notley announced in December the provincial government would impose mandatory oil production restrictions of ~ 325k b/d starting in January 2019. Moreover, her government secured contracts to lease 4,400 rail cars – ~ 120k b/d by mid-2020 – with Canadian National (CN) and Canadian Pacific (CP) to move crude out of the WCSB. The Alberta government’s intervention rapidly distorted the market’s price mechanism. Initially, the government-mandated production curtailment had the desired impact. The transportation component of the WCS-WTI discount began to narrow, and Alberta’s crude inventory started declining (Chart 2). Chart 2... But Infrastructure Lags However, the Alberta government’s intervention rapidly distorted the market’s price mechanism. To be profitable, moving oil by rail requires a WCS-WTI discount that is somewhere between -$12/bbl to -$22/bbl on top of a quality discount, and possibly higher when additional investments in trains and crews are needed (Chart 3). In January 2019, the transportation discount overshot its equilibrium – narrowing to -$2.90/bbl below the quality component – which weakened crude-by-rail volumes and led to a build in inventories. Chart 3Provincial Government Policy Distorts Market's Heavy-Oil Pricing Dynamics The Great Balancing Act To address these imbalances, the provincial government gradually started easing production curtailments (Chart 4). But this is a work in progress: Ultimately, its goal is to find the right balance between production levels and the WCS-WTI spread – i.e. the necessary price incentive for the market to move further crude by rail (CBR). The following projects still are being advanced by developers. However, no significant additional pipeline takeaway capacity is expected before 2H20 (Chart 5): Chart 4Policy Remains A Work In Progress Chart 5Markets Are Attempting To Redress Takeaway Deficit Enbridge’s Line 3 replacement. This pipeline is part of Enbridge Mainline system. This project will restore the original capacity of the existing Line 3 pipeline to 760k b/d from 390k b/d. The replacement runs from Hardisty, AB, to Superior, WI in the U.S. Since its initial announcement in 2014, the project has faced multiple headwinds, most recently, a delay in permits from the State of Minnesota re the impact of a possible oil spill near Lake Superior. The company continues to expect the project will be completed in 2H20. The Canadian and Wisconsin portions are already completed. TC Energy’s Keystone XL. This is the largest of the proposed projects. It will increase Canadian export capacity to the U.S. by 830k b/d. The project was first proposed in 2008, and will run from Hardisty, AB to Steele City, NE. Recently, Nebraska’s Supreme Court approved the Keystone XL route, lifting one of the last remaining – and probably the most important – legal challenges facing the pipeline construction. This is a positive development for Canadian oil producers. Nonetheless, the project is still facing a federal lawsuit in Montana filed by environmental groups blocking President Trump’s new permit, which gave the project a green light. A hearing is scheduled on October 9, this is a crucial win for TC Energy.4 Reaching a Final Investment Decision (FID) before year-end makes a completion by end-2022 possible. Federally-owned Trans Mountain expansion. The initial application was filed in 2013 and is projected to add 590k b/d of capacity from Edmonton, AB, to Burnaby, B.C. The pipeline was bought for $4.5 billion last year by the Federal government. Earlier this month, a Federal Court of Appeals judge ruled out six of the 12 legal challenges to the expansion, dismissing claims centered on environmental issues. Construction will continue, the government expects the expansion will be operational by mid-2022. Capacity expansion at existing pipelines. We expect some marginal capacity increases at existing pipeline to take place between 3Q19 and 3Q20. Enbridge communicated it could add up to 450k b/d without building new pipelines by 2022. At the moment, we believe ~150k b/d will be gradually added before the end of next year. Additionally, Enbridge mentioned it could boost capacity on its Express line by ~60k b/d before the end of 2020. Lastly, Plains Midstream Canada announced additional capacity on its Rangeland line in both the North and South directions.5 This will assist Canadian producers awaiting for the 2H20 Line 3 replacement. Delays in bringing new takeaway capacity online forced the newly formed Conservative provincial government led by Jason Kenney, which came to power in April 2019, to extend the curtailment program until December 2020. We expect this balancing act to continue over the next 12 months.6 Short- and Medium-term outlook We expect CRB needs to surpass 450k b/d to balance the market In our March 7, 2019 report, we argued the transportation component of the WCS-WTI spread needed to increase by ~ $10/bbl to support incremental crude-by-rail volumes. From March to July, the transportation discount rose by only $4.80/bbl to ~$12/bbl – the floor of our estimated rail price range – and collapsed soon after that. This failed to catalyze sufficient rail volumes to clear the market overhang. Preliminary estimates of CBR volumes based on CN and CP data shows it was largely flat in August and September (Chart 6). Chart 6Crude-By-Rail Shipments Stall As the government continues to relax production curtailments – reaching 100k b/d in October – we continue to believe the transportation discount needs to rise from current levels. Recent movements in the discount, averaging $10.3/bbl since the beginning of the month, support our view, and we expect this to continue until it reaches ~$15/bbl. We expect CRB needs to surpass 450k b/d to balance the market until the Line 3 replacement is completed, somewhere in 2H20 (Chart 7). We also expect the quality discount for WCS crude oil to start rising as IMO 2020 approaches. YTD the quality discount has remained relatively narrow, due to the global shortage of heavy-sour crude supply (Chart 8).7 Starting in January 2020, demand for heavy crude will moderate as shippers adapt to the new marine-fuel regulation, offsetting some of the effect of the limited supply. We project this will add $5/bbl to the WCS-WTI spread. Chart 7Additional CBR Capacity Required Chart 8Heavy-Crude Market Remains Tight Combined, the quality and transportation discount should push the WCS-WTI spread toward -$20/bbl over the next 6 months, which will, we believe, hurt Canadian producers’ cash flows. We expect WCSB supply will remain flat y/y in 2019. Next year, output is expected to grow 4%, and in 2021 by another 1.2% y/y. Long-term Production Outlook Investment in the Canadian oil sector never truly recovered from the 2014 global oil price collapse, despite the pickup in oil prices (Chart 9). Canada’s total capex ex-oil and -gas has been increasing since 2016, pushing down the share of capex from oil and gas extraction to 14% from 27% in 2014 (Chart 10). This is showing up in our longer-term production forecast: We expect WCSB production will average 5.1mm b/d in 2022 vs. 5.3mm b/d being forecast by the Canadian Association of Petroleum Producers (CAPP). The finite pool of funding available to the Canadian oil and gas sector is competing with U.S. shale development. A favorable regulatory and tax environment, shorter investment cycles and faster initial returns attract most of the funds allocated to oil and gas development to the U.S. at the expense of Canada (Chart 11).8 Most recently, the divergence in investment flows centers on market access Chart 9Canadian Oil Investment Lags Chart 10Canada's Oil & Gas Sector Losing Weight Chart 11U.S. Perceived As Favorable Investment Alternative Foreign companies are exiting the Canadian oil patch, divesting more than $30 billion since 2017.9 The government’s intervention to curtail production led firms to postpone new projects in Alberta. The rig count in Canada remains weak and shows no sign of picking up (Chart 12).10 Nonetheless, the sector should offer an opportunity for investors in the coming years. Once uncertainty around pipeline completion is resolved, we believe there could be a significant rebound in Canadian producers’ equity performance (Chart 13). Technology improvement has reduced oil-sands’ breakeven costs to somewhere between $45/bbl-$55/bbl for oil delivered at Cushing.11 Moreover, the low decline rates of oil-sands supply makes it a more stable and predictable source of supply compared to shale production. Chart 12Capex Reductions Reduce Rig Counts Chart 13Energy Stock Prices Could Rebound The upcoming new pipeline capacity allowing more Canadian heavy crude oil to be delivered to the complex U.S. Gulf Coast refineries will revive sentiment towards Canadian oil sand projects. Canada is judiciously positioned to be the clear winner of the market-share war fought by heavy oil-producing countries to secure capacity at U.S. Gulf refineries. Canadian oil is already dominating PADD 2 imports, and has been increasing its share of PADD 3 imports (Chart 14). The above-mentioned shortage of heavy crude oil presents an excellent opportunity for Canada to capture additional space at PADD 3 refineries. The collapse of Venezuela and the recent attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) highlight the attractiveness of Canadian heavy crude to U.S. refiners. Chart 14Strong U.S. Demand For Canada's Oil Impact Of The Upcoming Canadian Federal Election Canada is gearing up for a federal election on October 21. The consensus holds that the Liberal Party of Prime Minister Justin Trudeau will remain in power with a minority government, or possibly in a coalition with the left-wing New Democratic Party (NDP) and/or the Green Party. Our Geopolitical Strategists think the chances of Trudeau maintaining a single-party majority are much higher than consensus (which is about 25%), given that he is running on the back of a fairly strong economy, a renegotiated trade deal with the United States, and a stable socio-political environment (Chart 15). Chart 15Canadian Political Risk Is Muted And Should Stay That Way While Trudeau’s popularity has waned, his approval rating still puts him in the higher range of Canadian prime ministers and he does not face a charismatic challenger. He has a firm base in both of the traditional bastions of political power, Ontario and Quebec, and seat projections show the Liberals leading in both provinces. The small parties are not polling well; the NDP is faring poorly in Quebec and unlikely to steal many Liberal votes. There could still be surprises but it is telling that the Liberals remain in the lead despite the scandals and last minute controversies threatening them. The Canadian election should produce a status quo result that does not change the energy sector outlook. For the energy sector, the most positive outcome is a Conservative majority; otherwise a renewed Liberal majority is the status quo and hence least negative outcome. Trudeau is criticized by the Conservatives and in Alberta for compromising Canada’s energy interests, yet his support of the Trans-Mountain pipeline has him at odds with the left-wing parties. The worst scenario for the energy sector is if Trudeau is forced to rely on these parties in parliament – and this is a real possibility though not our base case. Bottom Line: The Canadian election should produce a status quo result that does not change the energy sector outlook – however, it holds a non-trivial risk of forcing the Liberals into a coalition with left-wing parties whose stances are market-negative for the energy industry. If this outcome is avoided, expect the market to celebrate in the short term, although the long-term effects of a second Trudeau term are not positive on the energy front.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      Please see Mohammad bin Salman denies ordering Khashoggi murder, but says he takes responsibility for it, which aired Sunday September 29, 2019, on CBS News. In a related development last week, Saudi Arabia announced a limited ceasefire with the Iranian-backed Houthi Movement in Yemen, with which it has been engaged in a war since 2015; please see Saudi Arabia agrees to limited ceasefire in Yemen, published by Arabian Business September 28, 2019. 2      Please see Canada's heavy oil exports to Asia from U.S. surge: data, traders published September 27, 2019, by reuters.com. 3      Enbridge Inc.’s 100k b/d pipeline expansion scheduled to be operational by December will marginally increase Canadian shipments south Enbridge us the dominant oil pipeline operator in western Canada. It is attempting to get shippers to sign long-term contracts – vs. existing monthly contracts – during its current auction for pipeline space. Its regulator has “has concerns regarding the fairness of Enbridge’s open season process and the perception of abuse of Enbridge’s market power.” Please see Canada regulator orders Enbridge to halt pipeline overhaul plan due to 'perception of abuse' published by reuters.com September 27, 2019. 4      Please see Court affirms alternative Keystone XL oil pipeline route through Nebraska, published August 23, 2019, by reuters.com. 5      Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. 6      The new government made additional small changes to the previous policy. For instance, it will give producers 2 months’ notice of any changes to the limits, increased the base limit to 20k b/d from 10k b/d and allows the energy minister to use discretion to set production limits after M&A. Please see the oil production limit section of the government of Alberta’s website. 7           As discussed in our March 2019 report, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and sanctions on Iranian oil exports volume limits the supply of heavy crude available to consumers. 8              In June 2019, the Canadian government passed Bill C-69, called “The modernization of the National Energy Board and Canadian Environmental Assessment Agency.” This law changes the federal environmental assessment process. Critics argued this would repel energy investors and limit pipeline projects approval. Additionally, Canada’s Senate passed Bill C-48 – which aims to ban large oil tankers from waters off the north of B.C.’s coast. This law makes it harder for Alberta to ship its oil via northern B.C. export facilities. Companies are now testing shipment of semi-solid bitumen rather than in liquid form to avoid complying with the new legislation. Please see Oilsands crude sails from B.C., sidestepping federal ban, published by the Edmonton Journal on September 26, 2019. 9           Please see The $30-billion exodus: Foreign oil firms keep bailing on Canada's energy sector published by the Financial Post on August 22, 2019. 10             Rig count does not fully capture Canadian oil production. Bitumen production from mining represent ~30% of total production. However, we believe rig count remains a good proxy of capex in the sector. 11             Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter.  A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity   The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1  Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter.  How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows:  Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China   Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

The latest ISM manufacturing report made for grim reading. All of the survey’s subcomponents were either contracting, slowing, too low or decreasing, despite the recent, at the margin, improved news on the U.S./China trade war. Importantly, new export orders fell further to 41 from last month’s 43.3 reading (middle panel), warning that U.S. manufacturing is hurting from the rising U.S. dollar and the ongoing trade war. Thus, CEO’s are clearly in retrenchment mode. As a reminder, this comes on the heels of the Duke CFO survey that was downright pessimistic and last week’s Business Roundtable CEO Survey release that sunk further (bottom panel). The Atlanta Fed’s compiled Survey of Business Uncertainty update corroborated these dire messages, underscoring that animal spirits are in retreat posing a rising threat to economic growth. Bottom Line: Such a backdrop warrants caution on the prospects of the overall equity market.   

In the latest Special Report we analyze historical sector performance since 1960 during deflationary periods that we define as two consecutive quarters of negative corporate sector price deflator growth. We find that following our deflationary signal, defensives are up 1.4% in relative terms on a 6-month horizon, while cyclicals are down 2.5%. We also note an inflection point around the 12-month mark as cyclicals start to recover their losses moving from -2.5% to just -0.21%, while defensives are giving up their gains moving from 1.38% to 0.76%. Similarly, if we look 24 months out, we observe that cyclicals are outperforming the market by 0.5% (largely driven by tech), and defensives are lagging the market by -1.2% (dragged by telecom and utilities) signaling that the market has recovered. To see a more in-depth discussion of the sector specific dynamics, please refer to this Monday’s Special Report.