Developed Countries

Dear Client, This is our last publication of 2018. We wish all our clients a Merry Christmas and a Happy New year! We will be back on January 3, 2019. Thank you, The Commodity & Energy Strategy Team!   Because they missed the first wave of North American Liquified Natural Gas (LNG) investments, Canadian gas producers will continue to endure low prices – compared to their U.S. counterparts – for the next three to five years. To become attractive to investors, proposed Canadian LNG projects will have to wait for demand to catch up to supply coming from the first wave of investment in 2010 – 2015.1 The good news is demand – mainly from Europe and Asia – is projected to outpace gas liquefaction capacity by 2023 – 2024.2 We believe this will create the necessary conditions to incentivize the second wave of LNG investment. To preserve its strong natural gas sector, Canada will have to become a leading LNG exporter, or risk seeing production decline. Highlights Energy: Overweight. The 2H18 OPEC 2.0 production surge undertaken to cover the re-imposition of U.S. sanctions against Iranian oil exports still is being absorbed in key refining centers. We expect to see inventories begin to draw heavily in January, given the transit from the Persian Gulf to the U.S. Gulf, where inventory levels are reported weekly, takes roughly 50 days per the U.S. EIA (Chart of the Week). Base Metals: Neutral. Asian copper concentrate treatment and refining charges (TC/RCs) appear to be headed lower next year. According to Metal Bulletin’s Fastmarkets, a deal agreed by Antofagasta and Jiangxi Copper setting TC/RCs at $80.80/MT / 8.08 cents/lb is setting next year’s levels. This will be the “the lowest benchmark since 2013,” coming in $1.45/MT under this year’s levels. Precious Metals: Neutral. Gold prices have rallied, as markets appear to be discounting fewer rate hikes by the Fed next year.3 We expect at least three rate hikes in 2019. Ags/Softs: Underweight. The USDA will release the second and final installment of farm assistance totaling $4.7 billion, to cover losses arising from the Sino – U.S. tit-for-tat tariffs and lost trade. This brings the total U.S. payout to $9.6 billion, according to agriculture.com. Feature U.S. LNG companies have the first-mover advantage in the North American LNG market.4 Because of this, these firms have a decided advantage in attracting capital investments and securing shorter- and long-term contracts to absorb their output. We believe the upcoming second wave of North American LNG investment – likely to get rolling in early 2019 – might be the last opportunity for Canadian producers to secure a position in the global gas market. If they miss this wave, Canadian natural gas production likely will plateau at close to current levels and begin to decline as early as 2019 (Chart 2).5 Currently, ~ 51% of Canadian natural gas production is exported to the U.S., but the shale revolution south of the border threatens every single cubic-foot of exports. U.S. gas supply is projected to increase by 20%, while its domestic demand by only 5%. This means the U.S.’s supply-surplus is poised to increase by 4.25 Bcf/d by 2023. Most of the American surplus will be exported via the LNG facilities that received final-investment decisions (FID) during the first wave of investment, and the rest via pipelines to Mexico and Canada. By 2020 the U.S. will have ~ 9.5 Bcf/d of liquefaction capacity and 3.4 Bcf/d of additional pipeline capacity destined to Mexico and Canada (Table 1). Table 1U.S. LNG Capacity To Reach 9.5 Bcf/d In The Early 2020s Canadian Gas Market Balance The U.S. natural gas market is the most important factor driving the evolution of Canadian natural gas production. Canadian natgas exports to the U.S. are expected to decrease from 8.2 Bcf/d to ~ 5 Bcf/d by 2040, according to EIA data. Moreover, Eastern Canada’s imports of natural gas from Northeast U.S. are projected to increase by 2.2 Bcf/d, due to the region’s proximity to the super-giant Marcellus and Utica gas fields in the Appalachian Basin. This trend has already started (Chart 3). Our base case projections for Canadian natural gas includes five new projects reaching FID in 2019-2020, with a combined capacity of 6.4 Bcf/d by 2024: Woodfibre LNG (prob > 80%): Small-scale project with capacity close to 0.3 Bcf/d located near Squamish, BC. This involves a 47-kilometer expansion of the existing FortisBC pipeline, transporting gas from the Western Canadian Sedimentary Basin. Goldboro LNG (prob > 80%): Although the project is placed in proximity to the Maritimes & Northeast Pipeline, the ~0.5 Bcf/d import capacity of this pipe would not sustain the 1.3 Bcf/d facility’s export capacity suggesting a required expansion, or new infrastructure to source its gas from the Marcellus Basin or Canada West. Bear Head LNG (prob > 80%): This project in Richmond County, NS must decide on whether to source 1.6 Bcf/d from the U.S. or Western Canada. Kitimat LNG (prob > 50%): This 1.3Bcf/d terminal in Bish Cove, BC will source its gas from the Horn River and Liard Basins via the proposed 480-kilmeter Pacific Trail Pipeline. Kwispaa LNG (prob > 50%): Formally known as Sarita LNG, the 1.9 Bcf/d project in Sarita Bay, BC would rely on gas supply from northeastern BC and/or Alberta. On the back of these expansions, we expect a short-term gas supply-surplus in Canada from 2019 to 2022, followed by balanced market, as LNG export capacity rises sufficiently to support Western Canadian gas production growth and pipeline-export declines (Chart 4). If there are no new Canadian LNG projects receiving FID decisions in the next two years, the domestic market will become over-supplied. This would depress the Canadian benchmark price at the AECO-C hub, and curtail investment in the energy sector. Should this scenario play out, we would expect future Canadian natural gas production to ~ 14.3 Bcf/d by 2040 (Chart 2). Bottom Line: Next year will be crucial for the medium- and long-term Canadian natgas outlook. Any delays in the construction of projects in the development pipeline would depress AECO-C prices and increase uncertainty for future investments in the Western Canadian Select Basin. Can Canada Compete With The U.S.? Canadian LNG projects are in direct competition with those in the U.S. to attract investment for the next wave of needed liquefaction capacity. We believe the Canadian LNG sector offers several advantages, which could favor its development versus the U.S. There are three major points of comparison: Proximity to key demand markets: One crucial advantage of Canadian LNG is its proximity to Asian markets, which will be the principal driver of LNG demand growth (Chart 5). In fact, a voyage from the Canadian Westcoast to Ningbo, China, takes on average 28 days less than from the GOM (Table 2). Moreover, the Canadian Energy Research Institute (CERI) estimates shipping from Eastern and Western Canada offers cost advantage over most liquefaction facilities around the world (Chart 6). Lastly, U.S. GOM exports to China are constrained by the Panama Canal and are expected to reach full transit capacity in early 2020s.6 This would increase U.S. voyage time by close to 14 days. Table 2BC’s LNG Voyage Time To Asia Is Advantageous Proximity to cheap and abundant feedstock gas: British Colombia’s integrated LNG projects are close to the growing Montney, Horn River and Liard production basins (Map 1).7 Natural gas reserves in these basins are estimated at ~ 41 Tcf, and are located within 400 miles of pipeline infrastructure.8 Moreover, prices have historically been lower compared to Henry Hub, and this is especially true today (Chart 7). We believe AECO-C prices will have to remain at a discount to U.S. prices over the next two years to incentivize LNG investments or disincentivizes production. Chart 7AECO-C's Discount To Henry Hub Widens Capital Costs and pipeline systems: Canadian LNG projects have competitive capital costs (Chart 8). However, Canada lacks a developed pipeline system from the Montney, Horn River and Liard basins to the west coast. Each proposed LNG project includes a dedicated pipeline. According to CERI, the cost of building a new pipeline in BC is higher than average due to the mountainous terrain. The U.S. has the advantage in regard to its developed pipeline system connected to the Henry Hub. This allows LNG projects to access an abundant and reliable feedstock by investing in short connection pipelines to the Hub. This makes the U.S. slightly more attractive in terms of capital costs. Bottom Line: Canada offers a competitive alternative to U.S. LNG projects. Western Canadian gas offers the most cost-effective solution to fill the rising Asian gas demand. Short- And Medium-Term Price Outlook We expect Canadian natural gas prices – i.e. the AECO-C benchmark – to modestly pick up and the U.S. Henry Hub prices to remain flat over the coming winter. Going into the winter heating season in November, Canadian gas storage levels were 15.5% lower than last year. Environment Canada continues to project a “normal” winter, which should not pressure prices in any direction. The Enbridge pipeline segment north of Prince George, BC is back at 85% utilization rate from reduced levels of 50-80% following the explosion in early October. As exports pick up, this will alleviate some of the downward pressure on Canadian prices. Over the medium term, however, we believe there is limited upside to Canadian gas prices. British Columbia pipelines to the U.S. already are close to full capacity, and no new projects are under construction (Chart 9). The province’s gas production is poised to grow by 1.56 Bcf/d from the prolific Montney and Horn River plays over the next 5 years. Given the lack of LNG export capacity until at least 2022, the excess capacity will have to find its way through Alberta – where the AECO-C benchmark is determined – increasing the available supply and pushing its price down. Domestic Canadian markets are unlikely to absorb this new supply. Higher-than-expected U.S. production from the Utica and Marcellus plays in the Appalachian Basin will satisfy a growing proportion of Eastern Canadian natural gas consumption, increasing the competition for Western Canadian gas. Reversals of pipeline flows within existing systems so as to import greater volumes from U.S. is evidence of this trend (Chart 10). Furthermore, according to the EIA, close to 1.3 Bcf/d additional pipeline capacity from Northeast U.S. to Canada will be built in the next 2 years. In the U.S., Henry Hub price volatility picked up as the U.S. market experienced an early-season freeze at the start of the November – March heating season, which was accompanied by record low working gas inventories (Chart 11). The April-October 2018 re-fill season paled in comparison to last winter’s withdrawal (Chart 12). Expressed in Days-Forward-Cover (DFC), this year’s October seasonal inventory peak was 16% lower than the historical average and 10% lower than the 5-year average. This was most recently followed by warmer-than-expected temperatures that subsequently crashed prices (Chart 13). Chart 13Weather-Related Natgas Volatility U.S. natgas prices remain vulnerable to weather shocks. We expect a premium on prices to remain throughout most of the winter season, keeping prices above $3.00/MMbtu. Still, upside price movements remain capped by higher-than-expected production (Chart 14, panel 1). U.S. production reached 90.7 Bcf/d in November 2018, according to EIA data, and is projected to reach 93.5 Bcf/d by the end of next year. This is an 8.4% revision to the EIA June 2018 projections. Moreover, our higher 2019 shale production estimates vs. the EIA estimates will support additional associated gas production. ​​​​​​​ Similarly, domestic demand and net exports are surging, and we expect these trends, especially regarding the U.S. natural gas exports, to continue next year (Chart 14, panel 2 & 3). This implies fundamentals will be fairly balanced in 1H19. The wildcard will be weather. The latest NOAA weather projections show extremely warm weather for the next 6-10 days, and warmer-than-normal temperature for the next two months. This keeps us Neutral.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1      According to NEB, since 2010, 43 projects have been proposed. Of those, 35% have been cancelled and 20 were approved and working toward receiving FID. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report “U.S. Set To Disrupt Global LNG Market,” published October 4, 2018. Available at ces.bcaresearch.com. 3      Please see “Druckenmiller Urges Fed to Pause Tightening `Blitz’ in WSJ Op-Ed,” published by bloomberg.com on December 17, 2018. 4      The U.S. already has more than 3 Bcf/d of liquefaction capacity. The experience/expertise acquired from these projects will facilitate the construction and permitting of new projects, reducing time delays and uncertainty. Brownfield expansions benefit from economies of scale (e.g. additional trains can share jetty, land, storage, pipeline and permitting). Lastly, the well-developed pipeline system reduces the need to built long direct pipelines to LNG projects, which speeds up the construction. For more details, please see Canadian Energy Research Institute, “Competitive Analysis Of Canadian LNG,” July 2018. 5      The largest LNG project in Canada clearing the FID hurdle is LNG Canada, the 1.8 Bcf/d project in Kitimat, BC, being developed by Shell. It is expected to cost $40 billion, and to be on line in 2023, with the possibility to double capacity eventually. 6      Please see Oxford Institute For Energy Studies, “Panama Canal and LNG: Congestion Ahead?” April 2018. 7      Please see National Energy Board, “Canada’s Role in the Global LNG Market: Energy Market Assessment,” July 2017. 8      Marketable reserves are estimated at 532 Tcf. Please see BC Oil and Gas Commission, “British Columbia’s Oil and Gas Reserves and Production Report,” December 2017. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table TRADE RECOMMENDATION PERFORMANCE IN 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017

Underweight The S&P soft drinks index popped in late October, driven by better than expected Q3 results, mostly at Coke. In truth, pricing power has been staging a fairly steady recovery since falling off a cliff in 2016, though it has recently rolled over (second panel). More important to the index is the structural underperformance in earnings growth (third panel). While pricing improvements seem to be helping close the gap, the industry has nearly a decade of uninterrupted earnings deficit relative to the broad market. As such, the recent recovery in the S&P soft drinks index without an accompanying EPS lift has driven sector valuations to a 40% premium to the S&P 500 (bottom panel). Considering the stalling pricing efforts, U.S. dollar strength and a generalized global trade slowdown, this seems overly optimistic. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, MNST. ​​​​​​​ ​​​​​​​

Highlights Asset allocation: Start 2019 with an overweight to industrial commodities versus equities. Await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Equities: Start 2019 with a cyclical equity sector tilt, but become more defensive as the global economy inevitably flips into a down-oscillation later in 2019. Start tactically overweight Italy’s MIB versus the Eurostoxx. Bonds: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. Currencies: Start 2019 short EUR/JPY combined with long EUR/USD. There will be a great opportunity to buy the GBP, but not yet. Alternatives: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. Feature 2019 will present investors a mirror-image pattern to 2018. Through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse. Growth To Rebound, Then Fade Global growth has entered an up-oscillation, for which the evidence is irrefutable: Industrial (non-oil) commodities are strongly outperforming equities, and rising even in absolute terms (Chart of the Week and Chart 2). Emerging markets are strongly outperforming developed markets (Chart 3). Financials are outperforming the broad equity market (Chart 4). Sweden’s manufacturing PMI – a bellwether of global activity – is rebounding strongly (Chart 5). Perhaps most importantly, China’s 6-month credit impulse has gone vertical (Chart 6). Chart of the WeekNon-Oil Commodities Are Strongly Outperforming Equities   Chart I-2Non-Oil Commodities Are Recovering In Absolute Terms Too   Chart I-3Emerging Markets Are Strongly Outperforming Developed Markets Chart I-4Financials Are Outperforming Chart I-5Sweden’s Manufacturing PMI Is Up Sharply Chart I-6China’s 6-Month Credit Impulse Has Gone Vertical Taken together, this is compelling evidence of a growth rebound, even if it is modest. Crucially, such up-oscillations tend to last at least six to eight months. Hence, equity sector performances, which always take their cue from global growth, will follow a mirror-image pattern in 2019 to that in 2018. Bottom Line: Start the year with an overweight to industrial commodities versus equities and a cyclical equity sector tilt, but prepare to fade to a more defensive tilt as the global economy inevitably flips into a down-oscillation later in 2019. Inflation Is The Dog That Will Not Bark There are not many things that are certain in the economy, but a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price – 40 percent so far and getting worse by the day – is about to feed through into headline consumer price indexes (Chart 7 and Chart 8). Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs. Chart I-7Headline Inflation Will Collapse In Europe Chart I-8Headline Inflation Will Collapse In The U.S. Coming at a time that central banks have professed a much greater reliance on “incoming data”, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Fed. This makes the dollar vulnerable, leaving us a choice between the euro and yen as our preferred major currency. And on this head-to-head the yen still beats the euro given its lower political risk: Bottom Line: Start 2019 short EUR/JPY combined with long EUR/USD. Use ‘The Rule Of 4’ And Fractals To Predict Tipping-Points For Equities Investment strategists are obsessed with timing the next recession. The thinking is that by predicting the next recession they can predict the next equity bear market. The logic sounds fine, except that the causality rarely runs from economic downturns to financial market instabilities. The causality almost always runs the other way. Paul Volcker, arguably the greatest central banker of the modern era, correctly points out that the danger to the economy almost always comes from systemic financial disturbances. The last three downturns, in 2000, 2007 and 2011, all resulted from financial disturbances: the bursting of the dot com bubble, the gross mispricing of U.S. sub-prime mortgages, and the distortion of euro area sovereign debt markets respectively. Instead of timing the next recession to predict financial market instability, the correct approach is to flip the logic around and ask: is there a glaring source of financial instability that could cause the next recession? To which the answer is yes. The current glaring instability is the hyper-vulnerability of elevated risk-asset valuations to the global bond yield. Near the lower bound of bond yields, bond prices develop the same unattractive negative asymmetry as equities, removing the need for an equity risk premium, and justifying sharply higher equity valuations. But when the 10-year global bond yield rises back to around 2 percent – or equivalently when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent ‘the rule of 4’ – the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower equity valuations (Chart 9 and Chart 10). Chart I-9Equities Plunged In February After A Spike In Bond Yields Chart I-10Equities Plunged In October After A Spike In Bond Yields In 2019, just as in 2018, investors should use this dynamic to allocate tactically to equities versus cash as follows: 1. When the rule of 4 approaches 4 and the market’s 65-day fractal dimension signals an overbought rally, go underweight equities. 2. When the rule of 4 approaches 3 and the market’s 65-day fractal dimension signals an oversold sell-off, go overweight equities. 3. At all other times stay neutral. Bottom Line: With the rule of 4 now approaching 3, await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Britain Escalates EU Tensions, Italy De-Escalates The two points of political tension in Europe, the U.K. and Italy, have a common theme: brinkmanship with the EU. The Brexit tension remains high and may even intensify in early 2019 before a resolution. Hence, while 2019 will offer a great opportunity to buy the pound, it might require a little patience. In contrast, Italy is de-escalating its brinkmanship with Brussels over its budget deficit. Meanwhile the crux of Italy’s long-standing woes – its banking system – is also showing signs of healing. The proportion of bank loans that are non-performing is plummeting, while the solvency of the banking system continues to improve (Chart 11 and Chart 12). Chart I-11Italian Banks’ NPLs Are Plummeting… Chart I-12…And Italian Banks’ Solvency Is Improving Bottom Line: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. And tactically overweight Italy’s MIB versus the Eurostoxx. Cryptocurrencies Will Rebound 60 Percent Cryptocurrencies are here to stay, because the underlying technology, the blockchain, is here to stay. Just as the internet’s major innovation was to decentralise and democratise information, the blockchain’s major innovation is to decentralise and democratise trust. Until now, counterparties without an established trust relationship could only transact through an intermediary who could provide the necessary trust overlay. But once each participant in a transaction trusts the blockchain itself, they no longer need to use a conventional intermediary, like a bank or a law firm. One major argument against the blockchain is that it is energy intensive and therefore prohibitively costly. But conventional intermediation also exacts a significant cost. Let’s say that the stock of excess savings that the banks intermediate to borrowers conservatively equals global GDP. If the risk-adjusted interest rate spread that banks charge for their intermediation role conservatively equals 1 percent, it means that this conventional intermediation is costing 1 percent of global GDP. Against this, global energy consumption equals roughly 5 percent of global GDP. So even if the blockchain consumed a fifth of the world’s energy, its cost might still be comparable to conventional intermediation. The plunge in cryptocurrencies during 2018 was exacerbated by the recent ‘hard fork’ in bitcoin protocol. But such hard forks are a necessary part of the evolutionary process – being analogous to a Darwinian mutation which eliminates the weakest protocols while allowing the strongest and fittest to thrive. In the latest fork, the battle was between those who want cryptocurrencies to remain a speculative asset with low long-term survival prospects, and those who want them to become a stable means of payment with high long-term survival prospects. A year ago almost to the day, we recommended selling bitcoin at a price of $18,000. Our rationale was that excessive herding required a price gap down to normalise liquidity. The subsequent decline in the price to $3500 today has rewarded that recommendation handsomely. But today, Litecoin and Ethereum are approaching an opposite tipping-point where the price may have to gap up to normalise liquidity (Chart 13 and Chart 14). Chart I-13Litecoin Is Oversold On A 65-Day Horizon   Chart I-14Litecoin Is Oversold On A 130-Day Horizon Bottom Line: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. For a 50:50 basket, target a return of 60 percent. And on that positive note, I am signing off for the year. I do hope that you have enjoyed reading this year’s reports, but more importantly that you have found value in them. This publication’s philosophy is to think out of the box, independently and unconstrained, never to shirk from challenging the received wisdom, and ultimately to provide successful investment ideas. We promise to continue this way in 2019! It just remains for me to wish you a very happy holiday season and a prosperous new year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com   Fractal Trading Model* As discussed in the main body of this report, this week’s recommended trade is to buy a 50:50 combination of Litecoin and Ethereum. Set a profit target of 60 percent with a symmetrical stop-loss. As also discussed in the main body of this report, remain tactically overweight Italy’s MIB versus the Eurostoxx. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1 Chart II-2 Chart II-3 Chart II-4 Interest Rate Chart II-5 Chart II-6 Chart II-7 Chart II-8

Special Report

Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead.     Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2      In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.    

  Overweight Household product stocks have typically performed well as retail gasoline prices have contracted; this iteration has proven no different (gasoline prices shown inverted, top panel). This boon to consumers has supported an uptick of the consumer’s wallet being deployed to household products which should translate into top line support for these equities (second panel). Curiously, the end of the bear market for this sector coincided with a moderating of S&P household products profit margins from their historically high level (third panel). The market is likely seeing ahead to a return to margin expansion. As noted above, the demand environment appears robust and, with commodity and labor costs well contained (bottom panel), things should continue looking up for the sector, especially given the recent success constituents have had in raising selling prices. Bottom Line: Earnings growth looks set to reaccelerate in the S&P household products index; we reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX and CHD.