Developed Countries

Dear Client, In addition to today’s report, we sent you our 2019 Outlook earlier this week, featuring a discussion between BCA editors and Mr. and Ms. X. Best regards, Peter Berezin, Chief Global Strategist Highlights Today’s macroeconomic backdrop of slowing global growth, plunging oil prices, falling equity prices, widening credit spreads, and a strong dollar is reminiscent of what transpired in 2015. We do not expect global capital spending to contract as much as it did back then, partly because Saudi output cuts should preclude the need for shale producers to slash capex plans. Nevertheless, global growth is likely to slow further into the first half of next year, suggesting that equities and other risk assets could face renewed near-term pressures. The sell-off in the dollar following Powell’s speech is unwarranted. We expect the DXY to reach 100 by early next year. Global bond yields will rise by more than currently discounted over a 12-to-18 month horizon, but are likely to fall somewhat over the next few months. Feature Echoes From The Past Today’s macroeconomic backdrop is starting to look increasingly similar to 2015, a year when the global economy slowed sharply and commodity prices took it on the chin. In 2014, the Fed was gearing up to raise rates while other central banks were still in full-out easing mode. The divergence in monetary policies between the U.S. and the rest of the world caused the U.S. dollar to surge. The broad trade-weighted dollar strengthened by 16% between July 2014 and March 2015 (Chart 1). Chart 1Current Dollar Strength: Replay Of 2015? The effects of the stronger dollar rippled across the global economy. Notably, since China had a de facto currency peg to the dollar at the time, the resurgent greenback made Chinese companies less competitive in global markets. The appreciation of the yuan came at a time when the Chinese government was tightening both monetary and fiscal policy. The year-over-year change in total social financing (TSF) reached as high as 23% in April 2013 but fell to 12% in May 2015 (Chart 2). Chart 2Just Like Today, China Was Tightening Monetary And Fiscal Policy Going Into 2015 Eager to give its export sector a competitive boost, China allowed the currency to weaken by about 4% in August 2015 (Chart 3). The “mini-devaluation” backfired. Rather than instilling confidence in the economy, it caused investors to bet on further currency declines. Capital outflows intensified as the yuan came under further pressure. Between June 2014 and January 2016, China lost almost US$1 trillion in foreign exchange reserves. Chart 3China's Mini-Devaluation Backfired The combination of a stronger dollar and sagging Chinese growth led to a steep decline in commodity prices. The London Metals Exchange index fell by nearly 40% between July 2014 and January 2016. Brent crude oil prices plunged from $110/bbl to as low as $26/bbl during this period (Chart 4). Capital spending in the commodity sector collapsed. Fears over the financial health of commodity producers and related firms caused credit spreads to widen (Chart 5).  Chart 4Stronger Dollar And Soggy Chinese Growth Were A Bad Combination For Commodity Prices Chart 5Weakness In The Commodity Complex Weighed On High-Yield Bonds In 2015 Throughout the course of 2015, the Fed refused to back off from its plans to start raising rates. It hiked rates in December of that year and signaled four more hikes for 2016. However, as markets continued to swoon, the FOMC quickly backed off. The Fed would not raise rates again for a full 12 months. The Federal Reserve’s decision to temper its hawkish rhetoric, along with China’s decision to ramp up stimulus in early 2016, put a floor under risk assets. Fast forward to the present and investors are again wondering if the Fed is about to blink and whether the Chinese authorities are set to deliver a massive dose of global reflationary stimulus. We would not exclude either option. However, we think that a lot more pain is required before either occurs. China’s Begrudging Stimulus Program The Chinese government’s reform agenda remains focused on curbing credit growth and reducing excess capacity. China has historically stimulated its economy with ever-more debt and investment spending (Chart 6). There is an obvious tension here – one that is likely to make the authorities reluctant to turn on the credit spigot unless the economy slows further. Chart 6China: Debt And Capital Accumulation Have Gone Hand In Hand Of course, China can try to stimulate its economy without relying on more debt-financed investment spending. In particular, it can try to boost consumption or net exports. The problem is that neither of these two options would be welcome news for other nations. Capital goods and raw materials account for more than 80% of Chinese imports. The rest of the world relies on Chinese investment, not Chinese consumption. Similarly, while stricter capital controls have given the authorities greater scope to weaken the yuan than they had in 2015, such a move would only hurt China’s competitors and curb Chinese imports.  The Fed Will Keep Hiking Stocks rallied and the dollar sold off on Wednesday after Chairman Powell seemingly suggested that the fed funds rate was already close to neutral. This appeared to be a sharp recanting of his statement in early October that the Fed was a “long way” from neutral. We think the financial media and many pundits overreacted to Powell’s remarks. What he actually said was that “interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy.”1 The “broad range” of estimates that Powell was referring to is drawn from September’s Summary of Economic Projections, which showed that FOMC members saw the appropriate “longer run” level of the fed funds rate as ranging between 2.5% and 3.5%. Given that the current target for the fed funds rate is 2%-to-2.25%, Powell was merely stating a fact about the current position of the Fed dots, not offering new forward guidance. In any case, investors are focusing too much on what Powell may or may not be thinking. The Fed does not know where the neutral rate is. True to its “data-dependent” approach, it will keep raising rates until the economy slows by enough that it needs to stop. Our base-case scenario envisions only a modest slowdown in U.S. growth, driven in part by increasing capacity constraints (the latter should make the Fed more, not less, eager to raise rates). So far, the data are consistent with this benign slowdown scenario. Holiday sales have been stronger than expected, based on data from Johnson-Redbook and Adobe Digital Insights. According to the Atlanta Fed’s GDPNow model, real GDP is on track to increase by 2.6% in the fourth quarter. Net exports and inventory destocking are expected to shave about half a percentage point off growth. This means that real final domestic demand is still growing at a healthy 3% pace. GDP growth could slow to about 2.5% next year as the fiscal impulse declines and the lagged effects from the recent tightening in financial conditions make their way through the economy. Nevertheless, given that most estimates peg potential growth at around 1.7%-to-1.8%, this should still be enough to push the unemployment rate towards 3% by the end of 2019, bringing it to the lowest level since the Korean War. This should keep price and wage inflation on an upward trajectory (Chart 7). Chart 7Does The Fed Like It Hot? The “dots” in the September Summary of Economic Projections foresaw one rate increase this December and three additional hikes next year. The market is currently pricing in only two hikes through to end-2019 and no hikes beyond then (Chart 8). If our baseline scenario for the U.S. economy unfolds as expected, the Fed will raise rates four times next year, which will keep the U.S. dollar well bid.  Chart 8The Market Does Not Buy The Dots Oil And The Global Economy: Why It Will Not Be As Bad This Time Around As in 2015, a key question today is how the recent drop in oil prices will affect both the U.S. and the global economy. Here there is some good news. The balance sheets of U.S. energy companies have improved markedly over the past few years. Rapid productivity has allowed shale producers to boost production to record levels without having to incur substantially higher costs. In fact, capital spending in the energy sector is far lower as a share of GDP today than it was in the lead-up to the 2015 shale bust (Chart 9). Chart 9Energy Sector Capex Is Far Below Its 2014 Peak Saudi Arabia’s reaction to the slide in oil prices is also likely to be different this time around. In 2015, the Saudis refrained from cutting output in the hope that this would undermine Iran and decimate the fledgling U.S. shale industry. In the end, the Iranian regime endured, and while U.S. production did fall temporarily, it quickly rebounded (Chart 10). Chart 10Who Won The Market Share War Of 2015? Going into September, the Saudis ramped up production after President Trump indicated his intent to tighten sanctions on Iranian oil exports. In the end, Trump declined to reimpose the sanctions. This left the market with a surfeit of crude. There is a limit to how much Saudi Arabia can cut output. Now that the stock market is well off its highs, President Trump has started to take credit for low oil prices. Nevertheless, the Saudis are keenly aware that they need crude to trade at about $83 per barrel just to balance their budget. Our geopolitical and energy strategists expect the Kingdom to cut production by enough to push up prices from current levels. Russia has also hinted at restraining supply. If U.S. producers fill part of the void created by Saudi and Russian production cutbacks, U.S. energy sector capital spending will hold up much better than it did in 2015. Provided that oil prices do not return all the way to their September highs, U.S. consumers will also benefit from an increase in spending power. Investment Conclusions We do not expect the global economy to weaken as much as it did in 2015. Nevertheless, most forward-looking economic indicators point to slower growth over the next few quarters (Chart 11). Global growth will likely bottom out by the middle of 2019, but until then, investors should continue to favor developed over emerging market stocks. They should also overweight defensive equity sectors, such as consumer staples and health care, relative to deep cyclicals, such as materials and industrials. Given sector skews, this implies a regional preference for the U.S. over Europe and Japan. Chart 11Global Growth Is Slowing As far as the near-term absolute direction of stocks is concerned, the equity score from our MacroQuant market-timing model has risen from its recent lows thanks to an improvement in sentiment/technical components. Nevertheless, the model is still pointing to heightened downside risks to global equities over the remainder of the year and into early 2019 due to slowing growth and the lagged effects of the recent tightening in financial conditions (Chart 12). Chart 12MacroQuant Equity Model* Score Is Off Its Lows, But Is Still Warning Of More Downside For Stocks Slower global growth and ongoing Fed rate hikes should keep the dollar well bid. Consistent with our qualitative analysis, our model is currently sending a very bullish signal on the greenback (Chart 13). We expect the DXY to reach 100 by early next year. Chart 13MacroQuant U.S. Dollar Model Is Pointing To Further Upside For The Greenback The model’s near-term outlook on bonds has improved greatly in recent weeks after having spent the better part of the last 18 months in bearish territory (Chart 14). To be clear, this is a tactical signal: The model’s cyclical fair-value estimate for the U.S. 10-year Treasury yield stands at 3.71% – 67 basis points above current levels – which implies that the 12-to-18 month path for yields remains to the upside (Chart 15). Nevertheless, with global growth slowing and lower energy prices dragging down inflation, there is a good chance that the 10-year yield will temporarily fall below 3% before resuming its structural uptrend. Chart 14MacroQuant Recommended Portfolio*: Tactically Favor Bonds Over Stocks   Chart 15MacroQuant U.S. Bond Model*: Treasury Yields Are Still Well Below Fair Value, But The Upside Is Capped Tactically Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Jerome H. Powell, “The Federal Reserve’s Framework for Monitoring Financial Stability,” Federal Reserve, November 28, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

OPEC 2.0’s meeting next week in Vienna once again will feature a full cast of dignitaries representing member states, including the energy ministers from the Kingdom of Saudi Arabia (KSA) and Russia, Khalid al-Falih and Alexander Novak. They have led the coalition since it was formed two years ago to halt a destructive oil-price collapse occasioned by the disastrous OPEC market-share war, which was launched at a similar gathering in November 2014. U.S. President Donald Trump will be present in Vienna, if only in spirit; and via Twitter, of course, continuing to press the oil exporters to maintain production at record high levels. We expect Trump’s demands to go unheeded. The leaders of OPEC 2.0 – and their bosses – likely will agree to production cuts in Buenos Aries at the G20 meeting starting tomorrow, which energy ministers will ratify in Vienna. If they don’t, the 30.2% decline in Brent since early October will mark a stopping-off point in a larger down move (Chart 1). Chart 1Another Price Collapse Looms, Without An OPEC 2.0 Production Cut Our 2019 Brent forecast remains at $82/bbl, with WTI $6/bbl lower. We expect OPEC 2.0 will agree to cut 1.0 – 1.4mm b/d of production, to undo the supply shock delivered via waivers on the U.S. export sanctions against Iran.1 Without production cuts our forecast will be lowered. Highlights Energy: Overweight. Canadian crude oil prices likely will remain depressed, as takeaway pipeline capacity remains fully booked and producers are forced to use expensive rail transport to move their barrels south (see below). The WCS – WTI differential recently traded close to -$50/bbl, due to pipeline constraints. Base Metals: Neutral. Zinc’s near-record physical-to-prompt futures backwardation remains close to recent highs, on the back of sharply lower stocks at the LME and SHFE. 2 Precious Metals: Neutral. Gold remains in the middle of the range it’s occupied since 2013, on either side of $1,225/oz going into the G20 meeting. Ags/Softs: Underweight. Soybeans recovered slightly ahead of the G20 meeting in Buenos Aries tomorrow. Markets will be watching for any sign of a thaw in the Sino – U.S. trade war. Feature Two years into the oil-price recovery, OPEC 2.0 member states continue to suffer from post-traumatic budget disorders (PTBD). The coalition’s leaders need higher prices, as do the rest of its members. KSA, Russia and the other OPEC 2.0 member states are coming off weak recoveries from the oil-price collapse of 2015 – 16. The oil price required to balance KSA’s budgetary obligations – its fiscal breakeven (FBE) price – averages $82.90/bbl this year and next, according to the IMF’s most recent estimates.3 If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. The Kingdom’s official reserves, which stand at ~ $495 billion by the IMF’s reckoning, have fallen by almost one-third versus their 2014 peak, as a result of the lingering effects of the oil-price collapse.4 The Kingdom needs higher prices to transition to a less oil-dependent economy, and to meet its budget obligations in the present. Lastly, if it ever hopes to IPO its state oil company, Aramco, to fund its diversification efforts, KSA will have to have higher prices. The Middle East oil exporters as a group (ex Libya and Yemen, which are failed states), also are especially vulnerable to another oil-price collapse. The IMF estimates that every $10/bbl reduction in oil prices translates into 3 percentage-point drop in these states’ GDPs, and spawns untoward economic ramifications – e.g., tightening financial conditions leading to asset-price corrections, deterioration of banks’ assets, and slower growth. 5 As for Russia, it only started recovering last year from the oil-price shock of 2015 – 16 and the imposition of Western sanctions following its annexation of Crimea. Prior to that, real wages fell precipitously, and the government was required to tighten fiscal and monetary policy to control inflation following the collapse of the rouble, when the central bank stopped defending it in the wake of falling oil prices. Real GDP fell 2.5% in 2015 and 0.2% in 2016, then grew at a 1.5% rate last year, which was below expectations, according to the IMF. Growth is expected to come in at 1.7% this year, although the recent collapse in oil prices and renewed tensions with Ukraine could temper this outlook.6 The IMF warned in its July 2018 assessment of the economy, that “structural constraints” – high levels of state control, economic concentration and regulation, weak institutions and infrastructure – and geopolitical tensions “raised uncertainty and dampened domestic and foreign private investment.” Against this backdrop, President Trump’s insistence upon keeping KSA’s and OPEC’s production higher to keep U.S. gasoline prices lower puts his “oil policy” directly in opposition to the interests of KSA and its Gulf allies. Even though Russia has geared its budget to withstand oil prices as low as $40/bbl, lower prices will impact it, albeit to a lesser extent than the Middle East OPEC states. These states are not alone in being disadvantaged by President Trump’s insistence on lower-for-longer oil prices. U.S. shale-oil producers, which are driving the country’s oil output surge, do not benefit from lower prices. WTI prices in the low-$50s – and West Texas Midland prices trading ~ $6/bbl below that, because of pipeline constraints in the Permian Basis – will reduce capex in the shales and imperil growth (Chart 2). Chart 2Bottlenecks Pressure Spreads In addition, the U.S. defense contractors, whose interest President Trump recently cited as his principal foreign policy driver when he was demanding higher OPEC production, know that without stronger oil prices, KSA will not be able to follow through on the $110+ billion of arms deals contained in various letters of intent signed last year during the president’s visit to the Kingdom.7 Net, we expect OPEC 2.0 to agree on production cuts of between 1.0mm and 1.4mm b/d at its December 6 meeting. In our balances modeling, to be conservative, we assume OPEC 2.0 (ex Libya, Nigeria and Venezuela) production next year will be 900k b/d below the peak reached this month (Chart 3). This, along with steady demand – we assume growth of 1.46mm b/d next year, which takes global demand over 101.6mm b/d next year – drives our $82/bbl forecast for Brent. We expect WTI to trade $6/bbl below Brent next year. Chart 3Lower OPEC 2.0 Production Expected In addition to the above assumptions, we also believe KSA and its Gulf allies will maintain their production cuts in 2H19, to make room for higher U.S. shale production once Permian Basin pipeline transportation is de-bottlenecked. With the exception of the 2014 – 16 price collapse, which resulted from the ill-fated market-share war launched by OPEC in an attempt to limit Iran’s revenues when it returned to export markets following the removal of export sanctions in 2015, OPEC’s modus operandi has been to reduce production to make room for non-OPEC production increases.8 Canada’s Takeaway Dilemma Unlike the Permian Basin, Canada’s takeaway bottlenecks – i.e., insufficient pipeline capacity to move all of the oil-sands crude it can produce south to the U.S. refining or Gulf Coast export market – are not likely to be resolved in the near future. This will reduce investment in oil-sands development, and keep pressure on oil producers selling their crude on a Western Canadian Select (WCS) basis, the Canadian benchmark. At present, there is a large takeaway deficit in the Western Canadian Sedimentary Basin (WCSB). Pipeline capacity has been maxed out since 2H17. There were five planned pipeline projects in the basin, four of which have been either cancelled or indefinitely delayed – i.e., the Trans Mountain Expansion, Northern Gateway, Energy Est and Keystone XL – while one is expected to be constructed in 4Q19 (i.e., the Line 3 Replacement). The outlook for pipeline capacity does not bode well for WCS prices. Since 2017, around 3mm b/d of needed pipeline infrastructure has been cancelled/delayed. The Enbridge Line 3 Replacement is expected to increase crude delivery to Superior, WI, in 4Q19, by ~ 370k b/d. Absent a major policy or court ruling U-turn, projected pipeline additions will be insufficient to cover Alberta’s growing oil sands surplus until 2022, and possibly beyond (Chart 4).9 Chart 4Expected Pipeline Additions In Canada Fall Short This persistent takeaway deficit pushed the WTI – WCS spread past the crude-by-rail cost range (Chart 5). This means prices are signaling the need for additional takeaway capacity – i.e., building additional pipeline, or importantly, additional trains/crews/rail infrastructure – and that production should be reduced. Chart 5WCS Differentials Signal More Takeaway, Less Production Is Required Our analysis of takeaway capacity in the WCSB leads us to believe investments in oil sands will be curtailed, which will lead to a slowdown in production starting in 2021 (Chart 6). According to IHS Markit, production growth this year and next is expected to come mainly from projects under construction before 2014. Capex is still low compared to pre-2014 levels (Chart 7). The current WTI – WCS spread should limit production growth to ~ 600k b/d between 2018 and ~ 2022. If, as we expect, the delayed pipelines are built in late 2021- early 2022, investment should start to rise again prior to this. Hence, production growth could resume close to 2022, or slightly thereafter. This is in line with the Canadian National Energy Board’s low-price scenario, in which oil production increases by 600k b/d from now to 2021, and plateau/declines afterward due to lack of investments. Chart 6Expect Lower Oil-Sands Capex Chart 7Capex Below Pre-2014 Levels The lack of pipeline takeaway capacity has forced crude producers to pay higher rates to move their oil out of the provinces via rail. In the short-term, this is a reasonable – although partial – solution. In theory, Saskatchewan and Alberta have enough loading-terminal capacity to transport all of the excess crude supply above pipeline capacity (Chart 8). Chart 8Takeaway Capacity Can Be Found However, loading-terminals are currently underutilized and shared with other commodities produced in the regions.10 Hence, crude-by-rail can only increase by: Taking capacity from other commodities currently using the rail cars, crews and locomotives. However, most of these substitute transportation modes are in already-agreed long- and medium term contracts with the railroad companies (Chart 9). Railroad companies are not willing to give away space paid for by grain shippers, which are long-term reliable customers – as opposed to uncertain crude-oil customers. Earlier this year, railroads said they would only pursue multi-year contracts with oil producers to finance new crews, locomotives, and track capacity: Short-term contracts are too risky, in the event oil shipments stop suddenly. This is ongoing; crude-by-rail volume should continue to rise through the end of the year, and part of next year.11 The fact that there is a low level of uncertainty around the lack of pipeline capacity for the next 3-4 years helps increase rail investments. Chart 9Railroads Make Grain Contracts First Priority Investing in new equipment, crews and infrastructures. The Alberta Government recently announced it wants the Federal government to invest in new rail cars and infrastructure to increase takeaway capacity by 120k to 140k b/d. However, those new rail cars are only projected to start moving oil in 2H19.12 We expect crude-by-rail volumes to increase in the next few months, but the growth should slow or even flatten in 1H19, given new capacity takes time to be brought on line and other commodities already have a claim on most of the rail space.13 Crude-by-rail growth should resume in 2H19, however. We expect crude-by-rail volume to reach ~ 300k b/d by year-end and ~ 450k b/d by 4Q19. This will help alleviate some of the pressure on WCS prices (Chart 10). The fact that no pipelines are expected in the next 3 years or so suggests the WCS discount to WTI will remain in the crude-by-rail price range shown in Chart 5 – i.e., a $15-to-$22/bbl discount over the quality discount for heavy sour crude vs. the light-sweet WTI benchmark.14 Chart 10Crude-by-rail Should Increase In 2H19 As bad as things sound for Canadian producers, there are two potentially important – and conflicting – regulatory and policy wildcards that could affect our projections. First the good news, then the bad news: Government-imposed production cuts: The current abnormally wide WCS spreads are caused by the marginal excess production above pipeline and rail capacity. We estimate this excess to be ~ 200k b/d. This means the marginal price received for producing these volumes sets the selling prices of the other ~ 4mm b/d produced in Canada by ~ $10-15/bbl. Therefore, as suggested by two leading Canadian oil producers, a relatively small government-imposed production reduction would have a large positive effect on WCS prices (Chart 11). As present, we assign a low probability to this outcome. Chart 11Government-Imposed Production Cut Would Lift Prices IMO 2020 regulation: The January 1, 2020, implementation of the International Maritime Organization’s (IMO’s) sulphur cap on marine fuels of 0.50% could contribute to widening the WCS price discount. A recent study by CERI concluded the new regulation would decrease prices of heavy sour crude, by driving down demand for these grades. This would significantly affect Canadian oil, as it competes with other heavy streams for limited complex refining capacity worldwide. According to CERI’s analysis, IMO 2020 regulation alone could maintain the differential at $31-33/bbl. We will be exploring the implications of IMO 2020 in future research. Bottom Line: Canada’s oil industry faces a Herculean lift if it is to attract capital to grow. Pipeline constraints limiting crude takeaway capacity to the south in the WCSB strongly suggest investment in oil sands will be curtailed, which will lead to a slowdown in production starting in 2021. Crude-by-rail is a palliative, which does not fully address the underlying transportation bottlenecks limiting the growth of the Canadian crude-oil industry.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Weekly Report “All Fall Down: Vertigo In The Oil Market … Lowering 2019 Brent Forecast To $82/bbl,” published November 15, 2018. It is available at ces.bcaresearch.com. 2     LME stocks are at 10-year lows, and the SHFE’s are just over 20% of their August levels. Please see “METALS – Zinc falls as weaker Chinese demand outweighs supply fears,” published by reuters.com November 26, 2018. 3      This assumes average crude-oil production of 10.1mm b/d by the IMF. Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018, Statistical Appendix Table 6. 4      Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018, Statistical Appendix Table 22. 5      Please see the IMF’s Regional Economic Outlook Update for the Middle East, North Africa, Afghanistan, and Pakistan, for May 2018 (p. 8). 6      The Russian seizure of Ukrainian ships and sailors earlier this week could prompt additional sanctions from the West. In its immediate aftermath, the ruble fell, credit-default insurance rates rose and the yield on local-currency bonds approached 9% p.a. Please see “Russian Assets Retreat as Ukraine Clash Revives Sanctions Risk,” published by bloomberg.com November 26, 2018. See also the IMF’s Country Report No. 18/275, Russian Federation, published in September 12, 2018, press release, and the full report published July 17, 2018. 7      Please see “In Trump’s Saudi Bargain, the Bottom Line Proudly Wins Out,” published by the nytimes.com October 14, 2018. 8      A failure by OPEC 2.0 to cut production and an extension of waivers on the Iran sanctions could add as much as 1.2mm b/d of oil to the market next year, which would renew the global inventory-building cycle and push Brent prices down by $20/bbl versus our forecasts, in our estimation. 9      Prior to the cancellation/delay by U.S. and Canadian Courts of the Kinder Morgan Trans Mountain and TransCanada Keystone XL pipeline projects – and before the record blow-out of the WTI – WCS basis – the Canadian Association of Petroleum Producers (CAPP) projected Canadian production would grow from 4.5mm b/d in 2018 to 6.1mm b/d in 2035. All of this growth is projected to come from the WCSB oil sands. On August 30, the Canadian Federal Court of Appeal ruled against the expansion of the Trans Mountain pipeline. The National Energy Board (NEB) now has to conduct a new review, which will require it to increase consultations with indigenous groups, and to assess the impact of marine shipping before submitting the project. On November 8, U.S. District Judge in Montana issued a ruling on the Keystone XL pipeline forcing the State Department to analyze new information in the environmental assessment of the project. The project is not cancelled, but it now needs a new environmental impact assessment. Please see the CAPP’s July report entitled 2018 Crude Oil Forecast. 10     Please see the CAPP’s July report entitled “2018 Crude Oil Forecast: Markets And Transportation,” for more details. 11     Cenovus signed three-year deals to transport approximately 100,000 barrels per day (bbls/d) of heavy crude oil from northern Alberta to the U.S. by rail. (https://www.cenovus.com/news/news-releases/2018/09-26-2018-cenovus-signs-rail-deals-to-transport-oil-to-u.s.-gulf-coast.html). GE Transportation announced CN ordered 60 new locomotives on top of an order of 200 made in December 2017 (http://trn.trains.com/news/news-wire/2018/09/05-cn-orders-60-locomotives-from-ge). 12     Please see “Desperate to move crude, Alberta may buy trains alone if Canada balks,” published November 22, 2018, by ca.reuters.com. The odds of the Federal government participating in this investment are low: First, the request wasn’t mentioned in the most recent Federal economic statement. Second, the Federal government already stepped in to buy the controversial Trans Mountain pipeline; Ottawa is now focused on making sure this will be approved in court challenges. 13     Both Canadian National and Canadian Pacific railroads mentioned their priority was to handle the Canadian grain harvest during the “challenging winter months” before allocating rail space to crude oil. Grains-to-oil rail space substitution should increase in spring 2019. http://trn.trains.com/news/news-wire/2018/11/14-cn-and-cp-expect-to-bring-on-even-more-crude-oil-traffic-next-year 14     The discount to get Canadian crude to Cushing, OK, where the NY Mercantile Exchange’s WTI futures contract delivers, can increase by $5/bbl for Gulf deliveries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed In 2018 Trades Closed in Summary of Trades Closed in 2017

  Underweight The S&P restaurants index has had an exceptional month, following surprisingly healthy results from both McDonalds and Starbucks, which collectively represent approximately 80% of the index. We think the move is short-sighted and we would be sellers into the strength. The positive results at these restauranteurs would typically be reflected in outsized forward earnings growth estimates. However, this is not the case; as shown in the second panel, estimates for the S&P restaurants index are falling behind the broad market. Given the index’s rise without a corresponding earnings lift, the valuation multiple has soared and is now at a level 50% higher than the market (third panel). Meanwhile, the index has been dining out on an unhealthy diet of debt and balance sheets are stretched to extreme levels (bottom panel). In the absence of an unlikely surge of cash flow, particularly given the headwinds an appreciating U.S. dollar represents, a painful cycle of belt-tightening lies ahead. Bottom Line: Tepid earnings growth, high valuations and bulging leverage are a recipe for stock price declines in the S&P restaurants index; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG.

Highlights On a 6-month horizon, go long a combination of banks and high quality 10-year bonds. The recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Stay short oil and gas versus financials. During December, use any sharp sell-offs in sterling to buy the pound… …and to downgrade the FTSE100 to underweight. Feature Chart of the WeekBanks And Bond Yields Were Connected At The Hip... Until This Year Back in June, in Oddities In The 1st Half, Opportunities In The 2nd Half we pointed out two striking oddities in financial market behaviour. One oddity was the sharp decoupling of crude oil from industrial commodity prices (Chart I-2). It is highly unusual for crude oil to outperform copper by 50 percent in the space of just six months. We argued that such an extreme deviation would have to correct one way or another. Which of course it did… Chart I-2Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled The other oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-3 and Chart of the Week). Bank equity prices and bond yields are usually connected at the hip. The tight connection exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart I-3Banks Decoupled From Bond Yields... But Will Recouple On the back of these two striking oddities, we recommended a compelling trade: short oil and gas versus financials. This trade is now in profit and has further to run, but today we want to introduce a new trade: go long a combination of banks and bonds. Explaining The Oddities Of 2018 The underperformance of banks from February through September was entirely consistent with similar underperformances in the other classically growth-sensitive sectors – industrials, and basic materials as well as the decline in industrial commodity prices (Chart I-4). Furthermore, these underperformances started well before any inkling of a trade war. This suggests that the cyclical sector underperformances were correctly reflecting a common or garden down-oscillation in global growth. Chart I-4Oil And Gas Was The Odd Man Out Oil was a striking oddity because its supply dynamics, rather than its demand dynamics, were dominating its price action, at one point lifting its year-on-year inflation rate to 70 percent for Brent and 80 percent for WTI. Part of this surge in year-on-year inflation was also to do with the ‘base effect’, the dip in the oil price to $45 in the summer of 2017. The base effect shouldn’t really bother markets. After all, most people do not consciously compare a price today with the price precisely a year ago. The problem is that central banks do compare a price today with the price precisely a year ago in their inflation targets. Clearly, when oil price inflation was running at 80 percent, it was underpinning headline CPI inflation, central bank reaction functions, and thereby bond yields. Hence, the two striking oddities – oil abruptly decoupling from industrial commodities (Chart I-5) and bond yields abruptly decoupling from banks – are two sides of the same coin. From February through September, bond yields were taking their cue, at least partly, from the rising price of oil, given its major impact on headline inflation and on central bank reaction functions. Whereas banks, industrials, and industrial commodity prices were taking their cue from fading global growth and industrial activity. Chart I-5It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months A Banks Plus Bonds Combination Could Be A Win-Win The oddities of 2018 are now correcting. With the oil price sharply lower, its year-on-year inflation rate has plunged to -10 percent (Chart I-6). Furthermore, as we have pointed out in recent reports, the sharp deceleration in global credit growth from February through September has clearly arrested and even reversed. The upshot is that banks and bond yields will recouple, one way or the other. Chart I-6Oil Inflation Down from 70% To -10% Most likely, global growth will rebound somewhat and the beaten-down bank equity prices have considerable scope for recovery (Chart I-7), while the restraint on headline CPI inflation will keep bond yields in check. Indeed, as President Trump recently tweeted: Chart I-7Global Growth Will Rebound, So Will Banks “Inflation down, are you listening Fed!” But if we are wrong and growth disappoints, bank equities are already beaten-down while a further downdraft in inflation will pull down bond yields. Either way, on a six month horizon a combination of banks and high quality 10-year bonds should be a win-win strategy. Given the different betas of the two investments, the recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Focus On Sectors And Currencies The remainder of this report is a reminder that successful macro investing requires the application of the Pareto Principle, also known as 80:20 rule. In macro investing, the vast majority of performance outcomes, ‘the 80’, are explained by a very small number of drivers, ‘the 20’. We find that the vast majority of a region’s or a country’s stock market relative performance is explained just by its distinguishing sector fingerprint combined with its currency (Chart I-8 - Chart I-12). Chart I-8Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-10FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars Chart I-11FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-12FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Major stock markets comprise of multinational companies whose sales and profits are internationally diversified. But each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table I-1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Table I-1Each Major Stock Market Has A Distinguishing Fingerprint The other important factor is the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In other words, BP’s global business is currency neutral. But BP’s stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. What does all of this mean for our European country allocation right now? From a sector perspective, a stance that is short oil and gas versus financials penalises the FTSE100 versus the Eurostoxx50, given the FTSE100’s oil and gas fingerprint and the Eurostoxx50’s banks fingerprint. Against this, a weakening pound would support the FTSE100. Given that Theresa May’s Brexit agreement will meet stiff resistance when it comes to Parliament in the second week of December, the point of maximum risk for the pound is still ahead of us. But as we argued last week, we ultimately expect relief for the pound as: either the Article 50 process is extended, or the U.K. moves into a transition period within a negotiated Brexit.1 Hence, during December, use any sharp sell-offs in sterling to buy the pound, and to downgrade the FTSE100 to underweight.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week we note that this year’s sell-off in Italian equities is technically very stretched. Therefore, in a continued de-escalation of the budget spat between Italy and the EU, Italian equities would be ripe for a strong countertrend burst of outperformance. On this basis, our recommended trade is long MIB versus the Eurostoxx with a profit target of 5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnote 1 Please see the European Investment Strategy Weekly Report “DM Versus EM, And Two European Psychodramas”, November 22, 2018 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-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Highlights So What? A trade deal is unlikely at the G20. Stay short CNY/USD. Why? The odds of a U.S.-China tariff ceasefire are around 30%-40%. Investors should see any ceasefire as a temporary reprieve. Stay neutral on Chinese equities. Expect a weaker CNY/USD. Fade any rally in U.S. China-exposed equities. In Taiwan, local elections do not herald a decline in geopolitical risk, which is elevated. Feature The scheduled meeting between U.S. President Donald Trump and Chinese President Xi Jinping on the sidelines of the G20 summit in Buenos Aires on December 1 has generated a fair amount of speculation that the trade war will be resolved or at least put on pause. A major de-escalation would bring some consolation to global equity markets that have fallen by 11% since their peak in late January, 2018, especially to Chinese and Asian cyclicals, which have fallen by 27% and 21% respectively over the same time period (Chart 1). Chart 1Desperate For Good News We are doubtful that the summit will cause a major positive catalyst for markets. Yes, it is tempting to think that President Trump could wrap up the whole trade war promptly, just as he wrapped up negotiations with Mexico and Canada in October. If President Xi could add a few sweeteners to concessions he has already made, then Trump could proclaim a “historic new deal” and roll back the tariffs. Equity markets would celebrate. The past year would seem like a bad dream. But this is all fantasy. U.S.-China relations have gotten worse every year since 2008 for a host of economic, political, military, and strategic reasons. Is the current stock market selloff really enough to force Trump into a major capitulation, given that trade tensions were not the primary cause either of the October correction or of the earlier pullback in February? And is Xi really going to make significant concessions with Trump holding bigger threats over his head? We admit that some kind of improvement is plausible – say, a tariff ceasefire and an agreement to launch a new round of talks. We attach a 30%-40% subjective probability to such a scenario. But our base case – which is driven as always by structural factors – is that the summit will turn out to be a flop and the trade war will escalate in 2019. How Likely Is A Tariff Ceasefire? Presidential summits can have major consequences, but context is everything. Trump’s impending meeting with President Xi will be the third since he took office. The first two – in April and November 2017 – did not prevent the trade war. Neither did high-level negotiations in May 2018, which produced a “trade truce” that did not last a week. However, much has changed since then: the U.S. has imposed tariffs on half of Chinese imports, while China has suffered a bear market and some signs of domestic economic stress (Chart 2). Chart 2Signs Of Economic Weakness Over the past month, some developments suggest that the U.S. and China are managing their strategic tensions a bit better than they were earlier this year. Tensions peaked in early October, when the U.S. imposed sanctions on China’s People’s Liberation Army for purchasing Russian Sukhoi-25 jets and S400 surface-to-air missiles, under a law designed to punish Russia for meddling in the U.S.’s 2016 election. Meanwhile CNN reported that the U.S. military was considering staging a “global show of force” in November, a show that would have included sensitive operations in the Taiwan Strait and South China Sea. Since then, however, positive signs have emerged: Presidents Trump and Xi confirmed their meeting at the G20 in Buenos Aires. The two sides have exchanged letters and will bring trade negotiators to the summit, making it at least possible for substantive work to be done. Various preparatory discussions have been held, including a phone call between Treasury Secretary Steve Mnuchin and top Chinese economic adviser and negotiator, Vice Premier Liu He. Beijing offered to hold military-to-military talks that it had previously canceled between Defense Minister Wei Fenghe and Secretary of Defense James Mattis. The two officials met in Singapore and in Washington for the second round of the U.S.-China Diplomatic and Security Dialogue. The U.S. and China tentatively agreed to a multilateral protocol for avoiding accidental encounters by military aircraft, supplementing a similar agreement covering unplanned encounters at sea.1 Treasury Secretary Mnuchin met with People’s Bank of China Governor Yi Gang on the sidelines of the World Bank’s annual meeting in Bali, Indonesia in October, and afterwards refrained from accusing China of currency manipulation in the Treasury’s biannual foreign exchange report. Director of the National Trade Council Peter Navarro, a fierce trade hawk on China, is reportedly not attending the G20 summit. National Economic Adviser Larry Kudlow publicly chastised Navarro for criticizing the new negotiations as a Wall Street capitulation to China.2 This piece of anecdotal evidence has captured the imagination of sell-side analysts and many of our clients. These developments, in addition to Trump’s positive tweets on the subject, suggest that both China and the U.S. are trying to step back from the brink and accomplish something at the upcoming summit. However, there are many reasons to take these developments with a grain of salt: China is negotiating under duress: In statements over the past month, and reiterated by President Trump as we go to press, the U.S. has warned that if the G20 summit does not go well, it will ratchet up the pressure. In early December, it might move forward with the third round of threatened tariffs, covering the remaining $267 billion in imports from China. On December 19, the U.S. Department of Commerce will conclude consultations on whether to impose new export controls on “emerging technologies.” And on January 1, 2019, the existing tariff rate on $200 billion worth of imports (the second round) is supposed to rise from 10% to 25%, which implies that a third round of tariffs would eventually have the same rate. Indeed, since the confirmation of the G20 summit, the U.S. has imposed sanctions on Chinese technology companies like Fujian Jinhua. It has also begun implementing a new law strengthening the Committee for Foreign Investment in the United States and its foreign investment reviews, which already mostly target China (Chart 3). Chart 3Rising Scrutiny Of Chinese Investment Further, the U.S. has taken the occasion in the recent military and diplomatic dialogue to demand, for the first time ever, that China remove its missile systems from the Spratly Islands in the South China Sea.3 Some of these moves can be read as evidence that the U.S. will impose penalties for various grievances even if China agrees to some of its key trade demands. The demands on the South China Sea and arms purchases, for instance, will stand even if China makes major concessions on key trade issues like technology acquisition. At minimum, the above details suggest that Xi Jinping will be negotiating with a sword over his head and thus may refuse to make concessions on principle, despite the negative impact on China’s stock market and export sector (Chart 4). Chart 4The Impending Tariff Impact Leaks from the negotiations do not suggest any breakthroughs: China’s written response to Trump’s letter reportedly contains no new, significant trade concessions.4 U.S. Trade Representative Robert Lighthizer, the sine qua non of any trade deal, has issued a hawkish report on the eve of the summit arguing that China has not substantively changed any of the trade practices that prompted the tariffs so far.5 The report, an update to his initial Section 301 report, makes grave accusations about China’s use of cyber theft and corporate espionage over the past year alone, in addition to earlier years. These activities go far beyond trade disputes and clearly affect national security: a tariff freeze is hardly possible without substantial commitments by China to rein in these operations. Lighthizer also argues that China’s trade concessions so far are merely “incremental” and in several cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies (Chart 5), but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 6). Chart 5China’s High-Tech Protectionism Chart 6More High-Tech Protectionism Lighthizer further claims that China’s state-backed investment campaign in Silicon Valley continues despite a headline reduction in capital flight to the United States. And he also presents evidence that the full range of U.S. government agencies as well as the U.S.’s major allies are observing the same malicious or abusive practices from China and share the U.S.’s concerns. As for China hawk Navarro – who is far less important than Lighthizer to trade negotiations – his status today is not worse than it was in 2017, when his office was subordinated to that of former National Economic Council Director Gary Cohn. Of course, Cohn got fired, while Navarro’s office was upgraded and his pro-tariff argument won out. Trump’s olive branch is suspicious: Trump and his administration adopted friendly rhetoric during the lead-up to the midterm election, when it might have been desirable to show “progress” in the trade negotiations. It would have been impossible to engineer credible signs of progress without genuinely engaging the Chinese. Now, however, the midterms are over and there is no pressing political need for Trump to agree to a deal. Many of our clients – and almost all broker research – believe that Trump has a financial need to agree to a deal – i.e. to calm the stock market. However, there are two problems with this thesis. First, it is not clear that stock performance has had any relationship with President Trump’s approval rating (Chart 7). Chart 7Trump No Slave To Stock Market Second, both of the U.S. stock market pullbacks this year were catalyzed by sharp rises in treasury yields, not disruptive news on the trade front (Chart 8). As such, positive news about the trade war will yield only a passing relief rally in the United States. Chart 8Yields, Not Trade, Drive U.S. Selloff On this basis, we doubt that President Trump will agree to a hurried, watered-down trade deal that the Democrats will slam as a “giveaway” to China for the remaining two years of his presidency. With the U.S. economy fired up, the trade deficit is likely to widen regardless of tariffs (Chart 9), rendering any weak Trump-China deal a humiliation. Chart 9Trade Deficit To Rise Despite Tariffs However, while a trade deal is out of reach, there is a logic to suspending further tariff impositions: Trump may wish to disperse the negative impact of the trade tariffs over a longer period of time. This would give him room to try to settle a very tricky trade agreement before the 2020 election. Then, if the talks succeed, he can present himself as a great dealmaker. If the talks fail, he has all the more ammunition to launch a third round of tariffs. (And on this time frame, the effects of the third round would not be felt by consumers until after the election.) Xi, for his part, may wish to “lock in” Trump with concessions today rather than wait to see how aggressive Trump will become as 2020 draws near. True, Xi cannot afford to “lose face” by capitulating abjectly. But he is the dictator of a regime that has full control of the media; he will be able to suppress domestic criticism of his concessions. In fact, the most insidious criticism of Xi is that he flouted the maxims of both Sun Tzu and Deng Xiaoping by provoking the wrath of China’s greatest enemy prematurely. Thus, if he stays Trump’s hand on tariffs in exchange for a new round of talks or minor concessions, then he comes out of Buenos Aires looking okay. The reason we put this ceasefire scenario at only 30%-40% probability is that we still do not see Trump as heavily constrained by the trade war. His greatest constraint is political and works against a trade deal: it comes from the Democrats, whose protectionist candidates performed very well in the midterm election in the Rust Belt states that are critical for Trump’s reelection (Table 1). Table 1Massive Republican Losses Across The Midwest Economically, our assessment is that the selloff in U.S. financial markets is a correction, not a bear market, and that there is no sign that the U.S. economy is likely to slip into recession (Chart 10). Trump is constrained by the unemployment rate, not by the stock market alone. As long as Trump shares this assessment, he will not be lulled into a politically damaging capitulation to China. Chart 10No Sign Of Recession Yet Also, Xi will fear that difficult concessions will encourage Washington to continue what Chinese government officials have called “trade bullyism,” i.e. using coercive measures and upping its demands. In other words, the main argument for a tariff ceasefire is that Trump might simply prefer one to boost the stock market and thus may accept few or no concessions. And that preference is not enough to change our baseline view in light of his political constraints. Bottom Line: There is no basis for a resolution of the trade war at present, but there is a basis for a tariff ceasefire and a new effort at trade negotiations. Still, it is not our base case. Xi has good reason not to make major concessions under duress and Trump does not want to get outflanked by his political opponents by freezing tariffs without major Chinese concessions. Do Presidential Summits Matter? Have presidential summits between the U.S. and China ever brought about major breakthroughs? Yes, but not since the Great Recession. As Table 2 demonstrates, looking at 50 U.S.-China leadership summits since 1972, only 18 qualify as true “green light” summits in which the outcome was a concrete improvement in relations over the period before the next summit – and 10 of these were during the first decade of the 2000s, the heyday of “Chinamerica,” when China and Emerging Market economies roared ahead while George W. Bush courted China’s cooperation on terrorism and North Korea. Table 2U.S.-China Leaders Summits: A Chronology Only eight summits mark truly historic positive inflection points: Nixon 1972, Carter 1979, Reagan 1984, Clinton 1997, Clinton 2000, Bush 2002, Bush 2005, and arguably Obama 2009. Since 2009, under four different leaders (two from each country), Sino-American relations have categorically worsened. Moreover, both President Obama’s and President Trump’s major meetings with President Xi, at the Sunnylands estate in California in 2013 and at the Mar-a-Lago resort in Florida in 2017, saw much fanfare at the time but were followed by a significant deterioration in relations. Indeed, the Obama administration launched a more aggressive China policy in September 2015, including freedom of navigation operations in disputed areas of the South China Sea. This was after President Xi declared that China “does not intend to pursue militarization” of the Spratly Islands – a statement that American officials have repeatedly cited when arguing that China’s foreign policy is increasingly aggressive and that China is not following through with diplomatic promises. Investors should focus not on the Trump-Xi summit on December 1 but rather on the two governments’ actions afterwards. The substance of any positive outcome will depend, in particular, on whether Trump indicates that he will proceed with the tariff rate hike on January 1, 2019 and/or the initiation of a third round of tariffs covering the remainder of U.S. imports from China.6 Bottom Line: History does not give reason for optimism about the summit – especially not recent history, in which heavily hyped summits have not been able to arrest the secular decline in U.S.-China cooperation due to underlying strategic distrust. Investment Implications The primary driver of the recent selloff in global risk assets is not the trade war but the divergence between U.S. and Chinese economic policy writ large. The U.S. economy continues to support the case for Fed normalization, while China’s stimulus continues to disappoint. The result is a double whammy for commodity prices and EM assets as the dollar strengthens and exports of resources and capital goods to China soften (Chart 11). Chart 11A Bad Combination For EM Given that China’s December Central Economic Work Conference will likely reinforce the message of greater policy support, and that China tends to frontload new credit expansion in the beginning of the year (Chart 12), it is entirely possible that a rally in global risk assets on the back of positive trade news in late November could gain traction in December and the New Year. BCA’s Geopolitical Strategy will continue to hedge against the risk of substantial reflation in China by means of our Foreign Exchange Strategy’s long “China Play Index” trade (Chart 13). Chart 12China May See A Q1 Credit Spike Chart 13Monitoring The Risk To Our View Fundamentally, however, we would view a December-January rally as a short-term movement that is not worth playing. We expect the Xi administration to remain disciplined in its use of stimulus measures, for the purposes of economic restructuring. Ever worsening trade tensions give Xi the option of blaming the American administration for the economic pain incurred due to his reform agenda. Therefore we think global divergence can persist, which is positive for the dollar and USD/CNY exchange rate. While acknowledging the potential for a near-term rally, we remain neutral Chinese stocks relative to their global counterparts over a 6-12 month horizon and continue to favor low-beta stocks within the Chinese equity universe. We also remain neutral on Taiwanese equities. The ruling Democratic Progressive Party’s (DPP) loss in local elections on November 24 was severe (Chart 14), though not unexpected. The election result does not change Geopolitical Strategy’s view that Taiwan faces heightened geopolitical risk. Chart 14Taiwanese Voters Seek More Conciliatory Approach To Beijing Indeed, the election suggests that the Tsai Ing-wen administration may only have 14 months remaining in power, and hence that it will try rapidly to finalize some material improvement in the U.S.-Taiwan relationship. Since the Trump administration will also try to exploit this closing window of opportunity, the potential is rising for a controversy to erupt over diplomatic or military relations. This could prompt a negative, market-relevant reaction from Beijing. It is also too soon to bottom-fish within the tech sector in China and the U.S., and we remain pessimistic about the earnings outlook for companies exposed to the U.S.-China trade relationship.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      While these agreements do not ensure collisions will not occur, given the USS Decatur incident earlier this year, they are at least a sign of coordination. 2      Navarro had said the following at a speech at the Center for Strategic and International Studies: “Consider the shuttle diplomacy that’s now going on by a self-appointed group of Wall Street bankers and hedge fund managers between the U.S. and China. As part of a Chinese government influence operation, these globalist billionaires are putting a full-court press on the White House in advance of the G-20 in Argentina. The mission of these unregistered foreign agents – that’s what they are; they’re unregistered foreign agents – is to pressure this president into some kind of deal.” Please see “Economic Security as National Security: A Discussion with Dr. Peter Navarro,” CSIS, November 13, 2018, available at www.csis.org. 3      Please see U.S. Department of State, “U.S.-China Diplomatic and Security Dialogue,” November 9, 2018, available at www.state.gov.   For the proposed export controls, open for public comment until December 19, 2018, please see U.S. Department of Commerce, “Review of Controls for Certain Emerging Technologies,” Bureau of Industry and Security, November 19, 2018, available at www.bis.doc.gov. 4      Please see Jeff Mason and David Shepardson, “Exclusive: China sends written response to U.S. trade reform demands - U.S. government sources,” Reuters, November 14, 2018, available at www.reuters.com. 5      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at https://ustr.gov/ 6      It is very unlikely, but perhaps not impossible, that China would accept a ceasefire that allows the January 1 tariff hike to go forward but forswears the third round of tariffs on the remaining Chinese imports.