Developed Countries

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.

Energy Stocks Are Heading North Banks Clamoring For Higher Rates And A More Hawkish Fed Homebuilding Stocks Are Catching Up To Housing Starts Will Global Trade Get “Fed-Exed”? Do Not Try To Bottom Fish… ... In Cyclicals Vs. Defensives​​​​​​​

Special Report

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom Chart 2Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Chart 11Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... Chart 15...And Compared To ##br##Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed Chart 22A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993).

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom Chart 2Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Chart 11Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... Chart 15...And Compared To ##br##Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed Chart 22A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, Owing to BCA’s 40th Annual Investment Conference in New York City next week, we will not be publishing a report on Friday, September 27. We will return to our regular publishing schedule on Friday, October 4, when we will be sending out our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights The spike in oil prices underscores the vulnerability of key Saudi oil facilities. The fact that OPEC spare capacity is on the low side is an added source of concern. Fortunately, if oil prices do rise again, the impact on the global economy will be mitigated by the following: 1) the amount of oil necessary to produce one unit of real GDP is much lower than in the past; 2) oil prices are currently nowhere near restrictive levels; 3) higher oil prices will boost investment in the energy sector; and 4) unlike in the past, central banks will not need to hike rates to quell oil-induced inflationary pressures. The Federal Reserve is likely to cut rates once more in October and then keep rates on hold through 2020. The Fed will also begin expanding the size of its balance sheet to alleviate tensions in funding markets. Investors should remain overweight equities relative to bonds and start tilting exposure towards EM assets and cyclical stocks later this year. Feature All Aboard The Crude Oil Roller Coaster Chart 1A Price For The Books After gapping up by nearly 20% to $72/barrel on Monday morning – the biggest one-day spike in history – Brent oil prices have retreated to the $64-$65 range, representing a markup of around 7% over last Friday’s close (Chart 1). The near-term direction of oil prices will be governed by how quickly the Saudis are able to restore lost output. Brent fell by over $3/barrel on Tuesday following news reports quoting key Saudi sources saying that state-run Saudi Aramco would be able to bring production back to normal in the next two-to-three weeks. Bob Ryan, BCA’s chief commodity strategist, is skeptical of this reassurance. He notes that the drone attacks destroyed highly sophisticated “one-of-a-kind” equipment that had been specially built for the Abqaiq facility. Beyond the near-term impact, the longer-term question is whether Sunday’s pre-dawn strike is the start of a new violent trend. The fact that much of Saudi Arabia’s oil infrastructure is densely concentrated in the eastern part of the country makes it vulnerable to further attacks. The proliferation of drone technologies is also a source of concern since such devices can be used to wreak significant havoc at minimal cost.  Chart 2Limited Availability Of Spare Capacity To Offset Outages Chart 3Key Strategic Petroleum Reserves Iran’s apparent involvement in the attack further complicates matters. As Matt Gertken, BCA’s chief geopolitical strategist, has argued, the drone strike may have been orchestrated by hardliners in Iran who regard President Rouhani’s efforts to restart negotiations with the United States as evidence of appeasement (some of these hardliners are also profiting from the sanctions by smuggling crude out of the country). President Trump’s decision to sack John Bolton over Bolton’s opposition to making any deal with the Iranians may have created a sense of urgency among the hardliners. In this respect, attacking Iran would probably give the hardliners what they want. All this has occurred at a time when OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is below its historic average (Chart 2). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 3). Oil And The Economy: How Big A Risk? While a major spike in oil prices is not our base case, it cannot be ruled out completely. If the price of crude were to increase significantly, how much damage would this do to the global economy? History is certainly not encouraging: Every single U.S. recession since 1970 has been preceded by  a large jump in oil prices (Chart 4). Chart 4Oil Spikes And Recessions Chart 5The Global Economy Is Less Oil Intensive The fact that we are dealing with a potential supply disruption only makes things worse. It is one thing if oil prices are rising in response to stronger global growth; it is quite another if prices rise at a time, such as the present, when global growth is under pressure. Despite these concerns, there are four reasons to be optimistic that higher oil prices will not precipitate a major global economic downturn. First, the global economy is less reliant on oil than in the past. Chart 5 shows that the amount of oil necessary to produce one unit of real GDP has fallen by half since 1990. Second, oil prices are still quite low by historic standards. Even after this week’s jump, Brent is still 24% below where it was last October (Chart 6). In real terms, both Brent and WTI are more than 60% below their 2008 highs. Chart 6Oil Prices Are Well Off Their 2008 Peak Third, if oil prices do stay elevated, this will encourage investment in the oil patch, which will eventually bring prices back down. It is worth remembering that rising oil prices reduce aggregate demand in part by shifting wealth from oil consumers, who tend to spend most of their disposable income, to oil producers, who are often inclined to save the windfall from higher oil prices in such entities as sovereign wealth funds. However, if higher oil prices cause producers to expand production, the positive “investment effect” could offset much of the negative “consumption effect” on aggregate demand. Ironically, this means that a transfer of production from easily accessible oil deposits, such as those in Saudi Arabia, to less accessible shale or deep-sea deposits has the effect of increasing overall energy-sector capital spending, even if it does entail a loss of average efficiency. Fourth, higher oil prices today are unlikely to dislodge long-term inflation expectations. This represents a critical difference between the 1970s, 80s, and early 90s when central banks often felt the need to hike rates in the face of rising oil prices (Chart 7). These days, central banks are more likely to see oil price increases – especially those due to supply-side disruptions – as negative income shocks. Such shocks warrant looser, rather than tighter, monetary policy. Chart 7Core Inflation No Longer Driven By Oil Prices FOMC Cuts Rates As Expected This brings us to this week’s Fed meeting. As widely expected, the Fed cut rates by 25 basis points. It also lowered the projected policy rate path. Compared to the Summary of Economic Projections released in June – which suggested no rate change in 2019, one rate cut in 2020, and one rate hike in 2021 – the median dots in the September Summary of Economic Projections released this week show two cuts in 2019, no rate change in 2020, one rate hike in 2021, and one rate hike in 2022. Seven out of 17 participants penciled in a projected third cut for 2019. Judging from the tone of his post-meeting press conference, Jay Powell, dressed in his trademark bipartisan purple tie, was likely among those advocating for further easing. While it is far from a done deal, an additional rate cut in October appears more likely than not. In total, we expect 75 basis points in cuts, equivalent to the amount of easing orchestrated during both the 1995/96 and 1998 mid-cycle slowdowns (Chart 8). The Fed appears to be using these two episodes as a template for its current thinking. Chart 8Will The Fed Follow The 1990s Template Of 75 Bps Of Mid-Cycle Easing? The Fed is also likely to start expanding the size of its balance sheet starting in November. The spike in funding rates this week, while not at all related to the sort of counterparty risk that prevailed during the financial crisis, still underscored the fact that bank reserves are becoming increasingly scarce. To the extent that the Fed creates bank reserves when it purchases assets, this would help alleviate funding pressures. We are assuming that rate cuts beyond 75 basis points in total are possible. However, this would require a significant deceleration in U.S. growth, which looks unlikely. Real personal consumption spending is on track to increase by 3.1% in Q3, according to the Atlanta Fed’s GDPNow (Chart 9). While business capex spending continues to be weighed down by the manufacturing recession, rays of light are emerging. Industrial production rose by 0.6% in August, well above the consensus forecast of 0.2%. Despite an ongoing drag from the auto sector, manufacturing output rose by a solid 0.5%. Chart 9Inventories And Net Exports Have Subtracted From Growth Chart 10Easier Financial Conditions Will Boost Global Growth Globally, the growth picture remains shaky. Looking out, the sharp easing in financial conditions should boost activity (Chart 10). The nascent de-escalation in trade tensions, if sustained, should also help. As such, we continue to expect global growth to stabilize in the coming months and accelerate into year-end. Investment Conclusions Oil prices are likely to rise over the next 12 months. Geopolitical tensions could contribute to any upward pressure on the price of crude, but most of the increase in prices will probably be driven by stronger global growth. If global growth does pick up, the dollar will probably weaken (Chart 11). A weaker dollar will further boost oil prices, along with other commodity prices (Chart 12). Chart 11The Dollar Is A Countercyclical Currency Chart 12A Weaker Dollar Bodes Well For Commodities Stronger global growth, rising commodity prices, and a weaker dollar will hurt safe-haven government bonds but boost stocks. EM and cyclical equity sectors should gain disproportionately.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Special Report

Feature News reports suggesting the U.S. agrees with the Kingdom of Saudi Arabia's (KSA) assessment that the unprecedented attacks on the Kingdom’s oil infrastructure over the weekend were conducted with Iranian weapons will keep markets in overdrive sussing out the scope of an expected retaliation.1 Given the magnitude of this provocation, it is highly unlikely this war-like aggression goes unanswered. The U.S. has a range of retaliatory options, but the U.S. belief that the attacks originated in Iran makes for a much higher constraint for President Donald Trump to respond with direct air strikes, i.e. strikes on Iranian territory. On Wednesday, Trump ordered additional sanctions against Iran. This, combined with Trump’s dovish, establishment pick for a new national security adviser, suggests that whatever retaliatory strikes the U.S. authorizes, its intention will be to minimize the potential for escalation. Iran continues to deny any involvement in the attacks. Its response to any direct retaliation will be telling. If Iran’s response is to up the ante even further, events could escalate to head-on confrontation with the U.S. and Saudi Arabia. Even as tensions rise, a possible diplomatic off-ramp cannot be dismissed, given the political constraints confronting President Trump as the U.S. general election looms.2 KSA has stated its desire to bring the United Nations into the picture, presumably to either help it form a coalition to prosecute the actors determined to be responsible for the attacks, or to work out a diplomatic solution to de-escalate tensions in the Persian Gulf. In addition, the EU, which has maintained diplomatic relations with Iran, could be asked by the U.S. to mediate negotiations among the dramatis personae to avoid further escalation. For its part, Iran is ruling out any discussions with the U.S., insisting it does not want to give Trump anything that might be useful to him politically. Lastly, markets must fold in U.S. monetary policy – particularly as it affects the evolution of the USD – into its calculations, given the damage a strong dollar already has inflicted on oil demand globally over the past year or so.3 The Fed’s monetary accommodation could be significantly muted by similar efforts by central banks globally, keeping the broad trade-weighted USD well bid. This would continue to weigh on industrial commodity demand. Fundamentals driving price formation are highly dependent on how these issues resolve themselves. Considerable uncertainty exists on all fronts, given the forces shaping the evolution of supply, demand and prices are shaped by political outcomes, which still are in flux.4 At the very least, this will firmly embed a risk premium in prices – the range of which still is being defined – going forward. Despite Attacks, Fundamentals Remain Stable As tumultuous as the past week has been, little has changed in our base case supply-demand estimates, or in our price forecast. KSA officials are indicating repairs to its damaged 7-million-barrel-per-day processing facility at Abqaiq will mostly be completed by month-end. They indicate KSA has been able to use its 190mm barrels of storage – domestic and global – to meet contractual obligations while these repairs are underway.5 As tumultuous as the past week has been, little has changed in our base case supply-demand estimates, or in our price forecast (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) This leaves our price forecasts similar to last month, with Brent averaging $65/bbl for this year and $74/bbl next year (Chart of the Week). We continue to expect WTI to trade $6.50/bbl below Brent this year, and $4.00/bbl lower next year. While demand growth has weakened, available evidence suggests this process has bottomed. Chart of the WeekOil Fundamentals, Price Forecasts Little Changed, Despite Supply Shock On the supply side, the U.S. continues to be the dominant source of output growth going into next year, even as rig counts continue to fall due to lower prices at the end of last year and in 1H19. Despite the supply shock the attack on KSA induced, global physical imbalances have  largely been minimized, given the Abqaiq facility will be returned to service over the course of the coming month, and KSA has been able to supply contractual volumes out of global storage (Chart 2).  However, this implies global inventories will continue to draw (Chart 3), which will steepen the backwardation in crude-oil forward curves (Chart 4). Chart 2Absent Long-Lasting Shock, Balances Remain Unchanged Chart 3Inventories Will Continue To Draw Chart 4Crude Oil Backwardation Likely Steepens Chart 5U.S. Shales Continue To Drive Global Oil Supply Growth Chart 6U.S. Shale-Oil Output Rises In Top Five Basins On the supply side, the U.S. continues to be the dominant source of output growth going into next year, even as rig counts continue to fall due to lower prices at the end of last year and in 1H19 (Chart 5). Even so, U.S. shale-oil well completions continue to rise as more drilled-but-uncompleted (DUC) wells are brought online (Chart 6, top panel). Nonetheless, DUCs are not being completed as fast as we expected earlier, suggesting productivity gains to date are high enough to offset this slower DUC-completion rate (Chart 6, bottom panel). Geopolitics Dominates A Fraught Oil Market Moreso than at any point in the past, our base-case estimate is highly conditioned on what happens in the geopolitical realm. Markets are being forced to assess probabilities on outcomes that are, at this moment, highly uncertain. To account for some of the risk and uncertainty that will drive supply-demand fundamentals, we model several scenarios assessing the impact of prolonged production outages. Chart 7 shows our estimates of the price impact of 2.85mm b/d of KSA production remaining offline until the end of September (Scenario 1), October (Scenario 2), and December (Scenario 3). These scenarios are largely in line with guidance from KSA that processing and production will be fully restored by November. The end-December scenario makes the point that, without any adjustments in demand and supply elsewhere, prices will spike sharply if Saudi production fails to come back online completely by year-end.6 Chart 7Prolonged Loss of KSA Output Leads To Higher Prices Production outages of the sort simulated in scenario 3 above likely would be destabilizing to markets generally, which, all else equal, would strengthen the USD, as market participants sought safe-haven investments. A stronger USD, coupled with higher absolute oil prices, would lead to demand destruction. The effects of higher prices and a stronger dollar most likely would become apparent in 2020 (Chart 8). We would expect demand destruction would be most acute in EM economies, although DM would not be immune.7 Chart 8Demand Destruction Would Follow Higher Prices and Stronger USD Oil Market Enters Unknown Terrain The attacks on KSA – either by Iran or its proxies – indicates U.S. sanctions against Iran’s oil exports are forcing it to take increasingly desperate measures. Iran would prefer to remove sanctions than engage a large-scale war with the U.S., or with a U.S./GCC military coalition. Nevertheless we continue to believe Iran has a higher threshold for pain than the Trump administration. Under extreme economic sanctions, Iran believes it must show it can strike deep into the heart of KSA’s oil industry, almost at will. At present, we believe any KSA or U.S. militarily retaliation against Iran will be mostly symbolic – e.g., cyber-attacks, pinprick strikes at specific areas where the attack was launched from, or at Iran’s militant proxies across the region rather than at Iran proper. The point would be a warning back to Iran. If no action is taken by the U.S. or KSA, then Iran will conclude that it can continue pressing aggressively. Its previous actions this year – e.g., against tankers in Hormuz, the shooting down of an American drone – have not led to U.S. retaliation, so it has pressed on. This is dangerous because it erodes credibility of U.S. security guarantees in the region – and invites Iran to take even bolder actions. The U.S. public is opposed to wars in the Middle East and an expanding conflict threatens an oil price shock and recession that would get Trump kicked out of the Oval Office. This is a compelling set of reasons not to re-escalate tensions with Iran, but only to seek symbolic retaliation. Iran’s President, Hassan Rouhani, has a clear incentive to push and test Trump: He suffered the most from Trump’s withdrawal from the 2015 Iran Nuclear Deal – i.e., the Joint Comprehensive Plan of Action (JCPOA), which allowed Iran back into the oil export markets. Although his government is still in power, it is dealing with the fallout from U.S. economic sanctions. He has a great interest in renegotiating the deal – preferably with a Democratic President but possibly also with Trump. But Rouhani must be extremely hawkish in order to get it done and secure political cover at home. Iran’s Supreme Leader, Ali Khamenei, and the Islamic Revolutionary Guard Corps (IRGC) do not accept Rouhani’s approach and do not want rapprochement with Donald Trump. Moreover they ultimately have an interest to create a conflict that would unify Iran and buttress the regime.  Therefore, chances are that the regime hardliners triggered the attack against KSA to poison the atmosphere, prevent talks, and force Rouhani into a corner where he can no longer pursue diplomacy with the U.S. The chances of a political settlement between the U.S. and Iran are fading rapidly. The U.S. will need to retaliate somehow, diplomatically, economically, or militarily.  Either way it will push back the time frame for a political settlement with Iran. President Trump would need to make an incredibly bold diplomatic overture to convert this incident into a new nuclear deal and political settlement – he would have to give sanctions relief, rejoin the JCPOA, and, most important,  he would have to be matched by Rouhani’s own steps in the context of Iranian factional struggle. Given the fact that Trump ordered new sanctions on Iran Wednesday, the odds of any political settlement are approaching zero. President Trump is reportedly nominating Patrick C. O’Brien as his new national security adviser to replace John Bolton. O’Brien is an establishment Republican pick — he has worked with Senator Mitt Romney as well as the George W. Bush administration. He is also manifestly a “dovish” pick, not only in relation to the uber-hawkish Bolton but even compared to other candidates for the position. He has a specialty in hostage negotiations and legal work representing marginal groups as well as powerful U.S. interests. This suggests that President Trump is seeking negotiations rather than war as his ultimate objective and staging a “tactical retreat” from his aggressive foreign policy so far this year. However, O’Brien is only a single person and the underlying dynamic — Iran’s higher pain threshold for conflict and awareness of Trump’s fear of oil shock and recession — still entails that Trump will need to heighten deterrence, or Iran will press its advantage further. This means we are far from de-escalation in the wake of Abqaiq and markets will continue to add a risk premium. Bottom Line: The U.S. and KSA agree that Iran is responsible for the attacks. It is still unclear that they were launched from Iran by Iranians, however. Ahead of any formal finding, President Trump ordered increased sanctions against Iran on Wednesday. We strongly believe the U.S. will retaliate against Iran or its proxies in the Middle East in response to the attacks on KSA. But the retaliation will be limited because of U.S. political and economic constraints. Iran has the higher pain threshold, and it remains uncertain whether this dynamic will escalate into a full-on kinetic engage­ment involving Iran against the U.S., KSA and their GCC allies.     Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      Please see Saudi oil attacks came from southwest Iran, U.S. official says, raising tensions, published by reuters.com September 17, 2019. 2      We discuss these in detail in the Special Report Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response published jointly by BCA Research’s Commodity & Energy Strategy and Geopolitical Strategy September 16, 2019. 3      We examined the impact of the strong USD on industrial-commodity demand in two reports – Central Bank Easing Key To Oil Prices and Industrial Commodity Demand Recovery Will Boost Metals, Oil, published September 5 and 12, 2019. We conclude dollar strength, along with China’s deleveraging campaign in 2017 – 18 likely explains a significant amount of the dramatic contraction in oil demand over the 2H18 – 1H19 period. The Sino-U.S. trade war also contributed to lower demand, in our estimation, but its primary effect has been to increase firms’ reticence to fund longer-term capex and households’ desire to hold precautionary savings balances. 4      We are referring once again to Knightian uncertainty, i.e., risks that are “not susceptible to measurement.” This differs from the “risk” we routinely consider in this publication, which can be measured via implied volatilities in options markets. A pdf of Dr. Knight’s 1921 book "Risk, Uncertainty and Profit" can be downloaded at the St. Louis Fed’s FRASER website. 5      In our Special Report earlier this week (see footnote 1), we estimated KSA could cover ~ 33 days of its contractual obligations from its storage, if the outage remained at 5.7mm b/d. The Saudi Press Agency detailed the loss as follows: 4.5mm b/d are accounted for by Abqaiq plants going off line. Please see Saudi says oil output to be restored by end of September, published by khaleejtimes.com. 6      NB: This is the marginal price impact. It is not a forecast. Should production stay off line for an extended period, we would expect other OPEC members’ production to increase, and, at a minimum, the U.S. SPR would release barrels to the market. Eventually, demand destruction – from higher prices – would force oil prices lower. 7      Our demand-decline scenario in Chart 8 shows the impact of a stronger USD and lower demand brought on by high prices. We raise the probability of a stronger USD to 30% in our ensemble model, and simulate a loss of demand equal to 250k b/d next year – 200k b/d from non-OECD economies and 50k b/d from OECD economies. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades