Developed Countries

Highlights Monetary Policy: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Money Markets & Fed Balance Sheet: Investors shouldn’t worry about last week’s chaotic action in money markets, and should pay less attention to the Fed’s balance sheet policy in general. Yes, the Fed will start growing its balance sheet again in the coming months, but this is much less important than what it decides to do with the fed funds rate. Global Economy: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course. Feature Chart 1Fed Dots Versus Market Expectations Fed Chairman Jerome Powell had his work cut out for him at last week’s FOMC press conference. First, he had to craft a coherent message about the Fed’s reaction function following a meeting where three voting members dissented from the committee’s decision to lower the funds rate by 25 bps. One dissenter, St. Louis Fed President James Bullard, wanted a 50 bps reduction. The other two, Boston Fed President Eric Rosengren and Kansas City Fed President Esther George, preferred to leave rates unchanged. Not only that, but Powell also had to field questions about the recent turmoil in money markets. Turmoil that caused the overnight repo rate to spike and the effective fed funds rate to briefly print outside the Fed’s target band (see section titled “Repo Madness” below). Chart 2Tracking Financial Conditions How did he perform? On all accounts we give the Chairman top marks. He managed to articulate a reaction function that didn’t commit to any near-term policy action, but most importantly, he did so in a way that prevented a sharp tightening of financial conditions. As we have argued in past reports, Chairman Powell’s most important job is to ensure that financial conditions remain accommodative so that the economic recovery can continue for long enough to bring long-dated inflation expectations back up to target.1 Chart 2 shows that, even after a tricky Fed meeting, financial conditions remain significantly more accommodative than they were earlier in the month: Credit spreads are tighter (Chart 2, panel 2) The yield curve has un-inverted (Chart 2, panel 3) TIPS breakeven inflation rates have widened (Chart 2, panel 4) The trade-weighted dollar has weakened (Chart 2, bottom panel) All this with only 7 out of 17 FOMC participants agreeing with the market’s assessment that one more 25 bps rate cut before year-end will be appropriate (see Chart 1). All in all, Powell did exactly what he needed to do. Investment Implications Table 1What's Priced In For The Rest Of 2019? As mentioned above, the market is priced for roughly one more 25 bps rate cut before the end of the year. More specifically, the fed funds futures market is split 50/50 on whether that rate cut occurs at the October or December FOMC meeting (Table 1). The market currently sees only a 4% chance of a rate cut at both meetings, and zero chance of no rate cut at all. We think the market’s view of the next two FOMC meetings is roughly correct, though we would not discount the possibility that global economic data improve enough that further rate cuts are avoided (see section titled “Still Searching For A Bottom” below). Ideally, the Fed wants the economic data to lead rate expectations higher so that it can avoid cutting rates without shocking the market and tightening financial conditions. Conversely, if the market starts to fully price-in an October rate cut in the next few weeks, then the Fed will likely deliver. This reaction function is extremely supportive for credit spreads, and we recommend sticking with an overweight allocation to spread product versus Treasuries. Chart 3Treasury Returns Track Rate Expectations As for portfolio duration, we continue to abide by our Golden Rule framework.2 If the Fed delivers less than the 57 bps of easing that the market expects over the next 12 months, then the Bloomberg Barclays Treasury index will likely underperform a position in cash (Chart 3). We see better odds of zero or one rate cut over that timeframe, and therefore recommend a below-benchmark duration stance. Bottom Line: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Repo Madness What Happened? Chart 4What Happened Here? As mentioned above, overnight U.S. interest rates spiked dramatically last week, grabbing headlines and causing many to question the stability of financial markets. The commotion peaked last Tuesday when the overnight general collateral repo rate closed at just under 7% and the effective fed funds rate ended the day above the upper limit of the Fed’s target band (Chart 4). Why Did This Happen? Chart 5Looking For The Culprit The turmoil’s proximate cause is that dealer banks found themselves short of cash. They therefore scrambled to borrow in money markets, driving overnight rates higher. Dealer banks were short on cash for a number of reasons. Many corporations withdrew funds to pay tax bills, and there was an unusually large amount of Treasury issuance in September, along with few redemptions (Chart 5). Dealer banks must purchase Treasury debt at auction, and of course require cash on hand to do so. But setting the proximate cause aside, the more important question is: Why don’t dealer banks have sufficient cash to weather such periods, which are bound to occur from time to time? The answer to this question has to do with the quantity of reserves being supplied to the banking system, which is ultimately a result of the Fed’s balance sheet policy. The Fed’s Balance Sheet & The Supply Of Bank Reserves Table 2Simplified Fed Balance Sheet Table 2 shows an abridged version of the Fed’s balance sheet as of last Wednesday, September 18. Notice that the Fed’s securities holdings appear on the asset side of the balance sheet, while the Fed’s liabilities include: (i) currency in circulation, (ii) the Treasury department’s cash account and (iii) bank reserves. Reserves are a liability on the Fed’s balance sheet, but appear as an asset on the consolidated balance sheet of the U.S. banking system. In other words, the banking system’s supply of liquid reserves is always equal to the Fed’s assets less the amount of currency in circulation and the Fed’s other “non-reserve liabilities”. Put simply, if dealer banks don’t have enough cash, it is because the Fed is not holding enough securities. Chart 6The Fed's Balance Sheet Over Time In fact, the Fed has been steadily draining the supply of bank reserves since 2014 (Chart 6). Initially, it did so passively by keeping its securities holdings constant and allowing reserves to decline by the amount of increase in currency-in-circulation and other “non-reserve liabilities”. Then, between October 2017 and July of this year, it actually shrank its portfolio, causing reserves to leave the system even more quickly. In August, the Fed returned to a policy of keeping its securities holdings constant, slowing the rate of decline in bank reserves.   It is also worth mentioning that the rate of decline in bank reserves was recently exacerbated by a sharp increase in the Treasury department’s cash holdings (Chart 6, bottom panel). The Treasury department needed to rebuild its cash balance after having run it down in advance of the last debt ceiling deadline. Like currency-in-circulation, the Treasury department’s cash holdings are a liability on the Fed’s balance sheet. All else equal, an increase in the Treasury’s cash holdings leads to a decline in the supply of bank reserves. Next Steps Chart 7The Fed's Floor System This year the Fed has been navigating through a process of “balance sheet normalization” where it seeks to reduce its asset holdings while still supplying enough bank reserves to ensure the effective operation of monetary policy. The Fed has already decided to operate monetary policy using a “floor system”, in contrast to the “corridor system” it employed prior to the financial crisis. In a corridor system, the Fed keeps the supply of bank reserves scarce, and then engages in daily repo transactions to ensure that it supplies just enough bank reserves to prevent the overnight rate from breaking through the top of its target range. In contrast, to operate a floor system the Fed must supply more reserves than the banking system demands. The excess supply of reserves forces the overnight rate down toward a floor set by the Fed’s overnight reverse repo facility (ON RRP). Essentially, the Fed sets the ON RRP rate at a level near the bottom of its target range, and pledges to pay that rate to any banks with excess cash (Chart 7). The fact that interest rates broke out above the top-end of the Fed’s target band last week suggests that the Fed is not supplying enough reserves to effectively operate its floor system. This means that we should consider the Fed’s “balance sheet normalization” process complete. In the coming weeks the Fed will roll out a plan to start growing its securities portfolio. It will do this by purchasing Treasuries with a maturity structure that roughly matches that of the outstanding debt load. The pace of Treasury purchases will either be set equal to the estimated rate of growth in non-reserve liabilities, a pace that would keep the supply of bank reserves flat and one that the Fed calls “organic growth”. Alternatively, the Fed might decide that the supply of reserves needs to rise for a time before leveling off. In that case, it would purchase Treasuries at a somewhat faster pace for a few months, before settling into an “organic growth” regime. The Fed will probably also roll out a standing repo facility in the coming months, with a rate set close to the upper-end of its target band. This will act as the mirror image of the current ON RRP, essentially capping the upside in interest rates by agreeing to lend overnight cash at a stated rate. The supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis.period  It will take at least a few weeks for the Fed to roll out its new balance sheet strategy and standing repo facility. In the meantime, the New York Fed will transact daily in the repo markets to ensure that enough reserves are supplied. This action represents a temporary return to a corridor system. Once the Fed starts growing its Treasury holdings again, it will be able to resume its floor system and the daily repo transactions will not be necessary. Some have probably already noted that the supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis period (see Chart 6). This is purely the result of the new post-crisis regulatory environment (see Box). Box - New Regulations Mean Banks Want More Reserves Two new regulations, specifically, have increased the amount of reserves that banks wish to hold. The first is the liquidity coverage ratio (LCR). The LCR mandates that banks hold sufficient high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves qualify as HQLAs, as do Treasury securities. Some other securities can also count as  HQLAs after a haircut is applied. While banks can opt to hold Treasuries instead of reserves and still maintain compliance with the LCR. A St. Louis Fed report from March showed that large U.S. banks are using reserves to cover 20% - 65% of their net outflows.3  The second relevant regulation is the resolution plan, or living will, that large banks are now forced to file with regulators. While the criteria here are more opaque, banks must demonstrate to regulators that they have enough short-term liquidity to cover demands from counterparties and other stakeholders in the event of material financial distress. Regulators likely put a greater emphasis on reserves than Treasury securities during such stress tests, since during a period of financial turmoil there may be doubts about how quickly a bank can convert a Treasury security into cash in the repo market.  Is This The Return Of QE? The answer really depends on how you want to define QE. If you want to call any increase in the Fed’s securities holdings QE, then yes the Fed will soon re-start QE. If you want to define QE as an expansion in the supply of bank reserves, then the Fed might briefly engage in QE for a few months, before reverting to an “organic growth” policy that keeps the reserve supply stable. In any event, unless you are active in money markets, we would advise investors to pay much less attention to the Fed’s balance sheet policy. The goal of its balance sheet policy is to ensure that interest rates remain within its target band, and the Fed will move that target band around independently of what is happening with its balance sheet. Changes in the Fed’s target interest rates are what matter for financial markets. Still Searching For A Bottom For reasons articulated in prior reports – notably, accommodative financial conditions and resolute service sector growth – we remain convinced that the current global manufacturing slowdown is near a trough.4 However, we must also point out that the 10-year U.S. Treasury yield tends to track the broad swings in the Global Manufacturing PMI, and a significant rebound in the 10-year yield is unlikely without a corresponding PMI upswing (Chart 8). Chart 8No PMI Rebound Yet... Chart 9...But Leading Indicators Are Hooking Up On that note, September Flash PMI data for the U.S. and Eurozone were released yesterday, and were at best a mixed bag. The Eurozone Manufacturing PMI fell from 47.0 in August to 45.6 in September (Chart 8, bottom panel) while its U.S. counterpart ticked higher from 50.3 to 51.0 (Chart 8, panel 3). In general, it is too early to say that the global PMI data have bottomed, especially with the CRB Raw Industrials index – a broad commodities benchmark – still in free fall (Chart 8, panel 2). Global Leading Economic Indicators paint a somewhat rosier picture than the PMIs. In fact, our Global LEI appears to have bottomed, and should eventually lead the Global PMI higher if prior correlations hold (Chart 9). We also observe that the U.S. economic data are once again beating expectations, an occurrence that usually corresponds with higher yields (Chart 9, bottom panel). In general, it is too early to say that the global PMI data have bottomed. Bottom Line: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2  Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3  https://www.stlouisfed.org/on-the-economy/2019/march/banks-demand-reserves-face-liquidity-regulations 4  Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?”, dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights   Portfolio Strategy Firming relative profit prospects, rising likelihood of an oil price spike and higher geopolitical risk premia, bombed out valuations and extremely oversold technicals all signal that an overweight stance is warranted in the S&P energy sector. Rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities were range bound last week, digesting the aftermath of the drone attacks on Saudi Arabia’s oil facilities and the kneejerk oil price spike, and the Fed’s at the margin hawkish interest rate cut (Chart 1). While the U.S./China trade war news headlines took the back seat, it is disquieting that the largest oil production disruption in recent memory came to the forefront. Crude oil prices spiked and oil volatility skyrocketed as market participants were not pricing in any geopolitical risk premium on crude prices (Chart 1). This is a wake-up call for market participants and there are longer-term ramifications if the previously dormant geopolitical risk premium returns with a vengeance in the oil markets as we expect. Chart 2 shows that historically, an oil price shock is coincident with a U.S. recession. Given that our Commodity & Energy Strategy (CES) service would not rule out another oil price surge in the coming months, a near doubling in oil inflation would likely be the straw that broke the camel’s back and check the final box for recession. Chart 1Mind The Oil Vol Spike Chart 2Doubling In Oil Prices Are A Bad Omen For Stocks To be precise, since the mid-1970s a 91% year-over-year oil price increase – using end of period monthly data – is synonymous with recession, with no false positives. In order for that prerequisite to be satisfied, WTI crude oil would have to surge to roughly $86/bbl by December (top panel, Chart 2). While this may seem as a tall order, our CES service has started assigning a rising probability to a sizable oil price jump in the coming months. With regard to equities, in all previous five oil price shocks the S&P 500 suffered significant losses, and if history at least rhymes, then the SPX would steeply contract anew (middle panel, Chart 2). While the U.S. economy is not currently in recession, it is fragile enough that an exogenous oil price shock would tilt it in recession. As a reminder, the U.S. benefits from the “good deflation” i.e. lower oil prices and suffers from oil spikes. Chart 3 depicts this inverse correlation. Importantly, re-reading James D. Hamilton’s “Historical Oil Shocks” NBER paper was insightful.1 In this piece Hamilton documents that “All but one of the 11 postwar recessions were associated with an increase in the price of oil, the single exception being the recession of 1960.” Hamilton then argues that “The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence…This is not to claim that the oil price increases themselves were the sole cause of most postwar recessions. Instead the indicated conclusion is that oil shocks were a contributing factor in at least some postwar recessions (emphasis ours)”. Chart 3GDP And Oil Are Inversely Correlated  This week, we update a deep cyclical sector and one of its key subcomponents. Table 2Real GDP Growth (Annual Rate) And Contribution Of Autos To The Overall GDP Growth Rate In Five Historical Episodes While only the energy sector benefits from the oil price shock, the consumer, and most other sectors of the economy, have to contend with rising energy input costs. Hamilton finally makes a key point on auto production and a link to output: “one of the key responses seen following an increase in oil prices is a decline in automobile spending, particularly the larger vehicles manufactured in the United States”. He shows this relationship in Table 2 that we have replicated.2 Chart 4 also shows a number of different automobile-related economic series, and the current message is grim. It is clear that, were an oil price shock to hit, the motor vehicle-related production destruction would subtract from overall output and raise the probability of recession. Chart 4What’s Up With Autos? In sum, geopolitical risk is getting priced into the crude oil markets and were an oil spike to take place near $86/bbl, then this external shock would most likely tilt the economy in recession as has happened in all previous such oil inflation surges since the 1970s. We would refuse the temptation to listen to pundits that, similar to the initial December 2018 yield curve inversion, would declare that “this time is different”. As a result of all this heightened uncertainty, we remain cautious on the prospects of the overall equity market. This week, we update a deep cyclical sector and one of its key subcomponents. Energy’s Time To Shine? The recent drone attacks in Saudi Arabia’s oil processing and production facilities have re-concentrated investors’ minds on reassessing geopolitical risk premia in the crude oil market (top panel, Chart 5). Given the heightened risk of a future oil price spike that BCA’s CES and Geopolitical Strategy services outlined recently, we remain overweight in the S&P energy sector and re-iterate our high-conviction overweight status.   Rising oil prices will also filter through to rising inflation expectations and further boost the allure of the S&P energy sector (middle & bottom panels, Chart 5). This crude oil supply disruption comes at an inopportune time as U.S. crude oil inventories have been depleting recently; this represents another source of support for the relative share price ratio (crude oil supply shown inverted, second panel, Chart 6). Chart 5Energy Catch Up Phase Looms Chart 6Energy Can Burst Higher On the demand front, non-OECD demand remains on an upward trajectory since the start of its recovery path in the aftermath of the 2015/2016 manufacturing recession. Importantly, BCA’s Global Leading Economic Indicator diffusion index is accelerating driven by the emerging markets and signals that recent easing monetary policy measures in EM economies will put a lid under EM oil demand (Chart 6). As a result, still depressed relative S&P energy sales expectations should turnaround (third panel, Chart 6). Turning over to the financial statements of this now niche deep cyclical sector, there are no major red flags waving. Net debt-to-EBITDA is near 2x, on a par with the broad nonfinancial sector, and interest coverage is at a respectable 5x (Chart 7). The sector has been more stringent with shareholder friendly activities and the dividend payout ratio has fallen back to the historical mean (not shown). In more detail, the S&P energy sector sports the highest dividend yield compared with the rest of the GICS1 sectors, a full 185bps above the SPX, offering a relatively safe home for yield hungry investors in the era of depressed global interest rates (bottom panel, Chart 7). In fact, the S&P energy sector is so extremely undervalued that all of its 28 constituents combined are now worth as much as one stock, Microsoft. Indeed, our relative Valuation Indicator has plunged and is now roughly two standard deviations below the historical mean, a three decade low (second panel, Chart 8). Chart 7Repaired B/S With The Highest GICS1 Sector Dividend Yield Chart 8Oversold And…   Energy sector technicals are also bombed out, with our relative Technical Indicator in deeply oversold territory. Such depressed levels have marked prior reversals and a violent snap back would not surprise us. Internal energy sector dynamics reveal a similarly extreme picture, with both the percentage of subgroups trading above the 40-week moving average and with a positive 52-week rate of change perched at the zero lower bound (fourth & fifth panels, Chart 8). Sell-side analysts are equally pessimistic, assigning a low probability in energy sector revenues and profits besting the overall market. This is not only a near-term phenomenon, but the sell side has also thrown in the towel on a 5-year time horizon (Chart 9). All of this extreme bearishness overshadowing the S&P energy sector is contrarily positive. One key risk to our overweight stance in the S&P energy sector is the U.S. dollar. Historically, the higher the greenback goes the lower oil prices and energy shares fall. This multi-decade inverse correlation remains intact and were the U.S. dollar to materially increase from current levels, it would heavily weigh on relative share prices (top panel, Chart 8). BCA’s U.S. Equity Strategy’s relative profit growth macro-models have an excellent track record in forecasting relative profit trends as they accurately capture most of the key profit drivers. Currently, the relative EPS models are in a slingshot recovery, which stands in marked contrast to the overly pessimistic sell side analyst community (second panel, Chart 9). Chart 9…Undervalued Netting it all out, firming relative profit prospects, rising likelihood of an oil price spike and higher geopolitical risk premia, bombed out valuations and extremely oversold technicals all signal that an overweight stance is warranted in the S&P energy sector. Bottom Line: Stay overweight the S&P energy sector. This deep cyclical sector also remains on our high-conviction overweight list. Double Down On Exploration & Production Stocks S&P oil & gas exploration & production (E&P) stocks have closely tracked crude oil prices, but recently a wide gap has opened and we reckon that it will likely narrow via a catch up phase in the former (top panel, Chart 10). Even natural gas prices have come out of hibernation and caught a bid of late and similarly suggest that relative share prices are uncharacteristically depressed by steeply deviating from the underlying commodities (second panel, Chart 10). There is so much pessimism ingrained in the E&P space with net EPS revisions sinking to “as bad as it gets” warning that even a modest rise in oil prices can serve as a catalyst to raise the profile of this unloved corner of the deep cyclical universe (bottom panel, Chart 10). While the energy default rate has risen lately, the high yield E&P option adjusted spread is neither surging a la 2015/2016 nor sending a distress signal. If anything, given the recent jump in oil prices and prospects of an oil price surge, independent oil producers’ bond holders should further breathe a sigh of relief (junk spread shown inverted, middle & bottom panels, Chart 11). Chart 10Primed To Follow Oil Prices Higher Adding it all up, rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. With regard to operating metrics, free cash flow has more than doubled since the 2016 trough and has now stabilized (second panel, Chart 12). This highly capital intensive industry has gotten forced to live within its means and be more careful with expansion plans financed by rising indebtedness. Use of cash has also come under scrutiny. Capex as a percentage of overall cash flow rose from 35% to over 60% at the recent cyclical peak and has now corrected to 47%, just above the two decade average (Chart 12). Chart 11No Yellow Flags Chart 12Cash Discipline Should Start To Pay Off Similar to the broad energy space, E&P stocks are compellingly valued irrespective of the valuation metric chosen. To name a few, the dividend yield differential is at 150bps versus the broad market, relative price-to-sales has corrected from 3x to par, and on an EV/EBITDA basis E&P stocks trade at a 35% discount to the broad market (Chart 13). Nevertheless, there is a risk to our still constructive view of the E&P index. Oil prices have to stay above the $50-$55/bbl range in order for the shale oil space to breakeven and sustain crude oil production at recent all-time high levels. As a reminder, an industry capex collapse is synonymous with oil price plunges and major relative share price drawdowns (Chart 14). Chart 13Bombed Out Valuations Chart 14Capex Collapse Is A Big Risk Adding it all up, rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. Bottom Line: Continue to overweight the S&P oil & gas exploration & production index. The ticker symbols for the stocks in this index are: S5OILP – COP, PXD, DVN, HES, APA, MRO, XEC, COG, CXO, EOG, FANG, NBL.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   footnotes 1      https://www.nber.org/papers/w16790 2      Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights The attack on Saudi Arabian energy facilities brought oil price shocks back onto investors’ radar screens: Benchmark crude prices in Europe and the U.S. blasted higher following the September 14th attacks on Saudi oil installations. Although the initial price spike largely unwound, the incident demonstrated that oil infrastructure is vulnerable: Saudi officials say output will be restored sooner than markets initially feared, but oil production is now in play for bad actors. The probability of supply-driven price shocks has increased. How vulnerable is the U.S. economy to an oil price shock?: A whole heck of a lot less than it was at the time of the 1973-74 oil embargo. The U.S. is the world’s largest oil producer, and is on its way to becoming a net exporter. Higher oil prices now amount to much more than a tax on U.S. households and corporations. Feature On Saturday, September 14th, Saudi Arabia’s Abqaiq crude-oil processing facility and its Khurais oil field were struck by air attacks that caused multiple explosions. Yemeni forces claimed responsibility, in retaliation for Saudi Arabia’s involvement in its protracted civil war, though the Saudi and U.S. governments asserted that Iran was to blame. As our Commodity & Energy and Geopolitical Strategy colleagues have written, Iran’s involvement makes the situation more ticklish.1 It is unclear where escalating rounds of provocations between the U.S. and Iran might end up, but the geopolitical, energy and economic impacts could be quite serious. There are a lot of moving parts, and we will not rehash our colleagues’ analysis here. From the U.S. Investment Strategy perspective, the biggest takeaway is that Middle Eastern oil infrastructure is more vulnerable to malign state and non-state actors than markets previously realized. It is remarkable that the world’s single most important oil processing facility could be so easily and precisely targeted, though anyone who began flying after September 11th would likely be amazed to learn that passengers once boarded planes without anyone giving the contents of their baggage a second thought. Regardless of how quickly Abqaiq operations are fully restored, Middle East oil infrastructure has been exposed as a soft target. The net economic impact of higher oil prices is the sum total of a broad range of gross subsidiary impacts. The global oil market is therefore more vulnerable to shocks from unplanned supply outages than previously assumed, and should begin to price in a terrorism premium. Any given economy’s exposure to oil price shocks is a more important consideration than it was before the attack on Aramco operations. In this Special Report, we examine the U.S. economy’s susceptibility to an oil price shock. The good news is that we find the U.S. to be considerably less vulnerable to an oil price shock than it was at the time of the Arab oil embargo; the net “tax” from higher oil prices is a good bit lower than it was then, and it is no longer exclusively paid to foreign entities. Six Channels Of Economic Impact We count six primary channels through which oil prices impact the U.S. economy: consumption, capital expenditures, corporate profits, the trade balance, employment and financial conditions (Figure 1). Higher oil prices are unequivocally bad for consumption, because they reduce households’ discretionary income. They should be a net positive for capital expenditures, because oil exploration and production is a capital-intensive pursuit that would likely outweigh incremental cutbacks in investment by businesses in the rest of the economy. They directly increase input costs for the wide range of goods that incorporate petroleum, and the goods and services that use oil as fuel, though other businesses’ reduced profits will be offset somewhat by domestic oil producers’ increased profits. As long as the U.S. remains a net oil importer, they will act to widen the trade deficit; once it becomes a net exporter, possibly within the next few years, they will narrow it. Their net impact on employment and financial conditions is mixed. Figure 1Oil Prices And The Economy Consumption Consumption is the linchpin of the oil-shock/recession narrative, as typified by the 1973-74 oil embargo. During the October 1973 war between Israel and a coalition of Arab states, OPEC members angered by American support for Israel ceased exporting oil to the U.S. and sharply reduced production. Although the embargo lasted just six months, oil prices tripled. Inflation surged, consumer confidence suffered mightily amid ubiquitous images of gasoline lines, and a sharp recession and punishing equity bear market laid siege to the U.S. economy. Chart 1The '70s Oil Shocks ... The overthrow of Iran’s pro-western monarch in 1979 generated a second oil price shock (Chart 1). The U.S. soon entered the first phase of the Volcker double-dip recession, and the notion that oil price shocks cause recessions became entrenched in the introductory macroeconomics curriculum. Filling up the tank consumes a much smaller share of household budgets today than it did in the ‘70s, however, so household spending is nowhere near as vulnerable as it was then (Chart 2). Energy is no more expensive relative to the PCE basket than it was at the end of the ‘70s (Chart 3), allowing fuel efficiency gains to translate directly to increased discretionary income (Chart 4). The household savings rate is lower, as well (Chart 5), clearing the way for consumers to spend more of their discretionary income.2 Chart 2... Took A Big Bite Out Of Consumers' Wallets Chart 3Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Chart 4New-Model Mileage Has Doubled Chart 5Consumers Are More Willing To Spend Than They Were In The '70s ... Bottom Line: Consumption will be undermined by higher oil prices, but not nearly to the degree it was in the 1970s, when fuel costs ate up a greater share of discretionary income. Corporate Profits Higher input costs stoked the wage-price cycle in the ‘70s, but low inflation expectations and supine unions have all but stamped out cost-push inflation pressures today. Chart 6... And Economic Output Is Far Less Dependent On Oil Higher oil prices’ negative impact on input costs is as clear-cut as their impact on consumption. Higher input costs helped trigger the ‘70s and ‘80s recessions, dragging down corporate profits and exacerbating cost-push inflation pressures as employees demanded higher wages to keep up with rising prices. That dynamic still applies, but its force is considerably attenuated, as tepid inflation expectations and the decline of unions’ collective bargaining power have all but wiped out cost-push inflation pressures. The continuing shift from manufacturing to services also limits the impact of higher input costs; the oil intensity of the U.S. economy is little more than a third of what it was at the time of the embargo (Chart 6). Growing energy self-sufficiency keeps some of the increased input costs from escaping the domestic economy. It is still valid to think of higher energy prices as a tax on businesses and consumers, but at least some of the tax revenue now accrues to U.S. parties. Shale drillers, pipeline companies, vendors and workers, and the states and localities where they reside, all share in the benefits. That limits the drag on domestic corporate profits, and the second-order drags on fixed investment, employment, consumption and creditworthiness. Capital Expenditures And The Other Channels Energy production’s increasing role within the U.S. economy came to the fore when crude prices collapsed from $107 to $26/barrel between June 2014 and February 2016. Per the ‘70s foreign-oil-dependency template, households would have gotten a huge discretionary income boost, while corporate margins would have surged. Employment and investment would likely have followed, and the consequent increase in consumption would have fed back into even more investment. Improved U.S. terms of trade would have improved living standards, and the trade balance would have narrowed. The U.S. economy no longer has a simple one-way relationship with oil price moves. Those happy growth outcomes did not materialize in the latest oil bust. Consumption growth was robust for the six quarters through 2Q16, but nonresidential fixed investment staggered across 2015 and into 2016 (Chart 7), failing to surpass its 4Q14 level (in real terms) for good until 3Q16. Swooning oil prices had no apparent effect on the trade deficit, which continued to grow at a steady pace (Chart 8). Chart 7Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Chart 8The Oil Bust Didn't Affect The Trade Deficit, ... Financial conditions tightened as high-yield credit spreads blew out, driven by bankruptcies and defaults in the oil patch (Chart 9, top panel). Oil patch capex evaporated as lenders and equity investors deserted the sector. That would happen in any oil bust, but it spread to the broader economy because shale plays had come to account for a close to a sixth of high-yield bond issuance (Chart 9, bottom panel). The net result was to reduce the supply of loanable funds for non-oil entities, while increasing their cost, bringing about a sharp tightening of financial conditions. Chart 9... But It Tightened Financial Conditions Employment suffered at the margin, as five years of steady oil and gas job gains from 2010-14 were wiped out in 2016 alone. Oil-related employment doesn’t account for a meaningful share of overall employment, but it has been a critical driver of new manufacturing employment since the crisis (Chart 10). The bottom line is that the economy’s failure to respond more positively to 2014-16’s long and steep oil price decline showed that it no longer has a one-way relationship with oil prices. Where sharply lower oil prices would previously have been an unmitigated boon for the economy, they now produce a range of offsetting effects. Chart 10Help Wanted In The Shale Patch Investment Implications Modeling the quantitative impact of a given rise in oil prices on any one factor is beyond the scope of this report, and there is no lack of published studies which have attempted to do so. Research recently cited by Dallas Fed President Kaplan suggests that a 10 percent increase in the real price of oil from a supply-driven oil price shock would lead to a roughly 10- to 30-basis-point decline in real GDP growth.3 In a general sense, we agree with both the direction and the magnitude of those studies’ conclusion. Higher oil prices would be a drag on the U.S. economy, but an increasingly modest one as domestic oil production rises and the country approaches true energy independence. Figure 1 shows that the modest negative net impact on the economy is the aggregation of several individual gross impacts, implying that the key investment takeaways are some layers below the broad macro level. When the arrows conflict within any of the individual channels in the figure, there may be an opportunity for investors to pair exposures. The need to protect vital oil infrastructure could bolster defense stocks, which have long been a favorite of our U.S. Equity Strategy and Geopolitical Strategy services. U.S. airlines, which (with one exception) scorn the idea of hedging their fuel costs, could be an attractive short/underweight candidate to pair with a defense overweight. From a macro perspective, the increased potential for oil price shocks enhances the appeal of TIPS relative to nominal Treasuries. As long as an oil supply shock would act as a headwind for U.S. growth, investors seeking to add some inflation protection to their portfolios should focus on shorter-maturity TIPS. A supply shock pushes inflation higher in the short term, but weighs on it in the long term, as investors revise their long-run inflation expectations lower upon factoring in its long-run growth-dampening effect.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 16, 2019 and September 19, 2019 Commodity & Energy Strategy and Geopolitical Strategy Special Reports, “Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response,” and “Policy Risk, Uncertainty Cloud Oil Price Forecast,” available at www.bcaresearch.com. 2 Disposable income is after-tax income. Discretionary income is what’s left of disposable income after the costs of necessities, like food, rent, clothing, gasoline and utilities, are backed out. 3 Kaplan, Robert S., “A Perspective on Oil,” June 19, 2018. Downloaded September 16, 2019 from https://www.dallasfed.org/-/media/Documents/news/speeches/kaplan/2018/rsk180619.pdf.

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