Elections

Highlights The U.S. and China are moving toward formalizing a trade ceasefire that reduces geopolitical risk in the near term. The risk of a no-deal Brexit is finished – removing a major downside to European assets. Spanish elections reinforce our narrative of general European political stability. Go long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Geopolitical risks will remain elevated in Turkey, rise in Russia, but remain subdued in Brazil. A post-mortem of Canada’s election suggests upside to fiscal spending but further downside to energy sector investment over the short to medium term. Feature After a brief spike in trade war-related geopolitical risk just prior to the resumption of U.S.-China negotiations, President Trump staged a tactical retreat in the trade war. Chart 1Proxy For Trade War Shows Falling Risk Negotiating in Washington, President Trump personally visited the top Chinese negotiator Liu He and the two sides announced an informal “phase one deal” to reverse the summer’s escalation in tensions: China will buy $40-$50 billion in U.S. agricultural goods while the U.S. will delay the October 15 tariff hike. More difficult issues – forced tech transfer, intellectual property theft, industrial subsidies – were punted to later. The RMB is up 0.7% and our own measures of trade war-related risk have dropped off sharply (Chart 1). We think these indicators will be confirmed and Trump’s retreat will continue – as long as he has a chance to save the 2020 economic outlook and his reelection campaign. Odds are low that Trump will be removed from office by a Republican-controlled senate – the looming election provides the republic with an obvious recourse for Trump’s alleged misdeeds. However, Trump’s approval rating is headed south. While it is around the same level as President Obama’s at this point in his first term, Obama’s started a steep and steady rise around now and ended above 50% for the election, a level that is difficult to foresee for Trump (Chart 2). So Trump desperately needs an economic boost and a policy victory to push up his numbers. Short of passing the USMCA, which is in the hands of the House Democrats, a deal with China is the only way to get a major economic and political win at the same time. Hence the odds of Presidents Trump and Xi actually signing some kind of agreement are the highest they have been since April (when we had them pegged at 50/50). Trump will have to delay the December 15 tariff hike and probably roll back some of the tariffs over next year as continuing talks “make progress,” though we doubt he will remove restrictions on tech companies like Huawei. Still, we strongly believe that what is coming is a détente rather than the conclusion of the Sino-American rivalry crowned with a Bilateral Trade Agreement. Strategic tensions are rising on a secular basis between the two countries. These tensions could still nix Trump’s flagrantly short-term deal-making, and they virtually ensure that some form of trade war will resume in 2021 or 2022, if indeed a ceasefire is maintained in 2020. Both sides are willing to reduce immediate economic pain but neither side wants to lose face politically. Trump will not forge a “grand compromise.” Our highest conviction view all along has been – and remains – that Trump will not forge a “grand compromise” ushering in a new period of U.S.-China economic reengagement in the medium or long term. China’s compliance, its implementation of structural changes, will be slow or lacking and difficult to verify at least until the 2020 verdict is in. This means policy uncertainty will linger and business confidence and capex intentions will only improve on the margin, not skyrocket upward (Chart 3). Chart 2Trump Needs A Policy Win And Economic Boost Chart 3Sentiment Will Improve ... Somewhat The problem for bullish investors is that even if global trade uncertainty falls, and the dollar’s strength eases, fear will shift from geopolitics to politics, and from international equities to American equities (Chart 4). Trump, hit by impeachment and an explosive reaction to his Syria policy, is entering into dangerous territory for the 2020 race. Trump’s domestic weakness threatens imminent equity volatility for two reasons. Chart 4American Outperformance Falls With Trade Tensions Chart 5Democratic Win In 2020 Is Market-Negative First, if Trump’s approval rating falls below today’s 42%, investors will begin pricing a Democratic victory in 2020, i.e. higher domestic policy uncertainty, higher taxes, and the re-regulation of the American economy (Chart 5). This re-rating may be temporarily delayed or mitigated by the fact that former Vice President Joe Biden is still leading the Democratic Party’s primary election race. Biden is a known quantity whose policies would simply restore the Obama-era status quo, which is only marginally market-negative. Contrary to our expectations Biden's polling has not broken down due to accusations of foul play in Ukraine and China. Nevertheless, Senator Elizabeth Warren will gradually suck votes away from fellow progressive Senator Bernie Sanders and in doing so remain neck-and-neck with Biden (Chart 6). When and if she pulls ahead of Biden, markets face a much greater negative catalyst. (Yes, she is also capable of beating Trump, especially if his polling remains as weak as it is.) Chart 6Warren Will Rise To Front-Runner Status With Biden Second, if Trump becomes a “lame duck” he will eventually reverse the trade retreat above and turn into a loose cannon in his final months in office. Right now we see a decline in geopolitical risk, but if the economy fails to rebound or the China ceasefire offers little support, then Trump will at some point conclude that his only chance at reelection is to double down on his confrontation with America’s enemies and run as a “war president.” A cold war crisis with China, or a military confrontation with Iran (or North Korea, Venezuela, or some unexpected target) could occur. But since September we have been confirmed in believing that Trump is trying to be the dealmaker one last time before any shift to the war president. Bottom Line: The “phase one” trade deal is really just a short-term ceasefire. Assuming it is signed by Trump and Xi, it suggests no increase in tariffs and some tariff rollback next year. However, as recessionary fears fade, and if Trump’s reelection chances stabilize, U.S.-China tensions on a range of issues will revive – and there is no getting around the longer-term conflict between the two powers. For this and other reasons, we remain strategically short RMB-USD, as the flimsy ceasefire will only briefly see RMB appreciation. BoJo's Brexit Bluff Is Finished Our U.K. indicator captured a sharp decline in political risk in the past two weeks and our continental European indicators mirrored this move (Chart 7). The risk that the U.K. would fall out of the EU without a withdrawal agreement has collapsed even further than in September, when parliament rejected Prime Minister Boris Johnson’s no-deal gambit and we went long GBP-USD. We have since added a long GBP-JPY trade. Chart 7Collapse In No-Deal Risk Will Echo Across Europe Chart 8Unlikely To See Another Tory/Brexit Rally Like This The risk of “no deal” is the only reason to care about Brexit from a macro point of view, as the difference between “soft Brexit” and “no Brexit” is not globally relevant. What matters is the threat of a supply-side shock to Europe when it is already on the verge of recession. With this risk removed, sentiment can begin to recover (and Trump’s trade retreat also confirms our base case that he will not impose tariffs on European cars on November 14). Since Brexit was the only major remaining European political risk, European policy uncertainty will continue to fall. The Halloween deadline was averted because the EU, on the brink of recession, offered a surprising concession to Johnson, enabling him to agree to a deal and put it up for a vote in parliament. The deal consists of keeping Northern Ireland in the European Customs Union but not the whole of the U.K., effectively drawing a new soft border at the Irish Sea. The bill passed the second reading but parliament paused before finalizing it, rejecting Johnson’s rapid three-day time table. The takeaway is that even if an impending election returns Johnson to power, he will seek to pass his deal rather than pull the U.K. out without a deal. This further lowers the odds of a no-deal Brexit as it illuminates Johnson's preferences, which are normally hidden from objective analysis. True, there is a chance that the no-deal option will reemerge if Johnson’s deal totally collapses due to parliamentary amendments, or if the U.K. and EU have failed to agree to a future relationship by the end of the transition period on December 31, 2020 (which can be extended until the end of 2022). However, the chance is well below the 30% which we deemed as the peak risk of no-deal back in August. Johnson created the most credible threat of a no-deal exit that we are likely to see in our lifetimes – a government with authority over foreign policy determined to execute the outcome of a popular referendum – and yet parliament stopped it dead in its tracks. Johnson does not want a no-deal recession and his successors will not want one either. After all, the support for Brexit and for the Tories has generally declined since the referendum, and the Tories are making a comeback on the prospect of an orderly Brexit (Chart 8). All eyes will now turn toward the impending election. Opinion polls still show that Johnson is likely to be returned to power (Chart 9). The Tories have a prospect of engrossing the pro-Brexit vote while the anti-Brexit opposition stands divided. No-deal risk only reemerges if the Conservatives are returned to power with another weak coalition that paralyzes parliament. Chart 9Tory Comeback As BoJo Gets A Deal Chart 10Brexit Means Greater Fiscal Policy Whatever the election result, we maintain our long-held position that Brexit portends greater fiscal largesse (Chart 10). The agitated swath of England that drove the referendum result will not be assuaged by leaving the European Union – the rewards of Brexit are not material but philosophical, so material grievances will return. Voter frustration will rotate from the EU to domestic political elites. Voters will demand more government support for social concerns. Johnson’s own government confirms this point through its budget proposals. A Labour-led government would oversee an even more dramatic fiscal shift. Our GeoRisk indicator will fall on Brexit improvements but the question of the election and next government will ensure it does not fall too far. Our long GBP trades are tactical and we expect volatility to remain elevated. But the greatest risk, of no deal, is finished, so it does make sense for investors with a long time horizon to go strategically long the pound. The greatest risk, of a no deal Brexit, is finished. Bottom Line: Brexit posed a risk to the global economy only insofar as it proved disorderly. A withdrawal agreement by definition smooths the process. Continental Europe will not suffer a further shock to net exports. The Brexit contribution to global policy uncertainty will abate. The pound will rise against the euro and yen and even against the dollar as long as Trump’s trade retreat continues. Spain: Further Evidence Of European Stability We have long argued that the majority of Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 11). This month’s protests in Barcelona following the Catalan independence leaders’ sentencing are at the lower historical range in terms of size – protest participation peaked in 2015 along with support for independence (Table 1). Table 1October Catalan Protests Unimpressive Our Spanish risk indicator is showing a decline in political risk (Chart 12). However, we believe that this fall is slightly overstated. While the Catalan independence movement is losing its momentum, the ongoing protests are having an impact on seat projections for the upcoming election.  Chart 11Catalonians Not Demanding Independence Chart 12Right-Wing Win Could Surprise Market, But No Worries Since the April election, the right-wing bloc of the People’s Party, Ciudadanos, and Vox has been gaining in the seat projections at the expense of the Socialist Party and Podemos. Over the course of the protests, the left-wing parties’ lead over the right-wing parties has narrowed from seven seats to one (Chart 13). If this momentum continues, a change of government from left-wing to right-wing becomes likely. However, a right-wing government is not a market-negative outcome, and any increase in risk on this sort of election surprise would be short-lived. The People’s Party has moderated its message and focused on the economy. Besides pledging to limit the personal tax rate to 40% and corporate tax rate to 20%, the People’s Party platform supports innovation, R&D spending, and startups. The party is promising tax breaks and easier immigration rules to firms and employees pursuing these objectives. Chart 13Spanish Right-Wing Parties Narrow Gap With Left Another outcome of the election would be a governing deal between PSOE and Podemos, along with case-by-case support from Ciudadanos. After a shift to the right lost Ciudadanos 5% in support since the April election, leader Albert Rivera announced in early October that he would be lifting the “veto” on working with the Socialist Party. If the right-wing parties fall short of a majority, then Rivera would be open to talks with Socialist leader Pedro Sanchez. A governing deal between PSOE, Podemos, and Ciudadanos would have 175 seats, as of the latest projections, which is just one seat short of a majority. As we go to press, this is the only outcome that would end Spain’s current political gridlock, and would therefore be the most market-positive outcome. Bottom Line: Despite having a fourth election in as many years, Spanish political risk is contained. This is reinforced by a relatively politically stable backdrop in continental Europe, and marginally positive developments in the U.K. and on the trade front. We remain long European versus U.S. technology, and long EU versus Chinese equities. We will also be looking to go long EUR/USD when and if the global hard data turn. Following our European Investment Strategy, we recommend going long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Turkey, Brazil, And Russia Chart 14Turkish Risk Will Rise Despite 'Ceasefire' Turkey’s political risk skyrocketed upward after we issued our warning in September (Chart 14). We maintain that the Trump-Erdogan personal relationship is not a basis for optimism regarding Turkey’s evading U.S. sanctions. Both chambers of the U.S. Congress are preparing a more stringent set of sanctions, focusing on the Turkish military, in the wake of Trump’s decision to withdraw U.S. forces from northeast Syria. At a time when Trump needs allies in the senate to defend him against eventual impeachment articles, he is not likely to veto and risk an override. Moreover, Turkey’s military incursion into Syria, which may wax and wane, stems from economic and political weakness at home and will eventually exacerbate that weakness by fueling the growing opposition to Erdogan’s administration and requiring more unorthodox monetary and fiscal accommodation. It reinforces our bearish outlook on Turkish lira and assets. Chart 15Brazilian Risk Will Not Re-Test 2018 Highs Brazil’s political risk has rebounded (Chart 15). The Senate has virtually passed the pension reform bill, as expected, which raises the official retirement age for men and women to 65 and 63 respectively. This will generate upwards of 800 billion Brazilian real in savings to improve the public debt profile. Of course, the country will still run primary deficits and thus the public debt-to-GDP ratio will still rise. Now the question shifts to President Jair Bolsonaro and his governing coalition. Bolsonaro’s approval rating has ticked up as we expected (Chart 16). If this continues then it is bullish for Brazil because it suggests that he will be able to keep his coalition together. But investors should not get ahead of themselves. Bolsonaro is not an inherently pro-market leader, there is no guarantee that he will remain disciplined in pursuing pro-productivity reforms, and there is a substantial risk that his coalition will fray without pension reform as a shared goal (at least until markets riot and push the coalition back together). Therefore we expect political risk to abate only temporarily, if at all, before new trouble emerges. Furthermore, if reform momentum wanes next year, then Brazil’s reform story as a whole will falter, since electoral considerations emerge in 2021-22. Hence it will be important to verify that policymakers make progress on reforms to tax and trade policy early next year. Our Russian geopolitical risk indicator is also lifting off of its bottom (see Appendix). This makes sense given Russia’s expanding strategic role (particularly in the Middle East), its domestic political troubles, and the risks of the U.S. election. The latter is especially significant given the risk (not our base case, however) that a Democratic administration could take a significantly more aggressive posture toward Russia. Political risk in Turkey and Russia will continue to rise. Bottom Line: Political risk in Turkey and Russia will continue to rise. Russia is a candidate for a “black swan” event, given the eerie quiet that has prevailed as Putin devotes his fourth term to reducing domestic political instability. Brazil, on the other hand, has a 12-month window in which reform momentum can be reinforced, reducing whatever spike in risk occurs in the aftermath of the ruling coalition’s completion of pension reform. Canada: Election Post-Mortem Prime Minister Justin Trudeau returned to power at the head of a minority government in Canada’s federal election (Chart 17). The New Democratic Party (NDP) lost 15 seats from the last election, but will have a greater role in parliament as the Liberals will need its support to pass key agenda items (and a formal governing coalition is possible). The NDP’s result would have been even worse if not for its last-minute surge in the polls after the election debates and Trudeau’s “blackface” scandal. Chart 17Liberals Need The New Democrats Now The Conservative Party won the popular vote but only 121 seats in parliament, leaving the western provinces of Alberta and Saskatchewan aggrieved. The Bloc Québécois, the Quebec nationalist party, gained 22 seats to become the third-largest party in the House. Energy investment faces headwinds in the near-term. The Liberal Party will face resistance from the Left over the Trans Mountain pipeline. Trudeau will not necessarily have to sacrifice the pipeline to appease the NDP. He may be able to work with Conservatives to advance the pipeline while working with the NDP on the rest of his agenda. But on the whole the election result is the worst-case scenario for the oil sector and political questions will have to be resolved before Canada can take advantage of its position as a heavy crude producer near the U.S. Gulf refineries in an era in which Venezuela is collapsing and Saudi Arabia is exposed to geopolitical risk and attacks. More broadly, the Liberals will continue to endorse a more expansive fiscal policy than expected, given Canada’s low budget deficits and the need to prevent minor parties from eating away at the Liberal Party’s seat count in future. Bottom Line: The Liberal Party failed to maintain its single-party majority. Trudeau’s reliance on left-wing parties in parliament may prove market-negative for the Canadian energy sector, though that is not a forgone conclusion. Over the longer term the sector has a brighter future.   Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Appendix GeoRisk Indicator U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: GeoRisk Indicator Canada: GeoRisk Indicator Russia: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar

Highlights The investors we met last week were ready to hear some good news: The constructive story we told across three days of client meetings is more sanguine than the consensus view, but clients were open to considering it. Global economic weakness and the elevated risk of a U.S. recession were primary concerns, … : As our Global Investment Strategy colleagues have suggested, it will take some time for investors to be convinced that global manufacturing really has seen the bottom and that the U.S. isn’t flirting with a recession. … followed by trade tensions and corporate indebtedness, … : Our small sample suggests that investors may have become de-sensitized to the daily ebb and flow of the U.S.-China conflict, though we continue to believe it looms large in the minds of corporate managements. … but nothing matches the anxiety provoked by Elizabeth Warren’s ascent: Every client asked about the potential consequences of a Warren White House. Feature We spent most of last week meeting with a subset of wealth management and family office clients. They are more focused on absolute returns than relative returns, but their primary concerns are nearly identical to their relative-return peers’. Our meetings touched on a broad constellation of questions about the fate of the expansion, the equity bull market, global growth and the U.S.-China trade negotiations. Clients also asked about the credit outlook and if inflation should be on their radar, but the topic that they raised with the most fervor, in every single one of our meetings, was the prospect of a Warren or Sanders presidency. Q: What is the bond market telling us? We think of the bond market as having two distinct components, rates (Treasuries) and credit (spread product). We have gotten used to regular retracements in the 10-year Treasury yield since it bottomed in July 2016, but watching it melt from 3.25% last November to 1.5% this August has challenged our constructive take on the U.S. economy. Falling yields are not necessarily signaling imminent economic trouble, however, so we continue to hold the view that a recession won’t occur before late 2021 or early 2022. We see this year’s falling Treasury yields as a coincident reflection of decelerating growth, not a harbinger of a recession. On a purely domestic basis, the principal driver of the decline in yields has been the shift in monetary policy expectations. The Fed’s dovish pivot did not occur in a vacuum, of course. Clear signs of decelerating growth set the stage for easier policy, both here and abroad. Whether or not the Fed was always calling the tune, all three step-function declines in 12-month forward fed funds rate expectations occurred as it was guiding markets to expect easier policy: ahead of the March FOMC meeting, when Fed speakers began warning of the danger of inflation expectations becoming unanchored on the downside; in May, when they were busily preparing the ground for a rate cut; and after the July meeting raised the prospect that the July cut would not be a one-off event (Chart 1). Chart 1The Fed's Dovish Pivot, ... Sovereign rates are not entirely determined domestically, and much of the softness in Treasury yields reflects the softness in yields in the rest of the world. So far this year, 10-year sovereign yields have moved in lockstep on either side of the Atlantic (Chart 2), preserving no-arbitrage conditions in currency-hedged Treasuries, gilts and bunds. Crude prices are another global variable, and their decline has weighed on inflation break-even rates (Chart 3), dampening the inflation compensation demanded by Treasury buyers. From a rates perspective, we think the bond market is telling us that global growth has slowed, central banks have taken monetary accommodation up a notch, and oil prices have slid. That’s not exactly an ideal growth backdrop, but it hardly spells the end of the expansion. Chart 2... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower The credit market concurs. It doesn’t betray a whit of concern that the expansion is in trouble. Spreads quickly unwound last year’s fourth-quarter spike, and have since hung around their post-crisis lows (Chart 4). Non-financial corporations have become more indebted throughout the expansion, but servicing the debt is not at all onerous with yields at rock-bottom levels (Chart 5). Our U.S. Bond Strategy service’s proprietary corporate health monitor is signaling that corporate balance sheets have weakened (Chart 6, third panel), but the other elements required for a meaningful widening of spreads – a completed monetary tightening cycle1 (Chart 6, second panel), and a tightening of lending standards (Chart 6, bottom panel) – are not yet in place. Chart 3Falling Oil Prices Have Smothered Inflation Worries Chart 4Spreads Are Tight, ...   Chart 5... And Debt Service Is Easy Q: Isn’t it time to reduce credit exposures? Tight spreads may be a contrarian warning sign. Though it is sensible to shift some of a company’s financing burden to debt when it is so much cheaper than equity, combining a larger debt burden with degraded covenant protections is a concern. Low interest rates will keep debt service costs from chafing, and help keep defaults in check for now, but the bond market is increasingly vulnerable. Chart 6Spread Widening Conditions Aren't Yet In Place Chart 7Income Investors Need Not Apply Despite that vulnerability, when the next default cycle arrives, it will not have anywhere near the impact of the housing bust because it will deal no more than a glancing blow to the banks. Single-family homes collateralize the American banking system; corporate bonds are held by a diffuse assortment of unlevered players. It stinks for any unlevered investor when it loses money, but it doesn’t cause much of a ripple in the overall economy. Today’s buildup in corporate borrowing is not analogous to 2006-7’s residential mortgage Superfund site, and suggestions to the contrary are ill-founded. Elevated corporate leverage is a vulnerability, but it is not enough for an investor to identify a vulnerability; s/he also has to identify the catalyst that will cause it to snap. Nonfinancial corporate debt levels are a fissure that has been made longer by debauched covenants. Markets won’t suffer until the fissure lengthens and widens enough to turn into a crack that no investor can ignore. It is our view that easy monetary conditions will keep the fissure out of sight and out of mind for several months at least. Defaults only occur when a borrower is unable to refinance its maturing obligations. As long as there is at least one lender willing to extend new credit at manageable terms, the borrower won’t go bust. The current monetary policy backdrop, featuring zero/negative interest rate policy in much of the major economies, all but ensures a steady supply of willing lenders. Life insurers, pension funds and endowments with a need for income to offset fixed liabilities have been forced out the risk curve to source income sufficient to meet them (Chart 7). The net result has been to provide even wobbly credits offering an incremental 50 or 75 basis points with a line of would-be lenders out the door and around the corner. The global manufacturing sector has already succumbed to recession, but stout performance in the service sector has allowed developed economies to keep expanding. The weakest credits will not find lifelines, but plenty of dubious ones will. The current ultra-loose monetary policy environment is simply not a backdrop in which defaults pick up in earnest. Until central banks get a little less prodigal, the marginal lender won’t become more selective, the plates will keep spinning, and spread product will continue to generate excess returns over cash and Treasuries. Q: Things look worse outside the U.S. What’s your global growth outlook? Chart 8Manufacturing May Be Bottoming, ... The global manufacturing sector is in recession, but the overall global economy is not (Chart 8). A manufacturing recession does not necessarily lead to a full-blown recession, and the ongoing expansion in developed economies’ much larger service sector provides a formidable bulwark against manufacturing’s struggles (Chart 9). While it is too early to conclude if or when global activity will accelerate, our global leading economic indicator, and the diffusion index that leads it, suggest that it is in the process of bottoming (Chart 10). Chart 9... And Services May Have Stopped Decelerating ... Chart 10... If Leading Indicators Have Found A Footing Chart 11From Headwind To Tailwind Our China Investment Strategy team sees scope for Chinese growth to gather some steam in the first quarter of 2020, when local governments will be freed from the budget constraints imposed by Beijing through the end of this year. In the meantime, September money and credit growth topped expectations, and policymakers have been undertaking modest stimulus measures like trimming bank reserve requirement ratios. Changes in Chinese credit growth lead changes in global growth (Chart 11), via China’s credit-reliant import channel. Its imports are Europe’s, Japan’s, Asian EMs’, and Australia’s, Brazil’s and Chile’s exports. As their exports rise, so too does their aggregate demand, giving rise to a self-reinforcing virtuous circle. Q: What would President Warren mean for markets? Investors’ concerns about a Warren presidency are surely justified; Senator Warren has openly, and often gleefully, expressed hostility for banks, defense contractors, drug companies, oil companies engaged in fracking, and big tech. That’s quite a list, and it accounts for a considerable share of S&P 500 market capitalization. It is fair to say that a Warren administration would be unfriendly to equity investors, but there are several points to keep in mind before liquidating one’s portfolio and fleeing the country. It’s too early to award her the Democratic nomination. In October 2007, the smart money was certain that Hillary Clinton had already locked up a berth in the finals against the eventual Republican nominee. Very few Americans could have named the freshman senator from Illinois, known for little more than a well-received speech at the 2004 convention, but he became President Obama. A lot could still happen between now and the Iowa caucuses on February 3rd. Unseating an incumbent president is a tall order. As long as the economy does not enter a recession between now and next November, and the administration can achieve a policy victory without suffering a high-profile policy failure, our Geopolitical Strategy colleagues argue that Trump should be the presumed winner of the 2020 election. Their presumption applies no matter who captures the Democratic nomination, even as the U.S. electorate is shifting to the left over time (Chart 12). Transforming Washington is easier said than done. The framers designed the federal government to be fairly resistant to sweeping change. The Electoral College tamps down popular passions in the presidential election, and Congress and the courts limit the power of the executive branch. Administrations with majorities in the House and Senate routinely find themselves with less freedom than they would like, especially after they exhaust political capital achieving one major legislative initiative (as with the Obama Administration and the Affordable Care Act). Even if the Democrats ride President Warren’s coattails to control over Capitol Hill next November, legislators from conservative or swing districts and states will balk at her entire suite of proposals. Chart 12Democratic Voters Are Leaning More Left Investment Implications Our sunnier view of the global economic outlook translates into more constructive equity allocations across global regions and blocs. The BCA house view recommends equal weight allocations to Emerging Markets and the Eurozone within global equity portfolios across tactical (0-3-month) and cyclical (3-12-month) timeframes. We expect to upgrade EM and Eurozone equities to overweight, and downgrade U.S. equities from overweight, across those timeframes once global growth begins to accelerate. We would also favor higher-beta currencies versus the dollar, and limit or avoid exposure to lower-beta currencies like the yen or the Swiss franc, if the data are poised to validate our base-case growth scenario. BCA’s recommendations have become especially data dependent because global investors seem to be firmly ensconced in “show-me” mode. It has been our sense as a firm, supported by the impression we got from last week’s meetings, that investors are reluctant to give growth prospects, and risk assets, the benefit of the doubt. Ground down by trade-related tweets, and skeptical that the latest wave of extraordinary monetary policy measures will have a perceptible impact on growth or inflation, they want to see definitive evidence of a turn before they’ll adjust their portfolio positioning to accommodate it. The wariness is also a reflection of the conflicting signals issued late in the business cycle and the elevated levels of geopolitical uncertainty. If the global economy turns as we think it soon will, global investors should be prepared to add cyclical exposures to their portfolios, even if Elizabeth Warren solidifies her current status as the front-runner for the Democratic nomination. That sense of wariness keeps us recommending benchmark duration exposure in fixed income portfolios over the 0-to-3-month tactical timeframe, though we have little appetite for interest-rate exposure looking out beyond the near term, and are below-benchmark duration over the 3-to-12-month cyclical and greater-than-12-month strategic timeframes. We still like spread product over the full 12-month horizon, as we expect stronger growth will make viable U.S. corporations better credits and that ZIRP/NIRP will continue to protect some of the rest. We endorse the house view that relative U.S. equity returns may slow, but global growth should give a boost to absolute equity returns, and we continue to recommend that investors remain at least equal weight equities in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 We are in accord with Chair Powell’s stated view that the rate cuts are mid-cycle cuts, not the beginning of a new easing cycle.

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits   Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Chart 12Oil Price Constrains U.S. Policy Toward Iran An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.

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

Highlights President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention.   Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: GeoRisk Indicator Russia: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar

Following drone attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) over the weekend, which removed ~ 5.7mm b/d of output, the U.S. is likely to conduct a limited retaliatory strike. In addition, the U.S. will continue to build up forces in the Persian Gulf to deter Iran and prepare for a larger response if necessary. After this initial response, the Trump administration will likely seek to contain tensions, as neither Trump nor the United States has an immediate interest in launching a large-scale conflict with Iran. But that does not mean that one will not happen – indeed, the odds are now higher that this risk could materialize. If the oil-price shock caused by these attacks becomes prolonged and unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the negative impact on the global and U.S. economy will grow. Faced with a recession – which is not our base case but is possible – the incentive for Trump to engage war with Iran will rise sharply. Attack On KSA Will Prompt U.S. Retaliation If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions. Over the weekend, Houthi rebels in Yemen claimed responsibility for attacks on two critical oil assets in Saudi Arabia, removing ~ 5.5% of world crude output – a historic shock to global oil supply, and the largest unplanned outage ever recorded (Chart 1).1 U.S. Secretary of State Mike Pompeo accused Iran of being behind the attacks and said there was no evidence that Houthis launched them from Yemen. As we go to press, neither Saudi Arabian officials nor President Trump have confirmed Iran was the culprit, although the sophistication of the attack’s targeting and execution suggest that they will. President Trump said the U.S. is “locked and loaded depending on verification” and offered U.S. support to KSA in a call to Crown Prince Mohammad Bin Salman.2 Chart 1Oil Supply Disruption + Volume Lost A direct missile strike from Iran is the least likely source, as the Iranians have sought to act through proxies this year, in staging attacks to counter U.S. sanctions, precisely in order to maintain plausible deniability and avoid provoking a full-blown American retaliation. If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions, relative to a situation where militant groups in Iraq or Yemen (or even in Saudi Arabia) are found to be responsible. Assuming the strike came from outside Iran, the U.S. and Saudi Arabia would presumably retaliate against its proxies in those locations – e.g., the Houthis in Yemen, or the Shia militias in Iraq. Washington is certain to dial up its military deterrent in the region and use the attacks to gain greater worldwide support for a tighter enforcement of sanctions to isolate Iran. This deterrence includes a multinational naval fleet in the Strait of Hormuz, at the entrance to the Gulf, where ~ 20% of the world’s crude oil supply transits daily. Electoral Constraints Facing Trump There are several reasons President Trump will not rush to a full-scale conflict with Iran. First, the attack did not kill U.S. troops or civilians. Miraculously, not even a single casualty is reported in Saudi Arabia. Yet, unlike the Iranian shooting of an American drone, which nearly brought Trump to launch air strikes on June 21, the latest attack clearly impacted critical infrastructure in a way that threatens global stability, making it more likely that some retaliation will occur. Second, Trump faces a significant electoral constraint from high oil prices. True, the U.S. economy is not as exposed to oil imports as it was (Chart 2). Also, global oil producers and strategic reserves including the U.S. Strategic Petroleum Reserve (SPR) can handle the immediate short-term loss from KSA (Chart 3). However, the duration of the cut-off is unknown and further disruptions will occur if the U.S. retaliates and Iranian-backed forces attack yet again. Third, there is still a chance to show restraint in retaliation, contain tensions over the coming months, limit oil supply loss and price spikes, and thus keep an oil-price shock from tanking the U.S. economy. Chart 2U.S. Imports Continue Falling But as tensions escalate in the short term, they could hit a point of no return at which the economic damage becomes so severe that President Trump can no longer seek re-election based on his economic record (Chart 4). At that point the incentive is to confront Iran directly – and run in 2020 as a “war president” intent on achieving long-term national security interests despite short-term economic pain. Chart 3Key SPRs Are Still Adequate Chart 4An Oil Price Shock Lowers Trump's Re-Election Chances U.S.’s Volatile Attempt At Diplomacy What triggered the attack and what does it say about the U.S. and Iranian positions going forward? Ever since Trump backed away from air strikes in June, he has become more inclined to de-escalate the conflict he began with Iran by withdrawing from the 2015 Joint Comprehensive Plan of Action (JCPOA), designating the Islamic Revolutionary Guard Corps (IRGC) as terrorists, and imposing crippling sanctions to bring Iran’s oil exports to zero. Even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions. What prompted this backtracking was Iran’s demonstration of a higher pain threshold than Trump expected. President Hassan Rouhani, and his Foreign Minister Javad Zarif, were personally invested in the 2015 nuclear deal with the Obama administration, which they negotiated despite grave warnings from the regime’s conservative factions that they would be betrayed. Trump’s reneging on that deal confirmed their opponents’ expectations, while his sanctions have sent the economy into a crushing recession (Chart 5). Chart 5U.S. Sanctions Hammer Iran's Economy With Iranian parliamentary elections in February 2020, and a consequential presidential election in 2021 in which Rouhani will seek to support a political ally, the Rouhani administration needed to respond forcefully to Trump’s sanctions. Iran staged several provocations in the Strait of Hormuz to warn the U.S. against stringent sanctions enforcement (Map 1). And recently, even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions, a very high bar for talks. Map 1Abqaiq Is At The Very Core Of Global Oil Supply Realizing the large appetite for conflict in Tehran, and the ability to sustain sanctions and use proxy warfare damaging global oil supply, Trump took a step back – he withheld air strikes in late June, discussed a diplomatic path forward with French President Emmanuel Macron, and subsequently fired his National Security Adviser John Bolton, a known war hawk on Iran who helped mastermind the return to sanctions. The proximate cause of Bolton’s ouster was reportedly a disagreement about sanctions relief that would have been designed to enable a meeting with Rouhani at the United Nations General Assembly next week. Such a summit could possibly have led to a return to the pre-2017 U.S.-Iran détente. If Trump had compromised, Iran could have gone back to observing the 2015 nuclear pact provisions, which it has only gradually and carefully violated. Moreover the French proposal to convince Iran to rejoin talks by offering a $15 billion credit line for sanctions relief was gaining traction. Apparently these recent moves toward diplomacy posed a threat to various actors in the region that benefit from U.S.-Iran conflict and sanctions. Hardliners in Iran want to weaken the Rouhani administration and prevent further Rouhani-led negotiations (i.e. “surrender”) to American pressure. On August 29, three days after Rouhani hinted that he might still be willing to talk with Trump, Supreme Leader Ayatollah Ali Khamenei’s weekly publication warned that “negotiations with the U.S. are definitely out of the question.”3 The IRGC and others continue to benefit from black market activity fueled by sanctions. And Iranian overseas militant proxies have their own reasons to fear a return to U.S.-Iran détente. Saudi Arabia and Israel also worry that President Trump will follow in President Obama’s footsteps with Iran and strategic withdrawal from the Middle East, which has considerable popular support in the United States (Chart 6). Both the Saudis and Israelis have been emboldened by the Trump administration’s support and have expanded their regional military targeting of Iranian-backed forces, prompting Iranian pushback. The hard-line factions know that a full-fledged American attack would be devastating to Iranian missile, radar, and energy facilities and armed forces. The Iranians remember the devastating impact on their navy from Operation Praying Mantis in 1988. But with the Trump administration’s “maximum pressure” sanctions cutting oil exports nearly to zero, Iran’s economy is getting strangled and militant forces may feel they have no choice. Chart 6Americans Do Not Support War With Iran Moreover Trump’s electoral constraint – his need to make deals in order to achieve foreign policy victories and lift his weak approval ratings ahead of the election – means that foreign enemies have the ability to drive up the price of a deal. This is what the Iranians just did. But negotiations may be impossible now before 2020. Rouhani may be forced to play the hawk, Supreme Leader Khamenei is opposed to talks, and the hard-line faction is apparently willing to court conflict with America to consolidate its power ahead of the dangerous and uncertain period that awaits the regime in the near future, when Khamenei’s inevitable succession occurs. Bottom Line: We argued in May that the risk of U.S. war with Iran stood as high as 22%, on a conservative estimate of the conditional probability that the U.S. would engage in strikes if Iran restarted its nuclear program outside of the provisions of the JCPOA. Recent events make the risk even higher. This does not mean that Rouhani and Trump cannot make bold diplomatic moves to contain tensions, but that the risk of widening conflict is immediate. Supply Risk Will Remain Front And Center The risk to supply made manifest in these drone attacks will remain with markets for the foreseeable future. They highlight the vulnerability of supply in the Gulf region, and, importantly, the now-limited availability of spare capacity to offset unplanned production outages. There’s ~ 3.2mm b/d of spare capacity available to the market, by the International Energy Agency’s reckoning, some 2mm b/d or so of which is in KSA (Chart 7). These drone attacks highlight the need to risk-adjust this spare capacity. When the infrastructure needed to deliver it to markets comes under attack, its availability must be adjusted downward. Chart 7Limited Availability Of Spare Capacity To Offset Outages Chart 8Commercial Inventories Will Draw ... In the immediate aftermath of the temporary loss of ~ 5.7mm b/d of KSA crude production to the drone attacks, we expect commercial inventories to be drawn down hard, particularly in the U.S., where refiners likely will look to increase product exports to meet export demand (Chart 8). This will backwardate forward crude oil and product curves – i.e., promptly delivered oil will trade at a higher price than oil delivered in the future (Chart 9). Chart 9... Deepening Forward-Curve Backwardations We expect the U.S. SPR to monitor this evolution closely. It is near impossible to handicap the level of commercial inventories – or backwardation – that will trigger the U.S. SPR release, given the unknown length of the KSA output loss, however. Worth noting is the fact that U.S. crude-export capacity is limited to ~ 1mm b/d of additional capacity. Thus, the SPR cannot be directly exported to cover the entire loss of KSA barrels. Other members of OPEC 2.0 will be hard-pressed to lift light-sweet exports, which, combined with constraints on U.S. export capacity, mean the light-sweet crude oil market could tighten. Interestingly, these attacks come as the U.S. has been selling down its SPR. The sales to date have been to support modernization of the SPR, but, for a while now, the Trump administration has been signalling it no longer believes they are critical to U.S. security. That likely changes with these events. The EIA estimates net crude-oil imports in the U.S. are running at 3.4mm b/d. The SPR is estimated at 645mm barrels. There are 416mm barrels of commercial crude inventories in the U.S., giving ~ 1.06 billion barrels of crude oil in the SPR and commercial inventory in the U.S. This translates into about 312 days of inventory in the U.S. when measured in terms of net crude imports. China has been building its SPR, which we estimated at ~ 510mm barrels. As a rough calculation using only China imports of ~ 10mm b/d, and production of ~ 3.9mm b/d, net crude-oil imports are probably around 6mm b/d. With SPR of ~ 510mm barrels, the public SPR (i.e., state-operated stocks) equates to roughly 85 days of imports.4 Members of the IEA – for the most part OECD states – are required to have 90 days of oil consumption on hand. The IEA estimates its SPR totals 1.54 billion barrels, which consists of crude oil and refined products. Together, the IEA’s SPRs plus spare capacity likely could cover the loss of KSA’s crude exports, but the timing and coordination of these releases will be tested. KSA has ~ 190mm b/d of crude oil in storage as of June, the latest data available from the Joint Organizations Data Initiative (JODI) Oil World Database. If the 5.7mm b/d of output removed from the market by these oil attacks persists, these stocks would be exhausted in 33 days. Based on press reports, repairs to the KSA infrastructure will take weeks – perhaps months – which means the longer it takes to repair these facilities the tighter the global oil market will become. This is exacerbated if additional pipelines or infrastructure in KSA come under attack or are damaged. Critical Next Steps How the U.S. follows up Pompeo’s accusations against Iran will be critical. The next steps here are critical: Tactically, the Houthis or other Iranian proxies could continue with drone attacks aimed at KSA infrastructure. They’ve obviously figured out how to target Abqaiq, which is the lynchpin of KSA’s crude export system (desulfurization facilities there process most of the crude put on the water in the Eastern province). The Abqaiq facility has been hardened against attack, but these attacks show the supporting infrastructure remains vulnerable. In addition, militants could target KSA’s western operations on the Red Sea, which include pipelines and refineries. The Bab el-Mandeb Strait at the bottom of the Red Sea empties into the Arabia Sea. More than half the 6.2mm b/d of crude oil, condensates and refined-product shipments transiting the strait daily are destined for Europe, according to the U.S. EIA.5 In addition, the 750-mile East-West pipeline running across KSA terminates on the Red Sea at Yanbu. The Kingdom is planning to increase export capacity off the pipeline from 5mm b/d to 7mm b/d, a project that will take some two years to complete.6 During a July visit to India, former Energy Minister Khalid al-Falih stated importers of Saudi crude and products, “have to do what they have to do to protect their own energy shipments because Saudi Arabia cannot take that on its own.” On top of all this, Iran could ramp up its threats to shipping through the Strait of Hormuz once again. These actions could put the risk to supply into sharp relief in very short order. Even Iranian rhetoric will have a larger impact in this environment. In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage. How the U.S. follows up Pompeo’s accusations against Iran will be critical. Whether the deal being brokered with France – and the $15 billion oil-for-money loan from the U.S. that goes with it – is now DOA, or is put on a fast track to reduce tensions in the region will be telling. It is entirely possible the U.S. launches an attack on Yemen to take out these drone bases and to neutralize the threat there. If Iraq is identified as the source of the attacks, the U.S., along with Iraqi forces, likely would stage a special-forces operation to take out the bases used to launch the drone attacks. The U.S. has significant forces in theater right now: The U.S. 5th Fleet is in Bahrain, with the Abe Lincoln aircraft carrier and its strike force on station at the Strait of Hormuz; and the USS Boxer Amphibious Ready Group (ARG) and 11th Marine Expeditionary Unit (MEU) are on patrol in the Red Sea under the command of the U.S. 5th Fleet (Map 2). In addition, the U.S. also deployed B52s earlier this year to Qatar to have this capability in theater. Map 2U.S. Navy Carrier Battle Group Disposition, 9 September 2019 Bottom Line: In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage that removed 5.7mm b/d of crude-processing capacity from the market and damaged one Saudi Arabia’s largest oil fields. We expect the U.S. will conduct a limited retaliatory strike, and will continue to build up forces in the Persian Gulf to prepare for a larger response if necessary. While neither President Trump nor the United States has an immediate interest in a large-scale conflict with Iran, the risk of such an outcome has increased. If the oil-price shock caused by these attacks becomes unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the risk of recession increases. While this is not our base case, it could push Trump to adopt a “war president” strategy going into the U.S. general election next year.   Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil field, which produces close to 2mm b/d, were attacked on Saturday, September 14, 2019.  Since then, press reports claim the attack could have originated in Iraq or Iran, and could have included cruise missiles – a major escalation in operations in the region involving Iran, KSA and their respective allies – in addition to drones.  Please see Suspicions Rise That Saudi Oil Attack Came From Outside Yemen, published by The Wall Street Journal September 14, 2019. 2      Please see "Houthi Drone Strikes Disrupt Almost Half Of Saudi Oil Exports", published September 14, 2019, by National Public Radio (U.S.). 3      See Omer Carmi, "Is Iran Negotiating Its Way To Negotiations?" Policy Watch 3172, The Washington Institute, August 30, 2019, available at www.washingtoninstitute.org. 4      China is targeting ~500mm bbls by 2020, and is aiming to have 90 days of import oil cover in its SPR. 5      Please see The Bab el-Mandeb Strait is a strategic route for oil and natural gas shipments, published by the EIA August 27, 2019. 6      Please see "Saudi Arabia aims to expand pipeline to reduce oil exports via Gulf," published by reuters.com July 25, 2019.

Special Report

Following drone attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) over the weekend, which removed ~ 5.7mm b/d of output, the U.S. is likely to conduct a limited retaliatory strike. In addition, the U.S. will continue to build up forces in the Persian Gulf to deter Iran and prepare for a larger response if necessary. After this initial response, the Trump administration will likely seek to contain tensions, as neither Trump nor the United States has an immediate interest in launching a large-scale conflict with Iran. But that does not mean that one will not happen – indeed, the odds are now higher that this risk could materialize. If the oil-price shock caused by these attacks becomes prolonged and unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the negative impact on the global and U.S. economy will grow. Faced with a recession – which is not our base case but is possible – the incentive for Trump to engage war with Iran will rise sharply. Attack On KSA Will Prompt U.S. Retaliation If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions. Over the weekend, Houthi rebels in Yemen claimed responsibility for attacks on two critical oil assets in Saudi Arabia, removing ~ 5.5% of world crude output – a historic shock to global oil supply, and the largest unplanned outage ever recorded (Chart 1).1 U.S. Secretary of State Mike Pompeo accused Iran of being behind the attacks and said there was no evidence that Houthis launched them from Yemen. As we go to press, neither Saudi Arabian officials nor President Trump have confirmed Iran was the culprit, although the sophistication of the attack’s targeting and execution suggest that they will. President Trump said the U.S. is “locked and loaded depending on verification” and offered U.S. support to KSA in a call to Crown Prince Mohammad Bin Salman.2 Chart 1Oil Supply Disruption + Volume Lost A direct missile strike from Iran is the least likely source, as the Iranians have sought to act through proxies this year, in staging attacks to counter U.S. sanctions, precisely in order to maintain plausible deniability and avoid provoking a full-blown American retaliation. If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions, relative to a situation where militant groups in Iraq or Yemen (or even in Saudi Arabia) are found to be responsible. Assuming the strike came from outside Iran, the U.S. and Saudi Arabia would presumably retaliate against its proxies in those locations – e.g., the Houthis in Yemen, or the Shia militias in Iraq. Washington is certain to dial up its military deterrent in the region and use the attacks to gain greater worldwide support for a tighter enforcement of sanctions to isolate Iran. This deterrence includes a multinational naval fleet in the Strait of Hormuz, at the entrance to the Gulf, where ~ 20% of the world’s crude oil supply transits daily. Electoral Constraints Facing Trump There are several reasons President Trump will not rush to a full-scale conflict with Iran. First, the attack did not kill U.S. troops or civilians. Miraculously, not even a single casualty is reported in Saudi Arabia. Yet, unlike the Iranian shooting of an American drone, which nearly brought Trump to launch air strikes on June 21, the latest attack clearly impacted critical infrastructure in a way that threatens global stability, making it more likely that some retaliation will occur. Second, Trump faces a significant electoral constraint from high oil prices. True, the U.S. economy is not as exposed to oil imports as it was (Chart 2). Also, global oil producers and strategic reserves including the U.S. Strategic Petroleum Reserve (SPR) can handle the immediate short-term loss from KSA (Chart 3). However, the duration of the cut-off is unknown and further disruptions will occur if the U.S. retaliates and Iranian-backed forces attack yet again. Third, there is still a chance to show restraint in retaliation, contain tensions over the coming months, limit oil supply loss and price spikes, and thus keep an oil-price shock from tanking the U.S. economy. Chart 2U.S. Imports Continue Falling But as tensions escalate in the short term, they could hit a point of no return at which the economic damage becomes so severe that President Trump can no longer seek re-election based on his economic record (Chart 4). At that point the incentive is to confront Iran directly – and run in 2020 as a “war president” intent on achieving long-term national security interests despite short-term economic pain. Chart 3Key SPRs Are Still Adequate Chart 4An Oil Price Shock Lowers Trump's Re-Election Chances U.S.’s Volatile Attempt At Diplomacy What triggered the attack and what does it say about the U.S. and Iranian positions going forward? Ever since Trump backed away from air strikes in June, he has become more inclined to de-escalate the conflict he began with Iran by withdrawing from the 2015 Joint Comprehensive Plan of Action (JCPOA), designating the Islamic Revolutionary Guard Corps (IRGC) as terrorists, and imposing crippling sanctions to bring Iran’s oil exports to zero. Even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions. What prompted this backtracking was Iran’s demonstration of a higher pain threshold than Trump expected. President Hassan Rouhani, and his Foreign Minister Javad Zarif, were personally invested in the 2015 nuclear deal with the Obama administration, which they negotiated despite grave warnings from the regime’s conservative factions that they would be betrayed. Trump’s reneging on that deal confirmed their opponents’ expectations, while his sanctions have sent the economy into a crushing recession (Chart 5). Chart 5U.S. Sanctions Hammer Iran's Economy With Iranian parliamentary elections in February 2020, and a consequential presidential election in 2021 in which Rouhani will seek to support a political ally, the Rouhani administration needed to respond forcefully to Trump’s sanctions. Iran staged several provocations in the Strait of Hormuz to warn the U.S. against stringent sanctions enforcement (Map 1). And recently, even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions, a very high bar for talks. Map 1Abqaiq Is At The Very Core Of Global Oil Supply Realizing the large appetite for conflict in Tehran, and the ability to sustain sanctions and use proxy warfare damaging global oil supply, Trump took a step back – he withheld air strikes in late June, discussed a diplomatic path forward with French President Emmanuel Macron, and subsequently fired his National Security Adviser John Bolton, a known war hawk on Iran who helped mastermind the return to sanctions. The proximate cause of Bolton’s ouster was reportedly a disagreement about sanctions relief that would have been designed to enable a meeting with Rouhani at the United Nations General Assembly next week. Such a summit could possibly have led to a return to the pre-2017 U.S.-Iran détente. If Trump had compromised, Iran could have gone back to observing the 2015 nuclear pact provisions, which it has only gradually and carefully violated. Moreover the French proposal to convince Iran to rejoin talks by offering a $15 billion credit line for sanctions relief was gaining traction. Apparently these recent moves toward diplomacy posed a threat to various actors in the region that benefit from U.S.-Iran conflict and sanctions. Hardliners in Iran want to weaken the Rouhani administration and prevent further Rouhani-led negotiations (i.e. “surrender”) to American pressure. On August 29, three days after Rouhani hinted that he might still be willing to talk with Trump, Supreme Leader Ayatollah Ali Khamenei’s weekly publication warned that “negotiations with the U.S. are definitely out of the question.”3 The IRGC and others continue to benefit from black market activity fueled by sanctions. And Iranian overseas militant proxies have their own reasons to fear a return to U.S.-Iran détente. Saudi Arabia and Israel also worry that President Trump will follow in President Obama’s footsteps with Iran and strategic withdrawal from the Middle East, which has considerable popular support in the United States (Chart 6). Both the Saudis and Israelis have been emboldened by the Trump administration’s support and have expanded their regional military targeting of Iranian-backed forces, prompting Iranian pushback. The hard-line factions know that a full-fledged American attack would be devastating to Iranian missile, radar, and energy facilities and armed forces. The Iranians remember the devastating impact on their navy from Operation Praying Mantis in 1988. But with the Trump administration’s “maximum pressure” sanctions cutting oil exports nearly to zero, Iran’s economy is getting strangled and militant forces may feel they have no choice. Chart 6Americans Do Not Support War With Iran Moreover Trump’s electoral constraint – his need to make deals in order to achieve foreign policy victories and lift his weak approval ratings ahead of the election – means that foreign enemies have the ability to drive up the price of a deal. This is what the Iranians just did. But negotiations may be impossible now before 2020. Rouhani may be forced to play the hawk, Supreme Leader Khamenei is opposed to talks, and the hard-line faction is apparently willing to court conflict with America to consolidate its power ahead of the dangerous and uncertain period that awaits the regime in the near future, when Khamenei’s inevitable succession occurs. Bottom Line: We argued in May that the risk of U.S. war with Iran stood as high as 22%, on a conservative estimate of the conditional probability that the U.S. would engage in strikes if Iran restarted its nuclear program outside of the provisions of the JCPOA. Recent events make the risk even higher. This does not mean that Rouhani and Trump cannot make bold diplomatic moves to contain tensions, but that the risk of widening conflict is immediate. Supply Risk Will Remain Front And Center The risk to supply made manifest in these drone attacks will remain with markets for the foreseeable future. They highlight the vulnerability of supply in the Gulf region, and, importantly, the now-limited availability of spare capacity to offset unplanned production outages. There’s ~ 3.2mm b/d of spare capacity available to the market, by the International Energy Agency’s reckoning, some 2mm b/d or so of which is in KSA (Chart 7). These drone attacks highlight the need to risk-adjust this spare capacity. When the infrastructure needed to deliver it to markets comes under attack, its availability must be adjusted downward. Chart 7Limited Availability Of Spare Capacity To Offset Outages Chart 8Commercial Inventories Will Draw ... In the immediate aftermath of the temporary loss of ~ 5.7mm b/d of KSA crude production to the drone attacks, we expect commercial inventories to be drawn down hard, particularly in the U.S., where refiners likely will look to increase product exports to meet export demand (Chart 8). This will backwardate forward crude oil and product curves – i.e., promptly delivered oil will trade at a higher price than oil delivered in the future (Chart 9). Chart 9... Deepening Forward-Curve Backwardations We expect the U.S. SPR to monitor this evolution closely. It is near impossible to handicap the level of commercial inventories – or backwardation – that will trigger the U.S. SPR release, given the unknown length of the KSA output loss, however. Worth noting is the fact that U.S. crude-export capacity is limited to ~ 1mm b/d of additional capacity. Thus, the SPR cannot be directly exported to cover the entire loss of KSA barrels. Other members of OPEC 2.0 will be hard-pressed to lift light-sweet exports, which, combined with constraints on U.S. export capacity, mean the light-sweet crude oil market could tighten. Interestingly, these attacks come as the U.S. has been selling down its SPR. The sales to date have been to support modernization of the SPR, but, for a while now, the Trump administration has been signalling it no longer believes they are critical to U.S. security. That likely changes with these events. The EIA estimates net crude-oil imports in the U.S. are running at 3.4mm b/d. The SPR is estimated at 645mm barrels. There are 416mm barrels of commercial crude inventories in the U.S., giving ~ 1.06 billion barrels of crude oil in the SPR and commercial inventory in the U.S. This translates into about 312 days of inventory in the U.S. when measured in terms of net crude imports. China has been building its SPR, which we estimated at ~ 510mm barrels. As a rough calculation using only China imports of ~ 10mm b/d, and production of ~ 3.9mm b/d, net crude-oil imports are probably around 6mm b/d. With SPR of ~ 510mm barrels, the public SPR (i.e., state-operated stocks) equates to roughly 85 days of imports.4 Members of the IEA – for the most part OECD states – are required to have 90 days of oil consumption on hand. The IEA estimates its SPR totals 1.54 billion barrels, which consists of crude oil and refined products. Together, the IEA’s SPRs plus spare capacity likely could cover the loss of KSA’s crude exports, but the timing and coordination of these releases will be tested. KSA has ~ 190mm b/d of crude oil in storage as of June, the latest data available from the Joint Organizations Data Initiative (JODI) Oil World Database. If the 5.7mm b/d of output removed from the market by these oil attacks persists, these stocks would be exhausted in 33 days. Based on press reports, repairs to the KSA infrastructure will take weeks – perhaps months – which means the longer it takes to repair these facilities the tighter the global oil market will become. This is exacerbated if additional pipelines or infrastructure in KSA come under attack or are damaged. Critical Next Steps How the U.S. follows up Pompeo’s accusations against Iran will be critical. The next steps here are critical: Tactically, the Houthis or other Iranian proxies could continue with drone attacks aimed at KSA infrastructure. They’ve obviously figured out how to target Abqaiq, which is the lynchpin of KSA’s crude export system (desulfurization facilities there process most of the crude put on the water in the Eastern province). The Abqaiq facility has been hardened against attack, but these attacks show the supporting infrastructure remains vulnerable. In addition, militants could target KSA’s western operations on the Red Sea, which include pipelines and refineries. The Bab el-Mandeb Strait at the bottom of the Red Sea empties into the Arabia Sea. More than half the 6.2mm b/d of crude oil, condensates and refined-product shipments transiting the strait daily are destined for Europe, according to the U.S. EIA.5 In addition, the 750-mile East-West pipeline running across KSA terminates on the Red Sea at Yanbu. The Kingdom is planning to increase export capacity off the pipeline from 5mm b/d to 7mm b/d, a project that will take some two years to complete.6 During a July visit to India, former Energy Minister Khalid al-Falih stated importers of Saudi crude and products, “have to do what they have to do to protect their own energy shipments because Saudi Arabia cannot take that on its own.” On top of all this, Iran could ramp up its threats to shipping through the Strait of Hormuz once again. These actions could put the risk to supply into sharp relief in very short order. Even Iranian rhetoric will have a larger impact in this environment. In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage. How the U.S. follows up Pompeo’s accusations against Iran will be critical. Whether the deal being brokered with France – and the $15 billion oil-for-money loan from the U.S. that goes with it – is now DOA, or is put on a fast track to reduce tensions in the region will be telling. It is entirely possible the U.S. launches an attack on Yemen to take out these drone bases and to neutralize the threat there. If Iraq is identified as the source of the attacks, the U.S., along with Iraqi forces, likely would stage a special-forces operation to take out the bases used to launch the drone attacks. The U.S. has significant forces in theater right now: The U.S. 5th Fleet is in Bahrain, with the Abe Lincoln aircraft carrier and its strike force on station at the Strait of Hormuz; and the USS Boxer Amphibious Ready Group (ARG) and 11th Marine Expeditionary Unit (MEU) are on patrol in the Red Sea under the command of the U.S. 5th Fleet (Map 2). In addition, the U.S. also deployed B52s earlier this year to Qatar to have this capability in theater. Map 2U.S. Navy Carrier Battle Group Disposition, 9 September 2019 Bottom Line: In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage that removed 5.7mm b/d of crude-processing capacity from the market and damaged one Saudi Arabia’s largest oil fields. We expect the U.S. will conduct a limited retaliatory strike, and will continue to build up forces in the Persian Gulf to prepare for a larger response if necessary. While neither President Trump nor the United States has an immediate interest in a large-scale conflict with Iran, the risk of such an outcome has increased. If the oil-price shock caused by these attacks becomes unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the risk of recession increases. While this is not our base case, it could push Trump to adopt a “war president” strategy going into the U.S. general election next year.   Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil field, which produces close to 2mm b/d, were attacked on Saturday, September 14, 2019.  Since then, press reports claim the attack could have originated in Iraq or Iran, and could have included cruise missiles – a major escalation in operations in the region involving Iran, KSA and their respective allies – in addition to drones.  Please see Suspicions Rise That Saudi Oil Attack Came From Outside Yemen, published by The Wall Street Journal September 14, 2019. 2      Please see "Houthi Drone Strikes Disrupt Almost Half Of Saudi Oil Exports", published September 14, 2019, by National Public Radio (U.S.). 3      See Omer Carmi, "Is Iran Negotiating Its Way To Negotiations?" Policy Watch 3172, The Washington Institute, August 30, 2019, available at www.washingtoninstitute.org. 4      China is targeting ~500mm bbls by 2020, and is aiming to have 90 days of import oil cover in its SPR. 5      Please see The Bab el-Mandeb Strait is a strategic route for oil and natural gas shipments, published by the EIA August 27, 2019. 6      Please see "Saudi Arabia aims to expand pipeline to reduce oil exports via Gulf," published by reuters.com July 25, 2019.

Highlights We remain bullish on global equities and spread product but acknowledge a variety of risks to our thesis. One such risk involves a scenario where a weaker U.S. economy hurts President Trump’s re-election prospects, causing investors to price in an Elizabeth Warren victory. According to the betting markets, she is the current front-runner for the Democratic nomination. A Warren presidency would likely be bad news for drug makers and health care insurers, defense contractors, banks, oil and gas companies (especially frackers), and tech stocks. Infrastructure and home builder stocks would probably benefit at the margin. Despite these risks, equity investors can take comfort in the following: 1) Global growth should strengthen, thanks in part to easier monetary policies; 2) China will be more keen to cut a trade deal with Trump if Warren looks like she will become the Democratic nominee; and 3) A Warren victory is less likely to translate into a Democratic takeover of the Senate than, say, a Biden victory. Feature The Warren Factor We remain bullish on global equities and other risk assets but continue to be on the lookout for evidence of any scenario that could undermine our thesis. One particular risk, which we explore in this week’s report, is the possibility that a weaker U.S. economy further undermines Donald Trump’s poll numbers, thus raising the odds that Democratic Senator Elizabeth Warren wins the White House next year. Presidential approval ratings tend to correlate well with the state of the economy (Chart 1). Since 1952, no sitting president has lost an election when unemployment has been falling except for Gerald Ford in the wake of Nixon’s scandal and unprecedented resignation. In contrast, two presidents (Jimmy Carter and George H.W. Bush) have lost against the backdrop of rising unemployment. Chart 1Incumbents Fare Better When The Economy Is Doing Well President Trump’s approval ratings are quite poor given how low unemployment is these days. His perceived handling of the economy is the only area where he has continued to poll relatively well (Chart 2). If he were to lose his standing on this issue, his re-election prospects would deteriorate substantially. Chart 2Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Among the Democratic contenders, Elizabeth Warren is currently running behind Joe Biden in the polls, but bests Biden in online betting markets such as PredictIt (Chart 3). It is not clear if Warren’s standing in the betting markets is a statistical anomaly or truly reflects the “wisdom of the crowds.” Warren tends to poll best among better-educated voters – the sort who are more likely to use betting markets. Like Andrew Yang, who PredictIt gives a rather dubious 12% chance of winning the Democratic nomination (above the 11% garnered by Kamala Harris), Warren’s prospects may be inflated by the composition of the betting pool. That said, Warren is benefiting from a deep-seated shift to the left in political preferences among Democratic primary voters, as BCA’s Geopolitical Strategy recently observed in a report entitled “American Politics Warrants Near-Term Caution.1” Chart 4 shows that the share of Democrats who identify as “liberal” has more than doubled since the mid-1990s at the expense of those who identify as “moderate” or “conservative.” The “Great Awokening” is transforming the Democratic Party into a much more radical force than it was under Bill Clinton or even, for that matter, under Barack Obama.2 Chart 3Who Will Win The 2020 Democratic Nomination? Chart 4Democratic Party Shifting To The Left   Soak The Rich If Donald Trump was the right’s answer to populism, Warren, along with fellow traveler Bernie Sanders, is the left’s embodiment of the populist spirit. Not only has Warren pledged to raise the federal minimum wage to $15/hour, she has promised to roll back Trump’s corporate tax cuts. If that were not enough, she has also touted a 2% annual wealth tax on households with a net worth in excess of $50 million (rising to 3% for those with a net worth above $1 billon). Her team claims the wealth tax would bring in $2.75 trillion over a 10-year period (roughly 1% of GDP).3 It would help finance free universal health care coverage, fund a “Green New Deal,” and pay off most student loans. A Different Type Of Protectionist While Warren holds fairly protectionist views on international trade, they are qualitatively different from Trump's vision. Whereas Donald Trump has focused his efforts on reducing America’s bilateral trade deficits with other economies, Warren has concentrated on “social justice” issues. In the first few decades following World War II, trade agreements strove to cut tariffs and other overt trade barriers. Once this had been largely achieved, negotiations began to focus on fostering what trade economist Robert Lawrence has called “deep integration.” This involved harmonizing tax and regulatory policies across countries, strengthening intellectual property rules, and so on. Warren and other critics on the left have complained that this newfound emphasis of trade policy has helped multinational companies at the expense of ordinary workers. She has espoused creating prerequisites for all future trade agreements, including stronger protections for human rights, collective-bargaining, and environmental standards. Such preconditions would make it difficult for many countries, China included, to reach a deal with the U.S. on trade. What Warren Means For Investors Regardless of what one thinks about the overall merits of Elizabeth Warren’s political agenda, it is reasonable to conclude that equity investors would suffer if most of her preferred policies were implemented. In fact, as we were writing this report, Warren retweeted a CNBC story entitled “Wall Street executives are fearful of an Elizabeth Warren presidency” with a trollish comment saying “I’m Elizabeth Warren and I approve this message.”4 Box 1 reviews the impact of a Warren victory on various industries. Briefly stated, a Warren presidency would likely be bad news for drug makers and health care insurers, defense contractors, banks, oil and gas companies (especially frackers), and tech stocks. Infrastructure and home builder stocks would probably benefit at the margin. BOX 1 Elizabeth Warren’s Impact On U.S. Equity Sectors Negative Health care: Favors eliminating private health insurance; Backs price controls on pharmaceuticals; Advocates creating a government-owned pharmaceutical manufacturer to mass-produce generic drugs. Banks: Supports making it easier for individuals to file for bankruptcy; Would restore Glass-Steagall, effectively reversing some the mergers that took place during the financial crisis; Favors making private equity firms responsible for the debts of the companies they purchase as well as for some of their pension obligations. Defense: Has called for a smaller defense budget and promised to end “the stranglehold of … the so-called Big Five defense contractors.” Energy: Pledged to sign an executive order on her first day in office placing a complete moratorium on all new fossil fuel leases for offshore drilling and on public lands; Favors banning fracking everywhere and supports the introduction of a cross-border carbon tax. Tech: Anti-trust efforts are likely to be increased under a Warren administration. She has singled out Amazon, Facebook, and Google as companies she believes should be broken up. She recently added Apple to the list, citing her belief that the Apple app store unfairly gives an edge to Apple products. Marginally Positive Infrastructure: Infrastructure stocks (except for nuclear) would probably benefit from a Warren victory due to increased public-sector investment spending. Home builders: Home builders could gain from stepped-up efforts to expand home ownership. Warren is also in favor of decriminalizing illegal immigration which, despite her ostensible efforts to help blue collar workers, could dampen wage pressures in the construction sector. Despite these clear downside risks, we would dissuade investors from turning bearish on stocks right now. There are a few reasons for this. Global Growth Should Rebound Chart 5Easier Financial Conditions Will Boost Global Growth First and foremost, global growth is likely to stabilize over the coming months and rebound into yearend. Global financial conditions have loosened significantly, thanks in part to easier central bank policy (with the ECB’s rate cut and QE announcement this week being just the latest example). Looser financial conditions are positive for growth prospects (Chart 5). Manufacturing activity has been held back by weakness in the auto sector (Chart 6). Judging by the outperformance of auto stocks since mid-August (Chart 7), the auto recession may be coming to an end (we have been recommending global auto stocks since August 29). Chart 6Auto Sector: The Culprit Behind The Manufacturing Slowdown Chart 7Global Auto Manufacturers: Better Times Ahead?     In the U.S., the economic surprise index has jumped firmly into positive territory (Chart 8). Real consumer spending is on track to rise by a sturdy 3.1% in Q3, according to the Atlanta Fed’s GDPNow model, following a blockbuster 4.7% reading in Q2. Given the decline in mortgage rates over the past few months, residential investment should also recover later this year (Chart 9).       Chart 8U.S. Data Has Begun To Surprise On The Upside Chart 9Lower Mortgage Rates Bode Well For Housing Trump, Warren, And Trade The trade war represents the biggest risk to our sanguine outlook on global growth. Now that Trump has proven his credentials as “Tariff Man,” he has to prove that he is the “Master Negotiator” he claimed to be on the campaign trail. This means getting a deal done with China. As we saw with the revised NAFTA agreement, the new deal does not need to be radically different from the status quo for Trump to sell it as a game changer, and a 'win' for the American people. Trump’s decision to delay the October 1st tariff hikes by two weeks, following China’s announcement that it will waive tariffs on some U.S. imports, certainly moves things in the right direction. As we go to press, conflicting media reports are circulating that Trump is considering an interim trade deal that would delay and possibly roll back some U.S. tariffs in exchange for commitments from China to purchase more U.S. agricultural goods and better enforce intellectual property rights.5 If such an agreement materializes, it would be very much consistent with our expectation of a de-escalation in the trade war as the election approaches. How Warren’s ascent could alter the trade war calculus is unclear. On the one hand, given her own protectionist leanings, Trump may be reluctant to cede any ground to her by further softening his stance towards China. On the other hand, the Chinese are more likely to cut a deal with Trump if Biden’s star continues to fade, thus making it easier for Trump to secure an agreement. From China’s perspective, better the devil you know than the devil you don’t. On balance, we lean towards the latter theory, although much will depend on how the ongoing trade negotiations unfold. Trump Prefers Warren What does seem certain is that Trump’s re-election prospects are better if Warren gets the nomination than if Biden does. In head-to-head matchups against Trump, Biden outperforms Warren in the country as a whole, as well as in individual swing states (Chart 10). Chart 10Biden's Chances Of Beating Trump Are Better Than Warren’s Even if Warren did become the nominee and went on to beat Trump, her margin of victory would be slimmer than Biden’s. This implies that she would have a smaller chance of bringing over the Senate to the Democratic side. Without Democratic control of the senate, the Republicans will thwart much of her agenda and many of the pro-business policies they have enacted will remain on the books. Investment Conclusions When it comes to investing, there is no shortage of risks to worry about. One way of benchmarking the degree to which stocks are discounting these risks is by estimating the equity risk premium. Today, equity risk premia remain fairly elevated, especially outside the United States (Chart 11). Chart 11AEquity Risk Premia Remain Quite High (I) Chart 11BEquity Risk Premia Remain Quite High (II)   One can see this point by calculating how much various stock market indices would need to fall over, say, the next ten years for stocks to underperform bonds. Even if one were to assume that nominal dividend payments per share do not rise at all over the next decade, U.S. equities would still need to decline by more than 18% in real terms for stocks to underperform bonds. Japanese stocks would need to fall by 28%. Euro area stocks would need to drop by 41%. U.K. stocks would need to tumble by almost 60%! (Chart 12). Chart 12AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 12BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II)   To be sure, much of the relative attractiveness of stocks is a function of how low real yields are. In absolute terms, global equities are poised to deliver long-term real returns on par with their historic average. U.S. stocks should generate returns that are somewhat below their historic average given that they trade at premium to their global peers. Valuations are mainly useful for gauging the long-term outlook for assets. Over a horizon of around 12 months, cyclical factors are the dominant drivers of both stocks and bonds (Chart 13). The rebound in government bond yields since last Thursday has erased most of the extreme overbought conditions that prevailed in fixed-income markets. Nevertheless, as we highlighted in last week’s report entitled “Bond Yields Have Hit Bottom,” yields should move higher over the coming months as global growth picks up and inflation eventually rises.6 As a countercyclical currency, the dollar should also start to weaken later this year. The combination of stronger global growth and a weaker dollar will boost commodity prices, EM currencies and equities, and cyclical stocks. Industrials, materials, and energy stocks should all gain. Financials will also benefit from a modest resteepening of yield curves. Financials are overrepresented in value indices while tech is underrepresented. Indeed, a trade that is long the former while short the latter has tracked the value/growth split very closely (Chart 14). Value stocks are very cheap compared to growth stocks based on standard valuation measures such as price-to-earnings, price-to-book, and dividend yield. The outperformance of value stocks over the past few days versus both growth and momentum stocks is likely to continue. Chart 13Economic Growth Drives Stocks And Bonds Over 12-Month Horizons Chart 14Is Value Turning The Corner?   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Weekly Report, “American Politics Warrants Near-Term Caution,” dated July 19, 2019. 2      Matthew Yglesias, “The Great Awokening,” Vox, April 1, 2019. 3      Please see Emmanuel Saez and Gabriel Zucman, January 18, 2019. 4      Elizabeth Warren, “I'm Elizabeth Warren and I approve this message,” Twitter, 10 September 2019, 2:39 pm. 5      Jenny Leonard and Shawn Donnan, “Trump Advisers Considering Interim China Deal to Delay Tariffs,” Bloomberg, September 12, 2019. 6      Please see Global Investment Strategy Weekly Report, “Bond Yields Have Hit Bottom,” September 6, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Special Report

HighlightsEuropean fiscal stimulus will not drive European equity outperformance – Europe needs China to open the stimulus taps.Our mega-theme of European integration continues – the continent is politically stable.The U.S.-China trade war is an opportunity for Europe. Any Sino-American trade deal is unlikely to resolve tech disputes. Go long European tech stocks versus American.The euro has room to grow as a global reserve currency given the dollar’s mounting structural flaws. Look for an opportunity to go long EUR/USD on a strategic basis within the near future.FeatureTalk of European fiscal stimulus is accelerating as investors look for reasons to take advantage of depressed European valuations (Chart 1) and traditional late-cycle outperformance relative to the U.S. (Chart 2). We are skeptical of the thesis. Chart 1European 'Cheapness' An Obvious Inducement  Chart 2Euro Stocks Outperform Late In The Cycle Europe is a price taker, not a price maker, when it comes to global growth. In order for investors to generate alpha from an overweight Europe position, the rest of the world needs to pick up the slack and reverse the current decline in economic fundamentals. That will require policy action on the behalf of the Fed, the Trump administration, and – most relevant to Europe – Chinese fiscal policy.That said, long-term investors should start thinking about increasing exposure to Europe. Not only is the continent well priced relative to the rest of the world, but it may have two more things going for it. First, political risks remain low. Second, Europe stands to gain in any prolonged China-U.S. confrontation. The flipside risk is that it stands to lose enormously in any temporary resolution as well.Europe Is A Derivative – Not A Source – Of Global Growth…Despite accounting for 16% of global GDP, the Euro Area generates an ever-shrinking proportion of the annual incremental change in global GDP (Chart 3). This is not surprising, given that the world has undergone significant transformation due to China’s industrialization and the growth of EM economies. Chart 3Europe’s Contribution To Global Growth Declining China’s imports today drive Euro Area manufacturing PMI broadly and Chinese retail sales drive German manufacturing orders specifically (Chart 4). As such, it is critically important to watch Chinese total social financing (TSF) impulse, which closely leads Europe’s exports to China by six months (Chart 5). Chart 4Europe And Germany Rely On China  Chart 5China's Credit Cycle Drives EU Exports  The problem is that the Chinese credit impulse has only tepidly recovered and implies more downside to European exports ahead. In addition, hopes of a rebound in Chinese retail sales have been dashed (Chart 6). The jump in auto sales in June was the result of heavy discounts offered by manufacturers and dealers to clear inventory before new emission standards came into effect on July 1. Due to the frontloading, car sales are now declining in what is traditionally an off-season for car purchases in China. While the worst may be over, weakness could linger for months. Chart 6China's Retail Sales Flashing Red The bottom line is that without an upturn in global growth, Europe will remain in the doldrums. The good news is that BCA’s Chief Strategist Peter Berezin expects precisely such a development in the second half of 2019.1 The bad news is that Chinese credit stimulus appears to be weighed down by a combination of impaired transmission mechanisms and policymaker unwillingness to launch an old-school credit orgy (Chart 7). This is creating a highly unusual – for this cycle – development where China is not playing its usual counter-cyclical role amidst the global manufacturing cycle (Chart 8). Chart 7China's Credit Stimulus Restrained Thus Far  Chart 8Beijing Goes On Strike As Global Spender Without more Chinese stimulus, European fiscal spending won’t be that meaningful.As such, it is difficult to get excited about European growth. As we discussed in last week’s missive, Europe is moving gingerly towards more fiscal spending. However, it has already done so this year, with fiscal thrust at 0.46% of GDP, the highest figure since 2009 (Chart 9). Did anyone notice? Not really. Chart 9Headwinds Overpower EU's Strong Fiscal Thrust Moreover Euro Area countries have to submit their 2020 budgets in early Q4 to the European Commission. It is unlikely that these proposals will be meaningful, given that there is not yet enough panic to spur massive stimulus.Bottom Line: Yes, Europe will provide more fiscal spending in 2020. But it will remain at the mercy of global growth given its high-beta nature.…But At Least It Is Not Falling Apart!   That said, not all is disappointing on the Old Continent. For one, the aforementioned fiscal thrust at least prevented a deeper slowdown this year – and the drop-off in thrust next year will be less dramatic as budgets turn more accommodative.Meanwhile political risk is falling. Anti-establishment parties are either cleaning up their act, putting on a tie, and becoming part of the establishment, or they are losing power. Our long-held thesis that European integration would persist into the next decade remains well-supplied with empirical evidence.2On the Euroskepticism front, much of the hype today surrounds the collapse of the Five Star Movement (M5S) coalition with the League in Italy. The formerly Euroskeptic M5S has shed its critique of European integration and has decided to partner with the center-left and pro-establishment Democratic Party (PD).This is merely the tip of the iceberg. Several key developments throughout 2019 have signaled to investors that the Euroskeptic moment has passed. For a plethora of data and polling to support this view, please refer to our May report on the European Parliament (EP) election. Here we merely survey the latest developments:European Parliament Election: As expected in our EP election forecast, the May contest was a non-event. Support for the euro and the EU is trending higher (Chart 10 and 11), and 73% of Euroskeptic seats are held by Eastern European or U.K. MEPs (Chart 12), both irrelevant for EU policy.3  Chart 10Even Italy Swings In Favor Of Euro  Chart 11Public Opinion Supports The Union  Chart 12Euroskepticism Overstated Random Elections: We rarely cover politics in Denmark or Finland, but the two Nordic countries have been at the forefront of the anti-establishment, right-wing, evolution in Europe. As such, the elections in Denmark (in June) and Finland (in April) were relevant. The Danish People’s Party (DPP) – one of the original “People’s Parties,” founded in 1995 – was massacred, losing 21 seats in the 179-seat legislature.In Finland, the moderately Euroskeptic Finns similarly saw a disappointing – if not as disastrous – performance.Finally, Austrian election on September 29 will likely see the other Europe’s prominent right-wing, Euroskeptic, party – the Freedom Party of Austria (FPO) – decline below 20% for the first time since 2008. Chart 13Macron Recovering In Polls France: Our high conviction view in February that the Yellow Vest protest would ultimately dissipate proved correct. President Emmanuel Macron has also seen a recovery in polling. Although tepid, at least he appears to be diverging from the trajectory of his disastrously unpopular predecessor François Hollande (Chart 13).The good news for Macron is that he continues to lead Marine Le Pen by double digits in the theoretical 2022 second round. While this represents a considerable improvement for Le Pen from her 2017 performance, the fact is that she has had to adjust her policies and rebrand the National Front in order to close the gap with Macron. The party is now called the National Rally and has publicly revised its stance towards both the EU and the euro.4The events in France, Denmark, Finland, and Austria have largely gone unnoticed amidst the China-U.S. trade war, attacks against Federal Reserve independence, and general breakdown in global institutions and paradigms. But they reveal that Euroskepticism in Europe is evolving from a definitive one – in or out – to a much more nuanced position.For students of history, this is not a surprise. European integration has always been a push-pull process. Charles de Gaulle famously caused a total breakdown in integration during the 1965 “Empty Chair Crisis” when France recalled its representative in Brussels and refused to take its seat on the Council.De Gaulle was a Euroskeptic in so far as he believed that European integration was a national, not a supra-national process.5 It could proceed apace, but only if controlled by national capitals. As such, he warred with the Commission all the time. However, de Gaulle did not want to eliminate European integration as he understood its geopolitical and economic imperative. He simply wanted to shape the process to fit French interests.Absolutist Euroskepticism – the idea that all European institutions ought to be replaced by national ones – is an alien idea to the post-World War Two continent, one imported from the nineteenth century. The irony of Brexit, therefore, is that the most vociferous supporters of an absolute end to the EU integrationist project are now abandoning their fellow absolutists on the continent.Geopolitical and structural factors are also pushing European Euroskeptics to evolve from absolutists to modern-era Gaullists. We have identified most of these factors before, but they are worth repeating:Europe has a geopolitical imperative to integrate. In a multipolar world dominated by global powers like the U.S. and China – and with Russia, India, Japan, Iran, and Turkey playing an increasingly independent role – European states are not large enough on their own to defend their economic and geopolitical interests. Chart 14Geopolitical Forces Behind Integration The purpose of integration is to aggregate the geopolitical power of Europe’s individual states amidst rising global multipolarity. Chart 14 is a stylized visualization of what European integration is attempting. It illustrates that the average BCA Geopolitical Power Index (GPI) score of an EMU-5 country is well below that of a BRIC state.6 By aggregating their geopolitical power, European states retain some semblance of relevance in the world.Obviously this is merely a thought experiment as European integration is not aggregation and never will be. Not only is aggregation politically unfeasible, but there is also a lot of double counting in simply adding GPI scores of European states. Nonetheless, the point is that European countries are asymptotically moving from the average to the aggregate score. Chart 15No Basis For Fascism In Great Recession No, the Nazis are not coming. Europe has managed to recover from a generational financial crisis. Pessimists point to the depth of the crisis to explain why Europe is unsustainable, with angst matching the severity of the downturn. However, analogizing to the 1930s is folly. First, Europe’s shared memories of the ravages of populism act as antibodies preventing precisely the same infection from breaking out on the continent.7 Second, the European financial crisis was simply nowhere close to the depth of the Great Depression that rocked Germany as it descended into National Socialism (Chart 15). As for the argument that the European Central Bank fed populism through unorthodox policy easing, the tide of populism would have been much more formidable if Europe had been allowed to sink into deeper recession and deflation.Europeans are just not that desperate. Europe scores much better than the U.S. (or the U.K.) when it comes to the balance between the median income and middle-income share of total population. Chart 16 shows that most Euro Area economies have around 70% of their population in the middle-income bracket. Those that fall short nonetheless hug the line of best fit closely (Italy, Spain, Greece, and the Baltic States). The U.S., on the other hand, has one of the highest median income levels, but with barely 50% of the population considered in the middle-income. Meaning that a lot of the people below the median line are far below it. This is a recipe for actual populist political outcomes (President Trump), as opposed to artificial ones (Italy). Chart 16U.S. At Greater Risk Of Populism Than EU European populism is artificial, U.S. populism is actual.What of the risks in Europe? For example, investors are concerned about mounting Target2 imbalances. Here we agree with our colleague Dhaval Joshi, who has pointed out that growing imbalances in Europe’s monetary system will only further constrain centrifugal forces among the nations.Target2 has seen a steady outflow of Italian cash to German banks as the ECB’s QE saw respective central banks purchase domestic bonds (Chart 17). This means that the Bank of Italy holds assets – BTPs – denominated in Italian euros, while the Bundesbank has a new liability to German banks denominated in German euros. EMU dissolution would be too painful due to this mismatch. Target2 is therefore not a threat to the EMU, but rather a Gordian Knot that can only be unraveled with immense pain and violence.That said, there may be an upcoming headline risk in Europe: the end of Chancellor Merkel’s reign. In our view, Merkel’s role in stabilizing Europe is greatly overstated. Her dithering and lack of conviction caused several crises to descend into chaos amidst the sovereign debt imbroglio. As such, an infusion of new blood will be positive for Europe. The populist threat is also overstated, with the Alternative for Germany (AfD) performing relatively tepidly in the polls. In fact, the liberal, Europhile, Greens are starting to gain votes (Chart 18). As such, an early election in Germany would create volatility and uncertainty but would not undermine our secular thesis on Europe. Chart 17Gordian Knot Supports Integration  Chart 18Germany Not Falling To Populism Bottom Line: There is an ever-strengthening case for the sustainability of the Euro Area and European integration well into the next decade.From Geopolitical Gambit To A Geopolitical Safe-Haven?At this point, we have built a strong case for why Europe will remain a high-beta play on global growth that is unlikely to collapse. As such, investors should plow into Europe when the rest of the world is doing well with confidence that the continent will not descend into chaos.The U.S.- China trade war offers an intriguing opportunity for Europe.This is largely underwhelming as an investment thesis. Could there be something more exciting to the story given a slew of well-known headwinds to European growth from demographics, low productivity, and regulatory malaise?The trade war between the U.S. and China does offer an intriguing opportunity for Europe.There appears to be an interesting development where European equities outperform those of the U.S. during periods of trade war turbulence (Chart 19). The outperformance is not major, but it is highly counterintuitive. Chart 19Europe Outperforms Amid Trade War Shocks As is understood, Europe is a high-beta play on global growth. Presumably, investors should abandon high-growth derivative plays when trade war accelerates. It is one of the reasons that EM equities and EM FX suffer whenever trade war accelerates.So why is Europe different? Because European exporters generally compete with their American counterparts (and Japanese and South Korean) for Chinese market share. And if China retaliates against U.S. companies, European companies stand to benefit, potentially massively.Take Boeing and Airbus. Boeing expects China to demand 7,700 new airplanes over the next two decades, an order valued at $1.2 trillion. It would be disastrous to the U.S. airline industry if the entirety of that order went to Airbus and its subsidiaries.8 According to the latest news reports, China has slowed down its airplane procurement to a crawl as it awaits the outcome of the dispute with the U.S.9 It is predictably using the procurement decision as leverage in the negotiations. Chart 20Europe To Lose If China Strikes U.S. Deal Yet this “substitution effect” thesis is a double-edged sword for Europe. A resolution of the trade war between the U.S. and China would likely include a massive purchase of U.S. agricultural, commodity, and manufacturing goods: the so-called “Beef and Boeings” deal. China bears often point out that such a massive purchase will negatively impact China’s current account, which is barely in surplus thanks to China’s trade surplus with the U.S. (Chart 20). This is false. Chinese policymakers are not suicidal. The last thing China needs is a balance of payments crisis due to a trade deal with the U.S.China would simply rob Peter to pay Paul, pulling its orders of soy from Brazil and Airbus from Europe in order to make a deal with the U.S. As such, it is highly likely that European capital goods exporters would suffer in any trade war resolution between China and the U.S.That said, a substantive trade deal that resolves all U.S.-China tensions is extremely unlikely. The U.S. and China are not just commercial rivals, they are also geopolitical rivals. As such, the tech conflict between the U.S. and China will continue well beyond any resolution of the trade war. This could create an opportunity for Europe’s traditionally beleaguered tech stocks to finally outperform their American counterparts (Chart 21). Chart 21Go Long EU Tech Versus U.S. Tech Bottom Line: A deterioration of the U.S.-China trade relationship would be a boon for European exporters. Short of a total breakdown of U.S.-China trade, however, European tech stocks may finally begin outperforming their U.S. counterparts thanks to the open distrust between U.S. and China.In addition, U.S. technology firms are likely going to face a slew of regulatory challenges over the next decade. While not necessarily negative, these challenges will nonetheless create new headwinds for the sector.10 We are therefore initiating a structural theme of being long European tech relative to U.S.Investment ImplicationsAre there any broader themes to be extracted from the combined geopolitical forecasts presented in this report? Europe will not collapse, and it may benefit from the souring of U.S.-China geopolitical and economic relations.Long euro is an obvious theme. As our colleague Dhaval Joshi has recently pointed out, the chasm between monetary policies of the Fed and the ECB has become a major geopolitical risk. This is because it has depressed the euro versus the dollar by at least 10 percent – based on the ECB’s own competitiveness indicators. The exchange rate distortion stemming from polarized monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart 22).In the short term, EUR/USD may have reached its practical (and geopolitically acceptable) lows. Yes, the ECB is readying another round of monetary stimulus on September 12, but the fiscal policy counterpart is likely to be tepid and thus fail to (yet again) take advantage of historically depressed borrowing costs on the continent. The September 12 ECB meeting may therefore be a “sell the rumor, buy the news” event for EUR/USD. Chart 22Monetary Policy Accounts For Bilateral Surplus  Chart 23U.S. Rivals Buying Gold, Ditching Dollar On the more cyclical and secular horizon, we see an opportunity for the euro to reestablish some of its lost reserve currency status due to the geopolitical conflict between China and the U.S. Washington’s willingness to use trade and financial sanctions for geopolitical benefit has given pause to central bank authorities around the world in using dollars as a reserve currency. Purchases of gold for FX reserve have surged, particularly among America’s geopolitical rivals (Chart 23), as our colleague Chester Ntonifor has recently pointed out.As we argued in a report entitled “Is King Dollar Facing Regicide?” the euro has some catch-up potential. In 1990, the combined currencies of the countries that today comprise the Euro Area accounted for 35% of total composition of global currency reserves. Today, the figure is merely 20% (Chart 24). Chart 24Euro Has Plenty Of Room To Grow As Reserve Currency Could Europe supply the world with enough euros to replace USD as a reserve currency? This is highly unlikely. However, at the margin, an expansion of European liquidity is possible, particularly if Germany finally learns to love fiscal expansion and if European policymakers capitulate on the issuance of Eurobonds. However, such a lack of euro liquidity is not negative for the euro. The world could soon experience a situation where the demand for non-USD liquid assets dramatically increases due to the politicization of America’s reserve currency status while the supply of USD-alternatives remains relatively low. This should be positive for the only true alternative to the USD as a global reserve currency: the euro.As such, we will be looking to initiate a strategic long EUR/USD position, potentially sometime this fall as the ECB and FOMC meetings take place and the risk of a no-deal Brexit is averted. We do not expect the massive monetary policy divergence between Europe and the U.S. to continue, while the Euro Area’s political stability, and the broader geopolitical demand for a non-USD reserve currency, create more long-term tailwinds for the euro.Marko PapicConsulting Editor, BCA Research              Chief Strategist, Clocktower GroupHousekeepingOur high-conviction view that no-deal Brexit odds were overrated has been confirmed by the recent events in the U.K. parliament. We are going long GBP-USD with a tight stop-loss of 3%. Since we expect further volatility – with an election likely and the Conservative Party performing well in the polls and monopolizing the Brexit vote in a first-past-the-post system – we will sell at the $1.30 mark.Footnotes1 Please see Global Investment Strategy, “Trade War: The Storm Before The Calm,” dated August 9, 2019, available at gis.bcaresearch.com.2 Please see Geopolitical Strategy, “Europe's Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011, available at gps.bcaresearch.com.3 The reason we extracted the U.K. Euroskeptics from the calculation is because with Brexit nigh, the U.K. members of European Parliament are no longer policy relevant. As for Central European Euroskeptics, we extracted them because they are irrelevant for EU policy as they hail from member states that – in truth – nobody seriously thinks would ever leave the EU.4 Ahead of the May EP election, National Rally electoral platform focused on “local, ecological, and socially responsible production." The party advocates combining environmentalism with protectionism, creating an ecological custom barrier at the EU’s doorstep which would defend the European market from products manufactured or produced with less environmentally friendly processes. On the matters of EU membership, the party now advocates a more traditionally Euroskeptic line, a purely Gaullist form of Euroskepticism that seeks to curb – or, at best, abolish – the EU Commission and replace its legislative prerogative by giving the Council of the EU all legislative powers. 5  Please see Julian Jackson, De Gaulle (Cambridge, MA: Harvard UP, 2018).6 We chose to use EMU-5 in the chart because it focuses on the top-five economies in the Euro Area: France, Germany, Italy, Spain, and the Netherlands. If we focused on the overall average EMU score, even one we weighed by population, the results would be even more stark in terms of loss of importance.7 And, worryingly, the U.S. lacks precisely the same shared memory of how wild pendulum swings of polarization can descend into extreme nationalism or left-wing extremism.8 Airbus would not have the capacity to fulfill that entire order today. However, demand creates its own supply, giving Airbus a reason to surge capex and reap the profits.9 Please see Reuters, “Exclusive: Boeing CEO eyes major aircraft order under any U.S.-China trade deal.”10 Please see Geopolitical Strategy, “Is The Stock Rally Long In The FAANG?,” dated August 1, 2018 and “Surviving A Breakup: The Investor’s Guide To Monopoly-Busting In America,” dated March 20, 2019, available at gps.bcaresearch.com.