Estados Unidos
Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, January 9th at 10 AM EST, when I will be discussing the economic and financial market outlook for 2019 and answering your questions. Best regards, Peter Berezin, Chief Global Strategist Highlights The lack of major financial and economic imbalances in the U.S., as well as the Fed’s ability to moderate the pace of rate hikes, reduce the risk of a vicious cycle where tighter financial conditions lead to slower economic growth and even tighter financial conditions. The scope for central banks to cut rates is more limited outside the United States. Imbalances are also greater abroad. Nevertheless, the news is not all bleak, with the recent rebound in China’s credit impulse being a case in point. We turned more bullish on risk assets following December’s post-FOMC equity sell-off. A moderately overweight position in global equities over a 12-month horizon is currently justified. While we continue to favor the U.S. over other bourses in dollar terms, our conviction level in this regional bias has decreased. Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. Outside Japan, global government bond yields will also increase in 2019. We are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. We are also taking profits on our March-2019 EEM ETF put for a gain of 104%. Feature Merry Crisis And A Happy New Fear Santa arrived early this year. The plunge in stocks allowed investors to buy some of the world’s premier companies at a mouthwatering 20%-to-30% discount to what they would have paid just a few months earlier. What a gift! Needless to say, most investors would not regard last month’s stock market performance in such a favorable light. But why not? One answer is that investors must mark their portfolios to market. Thus, even if the decline in equity prices raised future returns, it still implied a decline in present net worth. Yet, this cannot be the whole explanation, because if all investors expected stocks to bounce back quickly, they would not have sold in the first place. Clearly, many investors must have come to the conclusion that the stock market would not only go down but stay down. However, this presents a puzzle. The economic environment did not change that much in the weeks leading up to the October sell-off. Growth has slowed more recently (Chart 1), with this morning’s disappointing ISM manufacturing report being the latest example, but this appears to have been mainly a response to the souring market climate rather than the cause of it. Chart 1Tighter Financial Conditions Have Led To Slower Growth Reverse Causality? This raises an intriguing possibility: What if the drop in stock prices and jump in credit spreads that began in late September hurt expectations of economic growth by enough to justify a further discount in risk asset valuations? Such a “Financial Conditions Index (FCI) doom loop” is not just a theoretical construct. The last two U.S. recessions were both the products of burst asset bubbles — first the dotcom bubble and then the housing bubble. Could such a self-fulfilling vicious cycle be erupting again? If so, any rally in stocks or credit should be sold into, just as was the case in both 2001 and 2007. U.S. Fairly Resilient To A Doom Loop Fortunately, there are two reasons to think that such an outcome will not reoccur, at least not in the United States. First, as Box 1 explains, an FCI doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. That does not appear to be the case today. Unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart 2). Cyclical spending – the sum of residential investment, business capex, and expenditures on consumer durable goods – is also far below prior business-cycle peaks as a share of GDP (Chart 3). Chart 2The U.S. Private Sector Is A Net Saver Chart 3U.S. Economy: Cyclical Spending Is Still Restrained Despite recent releveraging in some categories, U.S. household debt has continued to decline in relation to the size of the economy. The ratio of personal debt-to-disposable income is now 34 percentage points below pre-crisis levels (Chart 4). Chart 4Household Leverage Is Below Its Peak U.S. corporate debt has moved in the opposite direction. Nevertheless, while the ratio of U.S. corporate debt-to-GDP has climbed to a record high, it is still quite low by global standards (Chart 5). Perhaps more importantly, corporate debt is generally held by non-leveraged institutions. If corporate defaults were to rise unexpectedly, the losses to lenders would not pose the same systemic risk to the financial sector as mortgage defaults did during the Global Financial Crisis. Chart 5U.S. Corporate Debt Is High, But It Is Higher Elsewhere The Fed’s Reaction Function It is not surprising that the stock market sell-off accelerated in early October following Fed Chairman, and failed golfer, Jay Powell’s comment that interest rates were “far from neutral.” We think that worries that the Fed will tighten too quickly are misplaced. Yes, monetary policy operates with “long and variable lags.” However, financial conditions, which lead growth, can be observed in real time (Chart 6). Chart 6Global Financial Conditions Have Tightened Most of the tightening in financial conditions since late September has been due to falling equity prices. Our baseline scenario envisions a gain of roughly 10% in the S&P 500 in 2019. A rebound in stocks of this magnitude will reverse most of the recent FCI tightening, thereby allowing the Fed to raise rates three times this year. But if equities continue to sag, the Fed will scale back further monetary tightening or even cut rates. The mere possibility of such a policy response reduces the odds of an FCI doom loop. A Mixed Bag Outside The U.S. The economic outlook is murkier outside the United States. Economic and financial imbalances are greater in the EM space and parts of Europe. Non-U.S. central banks also have less scope to respond to adverse shocks, either because of fears that looser monetary policy will spark capital outflows (as is the case in many emerging markets) or because of the presence of the zero-bound constraint on interest rates (as is the case in the euro area and Japan). Nevertheless, the situation is not that bad. EM assets have been fairly resilient over the past few months, at least in comparison to their developed economy counterparts (Chart 7). China’s credit impulse has actually perked up, an indication that while credit growth is falling, it is doing so at a slower pace. Chart 8 shows that the Chinese credit impulse is highly correlated with global industrial commodity prices. We still expect global growth to slow in the first half of 2019, but at this point, much of the slowdown has been discounted in asset markets. With that in mind, we are raising the stop on our short AUD/JPY trade to 10% and instituting a profit target of 15%. Chart 7EM Assets Have Been Outperforming Recently Chart 8The Increase In China's Credit Impulse Bodes Well For Industrial Commodity Prices The Perils Of Discrete Decision-Making One of the annoyances of being an investment strategist is that you often feel compelled to take discrete views on where the markets are heading. Are you bullish, bearish, or neutral? Actually, it is usually just bullish or bearish because most people regard neutral views as lacking in conviction and insight. This incentive structure is counterproductive. Not only does it cause analysts to turn a blind eye to incoming data that may challenge their thesis, it disregards how professional investors actually operate. Successful investors scale into positions as the market gets cheaper and scale out as it becomes more expensive. Trying to time the bottom (or the top) with exact precision is futile. With that in mind, we are going to tweak the way we make recommendations going forward in order to improve transparency, accountability, and accuracy. Rather than simply stating whether we are bullish, bearish, or neutral, we will assign the main asset classes a subjective score between zero and one hundred, with 0-to-40 being bearish, 40-to-60 being neutral, and 60-to-100 being bullish. We will adjust the score in every publication. To add analytic rigor to this framework, we will also compare our subjective model score with that of our MacroQuant model. Where Things Now Stand We downgraded global equities last June, but moved back to overweight following December’s post-FOMC meeting sell-off, as valuations reached that rather blurry line at which a modest equity overweight was warranted. Our subjective score for global equities currently stands at 65%, above the model’s estimate of 50%. Our moderately bullish view reflects our expectation that global growth will stabilize by mid-year and monetary policy will remain accommodative, even if the Fed raises rates by more than what the markets are currently discounting. Tempering our enthusiasm is the recognition that the business cycle is getting long in the tooth – especially in the U.S. – and that global equity valuations, while far cheaper than they were a few months ago, are still significantly less favorable than they were near past market bottoms (Chart 9). Chart 9Global Equity Valuations Have Improved Regionally, we continue to favor U.S. stocks over other developed markets, and DM over EM more broadly. However, our conviction level on this view is not high, and we are prepared to revise it if it looks like global growth is accelerating, an outcome that would limit any further dollar strength (our subjective dollar score currently stands at 70%, below the model’s estimate of 92%). Reflecting our expectation of decent global equity returns in 2019 and our waning conviction to be underweight EM, we are taking profits on in our March-2019 EEM ETF put for a gain of 104%. Please note that our view on EM is more optimistic than that of Arthur Budaghyan, BCA’s chief emerging markets strategist, who continues to see considerable downside risks to EM assets. For now, Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. We assign the 10-year yield a score of 30%, which is close to our model estimate of 32%. Accordingly, we are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. Core European bond yields will increase, reflecting diminished excess capacity in the euro area and the end of ECB net asset purchases. U.K. yields should also grind higher, as the odds of a soft Brexit (or no Brexit) improve. Only in Japan will yields remain contained, thanks to the BoJ’s ongoing yield curve control regime. We do not expect spread product to have a banner year, but the current yield pick-up should be sufficient to ensure that risky credit outperforms cash. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 The Analytics Of Doom Loops When will a tightening in financial conditions stemming from lower equity prices and higher borrowing costs lead to a vicious circle of slower economic growth and even tighter financial conditions? The answer depends on how sensitive economic growth is to financial conditions in relation to how sensitive financial conditions are to growth. Figure 1 shows two equilibrium schedules, one for the economy (EE) and one for asset markets (AA). Both schedules slope downward. The EE schedule is downward-sloping because easier financial conditions boost growth. If growth is too strong given the prevailing level of financial conditions, economic activity will slow (Panel A). The AA schedule is downward-sloping because equity prices tend to fall and credit spreads rise when growth slows. If equity prices are too high and credit spreads are too narrow for a certain level of growth, then financial conditions will tighten (Panel B). Suppose economic growth is not very sensitive to changes in financial conditions, perhaps because imbalances in the economy are limited (Panel C). Then changes in financial conditions will be fleeting: A decline in equity prices or a widening in credit spreads will not hurt growth very much, allowing the stock market and credit market to quickly normalize. In contrast, suppose that economic growth is very sensitive to financial conditions, so much so that the EE schedule is flatter than the AA schedule. In this case, the economy will be vulnerable to self-reinforcing booms and busts (Panel D). In particular, a small random jump from U to UI will send the economy careening towards a doom loop of ever-weaker growth and tighter financial conditions. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2018. The quant model reduced Spain’s large overweight to a slight overweight, and further downgraded the U.S. allocation. As a result, the model now has assigned overweight allocations to Germany, Switzerland, the Netherlands, Canada and Italy, with underweight allocations to the U.S., Japan, France and U.K. Australia and Sweden are now in the neutral zone, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI world benchmark by 38 bps in December, with a 48 bps of outperformance from Level 1 model offset by a 21 bps of underperformance from Level 2. Since going live, the overall model has outperformed by 96 bps, with Level 2 outperforming by 120 bps and level 1 outperforming by 57 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com
Feature No Recession – Add To Risk Again Markets have been notably weak and volatile since we published our 2019 Outlook1 in late November. Over the past couple of months, global equities have fallen by more than 10%, the 10-year U.S. Treasury yield has dipped from above 3.2% to below 2.7%, and high-yield bond spreads have risen by more than 200 basis points. The market is sniffing out the risk of recession on the near-term horizon. We think the market has got this wrong, and so we move back to overweight global equities (from neutral, to where we lowered our recommendation last June). Recommendations Last year, U.S. growth was much stronger than growth in the rest of the world (Chart 1). Markets are implying that the global slowdown will soon infect the U.S., with the stock market pointing to the manufacturing ISM, currently at 59.3, falling back to 50 in very short order (Chart 2). Chart 1Will U.S. Growth Also Fall Back? Chart 2Stocks Imply ISM At 50 It is, indeed, probable that growth will slow this year: the FOMC’s median forecast suggests a slowdown in real GDP growth from 3.0% in 2018 to 2.3%. And it may take the market a little longer to digest that deceleration. However, growth is likely to remain above trend (currently estimated at 1.8%). Higher interest rates have begun to take their toll on the housing market (with a noticeable deterioration in new housing starts and builder confidence). But residential investment is now only 4% of GDP, compared to 7% in 2006, so the impact of the slowdown will be limited. Moreover, consumption is likely to remain buoyant, with wage growth accelerating, consumer confidence strong, and the savings rate with room to fall (Chart 3). Additionally, though fiscal stimulus will not be as powerful in 2019, the IMF estimates that it will add a further half of one percentage point to U.S. GDP growth. Chart 3Consumption Likely To Remian Buoyant The Fed is reacting very pragmatically to the evolving circumstances. Chair Jerome Powell emphasized in his post-FOMC press conference in December that “some cross currents have emerged” and that “policy decisions are not on a pre-set course”. The FOMC cut its forecast for hikes in 2019 from three to two and lowered its estimate of the terminal rate from 3.0% to 2.8% (currently the fed funds rate is at 2.4%). This implies that it will take approximately two more 25 basis point rate hikes before the Fed gets rates back to neutral. As we have often shown, risk assets tend to outperform bonds until monetary policy is restrictive (Chart 4). Meanwhile, market sentiment has turned excessively bearish. Our sentiment index is at a level that has historically pointed to a good buying opportunity (Chart 5). The AAII survey shows that recently only 25% of U.S. retail investors expect the market to rise over the next six months, compared to 47% who expect it to fall. Valuations are cheap again: the forward PE for the MSCI All Country World Index (ACWI) is now back to the range it traded at in 2013 (Chart 6). The classic indicators of recession, such as the yield curve, are not yet flashing warning signals: the 3-month/10-year curve, which we have shown has historically been the most reliable,2 remains at +20 basis points (Chart 7). It needs to invert to signal recession – and, typically, it does that as much as 18-24 months in advance. Chart 5Sentiment Is Very Bearish Chart 6Global PE Back To To 2013 Level Chart 7Yield Curve Has Not Inverted Certainly, there are risks (we would highlight a reignition of the trade war after March 1, Brexit, U.S. government shutdown, the possibility that falling stock and house prices hurt consumer and business sentiment, and China’s reluctance to implement a massive 2016-style reflationary stimulus). But our analysis suggests there is significantly more upside than downside risk for equities over the next 12 months. If earnings growth, particularly in the U.S., comes in close to our top-down forecasts (Chart 8), it is hard to imagine – given the current depressed multiples – equities underperforming bonds this year. Accordingly, we recommend raising global equities to overweight in a multi-asset portfolio on a 12-month horizon, and lowering cash to neutral. For now, we have not changed our other tilts, and continue to recommend an overweight on U.S. equities and defensive sectors, a preference for equities over credit, and a high degree of caution towards emerging market assets. Chart 8Earnings On Track To Grow Healthily In 2019 Currencies: With growth likely to remain stronger in the U.S. than in the rest of the world, we expect appreciation of the dollar over the next six months. BCA’s Central Bank Monitors point to the need for the Fed to tighten policy further, but for the ECB to remain dovish. The gap between these two monitors has done a good job at forecasting EUR/USD over the past 10 years (Chart 9). However, speculative positions are already quite long dollar (Chart 10) and so the upside might be limited to around 5% in trade-weighted terms. If global growth begins to reaccelerate midway through 2019, the dollar might weaken again. Chart 9Relative Policy Suggests Stronger USD Equities: We prefer DM equities over EM. Further rises in the dollar and long-term U.S. interest rates, combined with continuing slowdown in global trade and Chinese growth, will remain headwinds for EM equities even if the market moves into a more risk-on phase. Valuations in EM do not look attractive either, with forward PE relative to DM in line with recent averages, and earnings growth forecasts likely to be revised down into negative territory over the coming months given the challenges facing developing economies (Chart 11). Within DM, we have a preference for the U.S., given its stronger growth and likely currency appreciation, over the euro zone and Japan, which are more sensitive to the global manufacturing cycle. Europe, in particular, will continue to be held back by the travails of its banks, which have been a major determinant of relative equity market performance in recent years (Chart 12). In a recent Special Report, we concluded that the long-term outlook for euro zone bank profitability remains lackluster.3 Chart 11EM Equities Are Not Cheap Chart 12Banks Will Weigh On Euro Zone Stocks Fixed Income: We see further upside for long-term rates in 2019, driven by a combination of above-trend economic growth, more Fed hikes than the market is pricing in, a moderate pick-up in inflation, and the unwinding of the Fed’s balance-sheet. We do not see rates being an impediment to growth until they reach the level of trend nominal GDP growth, currently 3.8% (which was the crunch point in both 1999 and 2006 – Chart 13). Despite our more positive view on equities, we remain more cautious on credit. Spreads have widened recently to more attractive levels (Chart 14). However, we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009 (Chart 15). Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019. At this stage of the cycle, credit spreads are unlikely to tighten much, even with an equity market rally. Furthermore, given the high leverage, credit is an asset class that is likely to perform particularly poorly in the next recession. Chart 13Only At 3.8% Do Rates Become A Risk Chart 14Credit Spreads Not More Attractive Chart 15U.S. Corporate Leverage Is A Problem Commodities: The sell-off in crude oil over the past two months was due to short-term supply-side shocks, most notably the U.S.’s agreeing to 180-day exceptions on Iranian sanctions. But supply is likely to tighten in coming months (Chart 16). Saudi Arabia and Russia intend to reduce production by 1.2 million barrels/day, and U.S. shale oil supply growth is likely to slow since one-year forward WTI is now around $49, slightly below the average breakeven level for shale oil producers. With global oil demand set to remain strong, our energy strategists see Brent oil rebounding to around $80 a barrel in 2019, with WTI $6 below that.4 Industrial commodities will continue to face headwinds from a stronger dollar and slowing China. Only when the effects of China’s moderate reflation measures start to come through in 2H 2019 would we expect to see a recovery in metals prices. Chart 16Oil Supply Set To Tighten Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1 Please see “Outlook 2019: Late-Cycle Turbulence,” dated 27 November 2018, available at bca.bcaresearch.com 2 Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?”, dated 15 June 2018, available at gaa.bcaresearch.com 3 Please see Global Asset Allocation Special Report, “Euro Area Banks: Value Play Or Value Trap?”, dated 14 December 2018, available at gaa.bcaresearch.com 4 For the detailed rationale of their forecast, please see Commodity & Energy Strategy Weekly Report, “2019 Key Views Policy-Induced Volatility Will Drive Markets,” dated 13 December 2018, available at ces.bcaresearch.com GAA Asset Allocation
Overweight Though it may be hard to see in the top panel of our chart amidst a spectacular long-term fall from grace, the S&P industrial conglomerates index has been outperforming for the past week. At first glance, much of the credit for this bounce can be given to GE which has seen even the longest term sell-side bears throwing in the towel and turning positive. However, GE is no longer the dominant name in industrial conglomerates; at only 21.5% of the market cap weight of the S&P industrial conglomerates index, it ranks below both MMM and HON which together account for more than two-thirds. As such, any outperformance would have to be broad based, as it has been since the beginning of December. Considering how valuations have contracted, this is of little wonder. The S&P industrial conglomerates index is a full standard deviation below fair value according to our Valuation Indicator (second panel) while our Technical Indicator (bottom panel) shows the index to still be exceptionally oversold. Bottom Line: The pessimism baked in to the S&P industrial conglomerates index is out of proportion. We reiterate our valuation-driven overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP.
Dear Client, This is our last publication of 2018. We wish all our clients a Merry Christmas and a Happy New year! We will be back on January 3, 2019. Thank you, The Commodity & Energy Strategy Team! Because they missed the first wave of North American Liquified Natural Gas (LNG) investments, Canadian gas producers will continue to endure low prices – compared to their U.S. counterparts – for the next three to five years. To become attractive to investors, proposed Canadian LNG projects will have to wait for demand to catch up to supply coming from the first wave of investment in 2010 – 2015.1 The good news is demand – mainly from Europe and Asia – is projected to outpace gas liquefaction capacity by 2023 – 2024.2 We believe this will create the necessary conditions to incentivize the second wave of LNG investment. To preserve its strong natural gas sector, Canada will have to become a leading LNG exporter, or risk seeing production decline. Highlights Energy: Overweight. The 2H18 OPEC 2.0 production surge undertaken to cover the re-imposition of U.S. sanctions against Iranian oil exports still is being absorbed in key refining centers. We expect to see inventories begin to draw heavily in January, given the transit from the Persian Gulf to the U.S. Gulf, where inventory levels are reported weekly, takes roughly 50 days per the U.S. EIA (Chart of the Week). Base Metals: Neutral. Asian copper concentrate treatment and refining charges (TC/RCs) appear to be headed lower next year. According to Metal Bulletin’s Fastmarkets, a deal agreed by Antofagasta and Jiangxi Copper setting TC/RCs at $80.80/MT / 8.08 cents/lb is setting next year’s levels. This will be the “the lowest benchmark since 2013,” coming in $1.45/MT under this year’s levels. Precious Metals: Neutral. Gold prices have rallied, as markets appear to be discounting fewer rate hikes by the Fed next year.3 We expect at least three rate hikes in 2019. Ags/Softs: Underweight. The USDA will release the second and final installment of farm assistance totaling $4.7 billion, to cover losses arising from the Sino – U.S. tit-for-tat tariffs and lost trade. This brings the total U.S. payout to $9.6 billion, according to agriculture.com. Feature U.S. LNG companies have the first-mover advantage in the North American LNG market.4 Because of this, these firms have a decided advantage in attracting capital investments and securing shorter- and long-term contracts to absorb their output. We believe the upcoming second wave of North American LNG investment – likely to get rolling in early 2019 – might be the last opportunity for Canadian producers to secure a position in the global gas market. If they miss this wave, Canadian natural gas production likely will plateau at close to current levels and begin to decline as early as 2019 (Chart 2).5 Currently, ~ 51% of Canadian natural gas production is exported to the U.S., but the shale revolution south of the border threatens every single cubic-foot of exports. U.S. gas supply is projected to increase by 20%, while its domestic demand by only 5%. This means the U.S.’s supply-surplus is poised to increase by 4.25 Bcf/d by 2023. Most of the American surplus will be exported via the LNG facilities that received final-investment decisions (FID) during the first wave of investment, and the rest via pipelines to Mexico and Canada. By 2020 the U.S. will have ~ 9.5 Bcf/d of liquefaction capacity and 3.4 Bcf/d of additional pipeline capacity destined to Mexico and Canada (Table 1). Table 1U.S. LNG Capacity To Reach 9.5 Bcf/d In The Early 2020s Canadian Gas Market Balance The U.S. natural gas market is the most important factor driving the evolution of Canadian natural gas production. Canadian natgas exports to the U.S. are expected to decrease from 8.2 Bcf/d to ~ 5 Bcf/d by 2040, according to EIA data. Moreover, Eastern Canada’s imports of natural gas from Northeast U.S. are projected to increase by 2.2 Bcf/d, due to the region’s proximity to the super-giant Marcellus and Utica gas fields in the Appalachian Basin. This trend has already started (Chart 3). Our base case projections for Canadian natural gas includes five new projects reaching FID in 2019-2020, with a combined capacity of 6.4 Bcf/d by 2024: Woodfibre LNG (prob > 80%): Small-scale project with capacity close to 0.3 Bcf/d located near Squamish, BC. This involves a 47-kilometer expansion of the existing FortisBC pipeline, transporting gas from the Western Canadian Sedimentary Basin. Goldboro LNG (prob > 80%): Although the project is placed in proximity to the Maritimes & Northeast Pipeline, the ~0.5 Bcf/d import capacity of this pipe would not sustain the 1.3 Bcf/d facility’s export capacity suggesting a required expansion, or new infrastructure to source its gas from the Marcellus Basin or Canada West. Bear Head LNG (prob > 80%): This project in Richmond County, NS must decide on whether to source 1.6 Bcf/d from the U.S. or Western Canada. Kitimat LNG (prob > 50%): This 1.3Bcf/d terminal in Bish Cove, BC will source its gas from the Horn River and Liard Basins via the proposed 480-kilmeter Pacific Trail Pipeline. Kwispaa LNG (prob > 50%): Formally known as Sarita LNG, the 1.9 Bcf/d project in Sarita Bay, BC would rely on gas supply from northeastern BC and/or Alberta. On the back of these expansions, we expect a short-term gas supply-surplus in Canada from 2019 to 2022, followed by balanced market, as LNG export capacity rises sufficiently to support Western Canadian gas production growth and pipeline-export declines (Chart 4). If there are no new Canadian LNG projects receiving FID decisions in the next two years, the domestic market will become over-supplied. This would depress the Canadian benchmark price at the AECO-C hub, and curtail investment in the energy sector. Should this scenario play out, we would expect future Canadian natural gas production to ~ 14.3 Bcf/d by 2040 (Chart 2). Bottom Line: Next year will be crucial for the medium- and long-term Canadian natgas outlook. Any delays in the construction of projects in the development pipeline would depress AECO-C prices and increase uncertainty for future investments in the Western Canadian Select Basin. Can Canada Compete With The U.S.? Canadian LNG projects are in direct competition with those in the U.S. to attract investment for the next wave of needed liquefaction capacity. We believe the Canadian LNG sector offers several advantages, which could favor its development versus the U.S. There are three major points of comparison: Proximity to key demand markets: One crucial advantage of Canadian LNG is its proximity to Asian markets, which will be the principal driver of LNG demand growth (Chart 5). In fact, a voyage from the Canadian Westcoast to Ningbo, China, takes on average 28 days less than from the GOM (Table 2). Moreover, the Canadian Energy Research Institute (CERI) estimates shipping from Eastern and Western Canada offers cost advantage over most liquefaction facilities around the world (Chart 6). Lastly, U.S. GOM exports to China are constrained by the Panama Canal and are expected to reach full transit capacity in early 2020s.6 This would increase U.S. voyage time by close to 14 days. Table 2BC’s LNG Voyage Time To Asia Is Advantageous Proximity to cheap and abundant feedstock gas: British Colombia’s integrated LNG projects are close to the growing Montney, Horn River and Liard production basins (Map 1).7 Natural gas reserves in these basins are estimated at ~ 41 Tcf, and are located within 400 miles of pipeline infrastructure.8 Moreover, prices have historically been lower compared to Henry Hub, and this is especially true today (Chart 7). We believe AECO-C prices will have to remain at a discount to U.S. prices over the next two years to incentivize LNG investments or disincentivizes production. Chart 7AECO-C's Discount To Henry Hub Widens Capital Costs and pipeline systems: Canadian LNG projects have competitive capital costs (Chart 8). However, Canada lacks a developed pipeline system from the Montney, Horn River and Liard basins to the west coast. Each proposed LNG project includes a dedicated pipeline. According to CERI, the cost of building a new pipeline in BC is higher than average due to the mountainous terrain. The U.S. has the advantage in regard to its developed pipeline system connected to the Henry Hub. This allows LNG projects to access an abundant and reliable feedstock by investing in short connection pipelines to the Hub. This makes the U.S. slightly more attractive in terms of capital costs. Bottom Line: Canada offers a competitive alternative to U.S. LNG projects. Western Canadian gas offers the most cost-effective solution to fill the rising Asian gas demand. Short- And Medium-Term Price Outlook We expect Canadian natural gas prices – i.e. the AECO-C benchmark – to modestly pick up and the U.S. Henry Hub prices to remain flat over the coming winter. Going into the winter heating season in November, Canadian gas storage levels were 15.5% lower than last year. Environment Canada continues to project a “normal” winter, which should not pressure prices in any direction. The Enbridge pipeline segment north of Prince George, BC is back at 85% utilization rate from reduced levels of 50-80% following the explosion in early October. As exports pick up, this will alleviate some of the downward pressure on Canadian prices. Over the medium term, however, we believe there is limited upside to Canadian gas prices. British Columbia pipelines to the U.S. already are close to full capacity, and no new projects are under construction (Chart 9). The province’s gas production is poised to grow by 1.56 Bcf/d from the prolific Montney and Horn River plays over the next 5 years. Given the lack of LNG export capacity until at least 2022, the excess capacity will have to find its way through Alberta – where the AECO-C benchmark is determined – increasing the available supply and pushing its price down. Domestic Canadian markets are unlikely to absorb this new supply. Higher-than-expected U.S. production from the Utica and Marcellus plays in the Appalachian Basin will satisfy a growing proportion of Eastern Canadian natural gas consumption, increasing the competition for Western Canadian gas. Reversals of pipeline flows within existing systems so as to import greater volumes from U.S. is evidence of this trend (Chart 10). Furthermore, according to the EIA, close to 1.3 Bcf/d additional pipeline capacity from Northeast U.S. to Canada will be built in the next 2 years. In the U.S., Henry Hub price volatility picked up as the U.S. market experienced an early-season freeze at the start of the November – March heating season, which was accompanied by record low working gas inventories (Chart 11). The April-October 2018 re-fill season paled in comparison to last winter’s withdrawal (Chart 12). Expressed in Days-Forward-Cover (DFC), this year’s October seasonal inventory peak was 16% lower than the historical average and 10% lower than the 5-year average. This was most recently followed by warmer-than-expected temperatures that subsequently crashed prices (Chart 13). Chart 13Weather-Related Natgas Volatility U.S. natgas prices remain vulnerable to weather shocks. We expect a premium on prices to remain throughout most of the winter season, keeping prices above $3.00/MMbtu. Still, upside price movements remain capped by higher-than-expected production (Chart 14, panel 1). U.S. production reached 90.7 Bcf/d in November 2018, according to EIA data, and is projected to reach 93.5 Bcf/d by the end of next year. This is an 8.4% revision to the EIA June 2018 projections. Moreover, our higher 2019 shale production estimates vs. the EIA estimates will support additional associated gas production. Similarly, domestic demand and net exports are surging, and we expect these trends, especially regarding the U.S. natural gas exports, to continue next year (Chart 14, panel 2 & 3). This implies fundamentals will be fairly balanced in 1H19. The wildcard will be weather. The latest NOAA weather projections show extremely warm weather for the next 6-10 days, and warmer-than-normal temperature for the next two months. This keeps us Neutral. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1 According to NEB, since 2010, 43 projects have been proposed. Of those, 35% have been cancelled and 20 were approved and working toward receiving FID. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report “U.S. Set To Disrupt Global LNG Market,” published October 4, 2018. Available at ces.bcaresearch.com. 3 Please see “Druckenmiller Urges Fed to Pause Tightening `Blitz’ in WSJ Op-Ed,” published by bloomberg.com on December 17, 2018. 4 The U.S. already has more than 3 Bcf/d of liquefaction capacity. The experience/expertise acquired from these projects will facilitate the construction and permitting of new projects, reducing time delays and uncertainty. Brownfield expansions benefit from economies of scale (e.g. additional trains can share jetty, land, storage, pipeline and permitting). Lastly, the well-developed pipeline system reduces the need to built long direct pipelines to LNG projects, which speeds up the construction. For more details, please see Canadian Energy Research Institute, “Competitive Analysis Of Canadian LNG,” July 2018. 5 The largest LNG project in Canada clearing the FID hurdle is LNG Canada, the 1.8 Bcf/d project in Kitimat, BC, being developed by Shell. It is expected to cost $40 billion, and to be on line in 2023, with the possibility to double capacity eventually. 6 Please see Oxford Institute For Energy Studies, “Panama Canal and LNG: Congestion Ahead?” April 2018. 7 Please see National Energy Board, “Canada’s Role in the Global LNG Market: Energy Market Assessment,” July 2017. 8 Marketable reserves are estimated at 532 Tcf. Please see BC Oil and Gas Commission, “British Columbia’s Oil and Gas Reserves and Production Report,” December 2017. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table TRADE RECOMMENDATION PERFORMANCE IN 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017
Underweight The S&P soft drinks index popped in late October, driven by better than expected Q3 results, mostly at Coke. In truth, pricing power has been staging a fairly steady recovery since falling off a cliff in 2016, though it has recently rolled over (second panel). More important to the index is the structural underperformance in earnings growth (third panel). While pricing improvements seem to be helping close the gap, the industry has nearly a decade of uninterrupted earnings deficit relative to the broad market. As such, the recent recovery in the S&P soft drinks index without an accompanying EPS lift has driven sector valuations to a 40% premium to the S&P 500 (bottom panel). Considering the stalling pricing efforts, U.S. dollar strength and a generalized global trade slowdown, this seems overly optimistic. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, MNST.
The Federal Reserve raised the target range for the fed funds rate by 25 basis points yesterday, bringing it up to 2.25%-2.5%, but was more conciliatory in its forward guidance. Specifically, the Fed made the following changes: FOMC participants significantly…