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Highlights So What? The U.S.-China tariff ceasefire is a net positive, but a final deal is by no means assured. Why? In the near term there may be a play on global risk assets, but beyond that we remain cautious. Global divergence remains the key theme, and China now has less reason to stimulate. What to watch for a final deal: Trump’s approval rating, China’s structural concessions, and geopolitical tensions. We recommend booking gains on our long DM / short EM trades. Go long EM oil producers on OPEC 2.0 cuts. Feature U.S. President Donald Trump and Chinese President Xi Jinping have agreed to a trade truce at the G20 summit in Buenos Aires. The deal includes: Tariff Ceasefire: A 90-day ceasefire – until March 1 – on hiking the second-round tariffs from 10% to 25% on $200bn of Chinese imports. Substantive Talks: The talks will center on structural changes to the Chinese economy, including forced tech transfer, IP theft, hacking, and non-tariff barriers. Vice-Premier Liu He, Xi Jinping’s key economics and trade advisor, may visit Washington in mid-December. Imports: China has agreed to import more goods to lower the U.S. trade deficit, including agricultural and capital goods. This harkens back to the failed May 20 “beef and Boeings” deal. As with the previous deal, there are no deadlines or quantities promised. Not included in the two-and-a-half-hour dinner between Trump and Xi was a substantive discussion on geopolitical tensions. While Chinese statements following the summit did reaffirm Chinese commitment to the U.S.-North Korean diplomacy, there was no broader agreement on tensions, particularly in the South China Sea. The U.S. has recently demanded that China demilitarize the area. Should investors “play” the summit? Tactically, there is an opportunity to play global risk assets in the near term. Cyclically and structurally, however, both economic fundamentals and the underlying trajectory of U.S.-China relations call for caution over the course of 2019. Will The Truce Hold? There are five reasons to doubt the sustainability of the truce: Trade imbalance: It is highly unlikely that the trade imbalance between China and the U.S. can be substantively altered over the course of 90 days. The U.S. economy is in “rude health,” the USD is strong, unemployment is low and pushing up wages, and the output gap is closed. These are the macroeconomic conditions normally associated with an elevated trade imbalance (Chart 1). Chart 1Trade Deficit To Rise Despite Tariffs Domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues throughout the election season, but not on the issue of his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair, unlike trade with other countries (Chart 2). As such, President Trump will have to produce a convincing deal in order to ensure that his base, and many Democrats, support the deal. Chart 2Americans Are Focused On China As Unfair Structural tensions: U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the G20 summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.1 The report was an update to the original investigation that launched the Section 301 tariffs against China. Lighthizer’s report therefore provides a road-map for what the U.S. will want to see over the course of 90 days. High-tech transfers: The Department of Commerce announced on November 19 a “Review of Controls for Certain Emerging Technologies.” This review will conclude on December 19 when the public comment period ends. In the report, the federal government lists biotech, AI, genetic computation, microprocessors, data analytics, quantum computing, logistics, 3D printing, robotics, hypersonic propulsion, advanced materials, and advanced surveillance as technologies with potential “dual-use” that may be critical to U.S. national security and thus might merit consideration for export control.2 As such, the U.S. may decide to impose export controls on technologies that China deems critical to accomplishing its “Made in China 2025” goals within the period of the 90 day talks. If those export controls were to include critical items – such as semiconductors, which are critical to China’s export-oriented manufacturing (Chart 3) – negotiations may become more complicated. Geopolitics: The trade truce did not contain any substantive resolution to ongoing strategic tensions between the U.S. and China. These tensions precede President Trump: we have detailed them in these pages since 2012.3 As such, the U.S. defense and intelligence community will have to be on board with any trade deal and that may suggest that Beijing will be asked to make geopolitical concessions over the course of the next 90 days. Chart 3China Accounts For 60% Of Global Semiconductor Demand Despite the above, the trade truce is a meaningful and substantive move away from an open trade war. Yes, the U.S. will retain tariffs on $250bn Chinese imports, with China maintaining tariffs on $66bn of U.S. imports (Chart 4). No, the U.S. did not rule out a third round of tariffs covering the remaining $267 billion of Chinese imports, if things go awry. Nevertheless, the 90-day truce implies that the U.S. will not ratchet up the tensions for now. Chart 4U.S.-China Trade Hit By Tariffs The truce also allows China to make substantive changes to its domestic economic policies that may satisfy some of the structural concerns cited in the above U.S. Trade Representative report. The soundest basis for a durable deal lies in China recommitting to structural reforms: this would both be positive for China’s productivity and would assuage some of Washington’s underlying anxieties about China’s state-backed industrial policies. Significantly, China’s Ministry of Foreign Affairs now says that it will “gradually resolve the legitimate concerns of the U.S. in the process of advancing a new round of reform and opening up in China.” When would this new round of reform occur? The upcoming Central Economic Work Conference, and the 40th anniversary of Deng Xiaoping’s reforms, should be watched closely for new initiatives. Also, the new March 1 tariff deadline lines up with the calendar for China’s National People’s Congress (NPC). The NPC meets every year and is the occasion when any major new domestic reforms would need to be laid out. Thus, any Chinese compromises on structural issues could be rolled out as part of a more general reform agenda in March. This is important because the U.S. administration is determined to focus on implementation and not to let China delay resolution of differences through endless rounds of dialogue. As such, investors should watch the following issues over the course of the next three months in order to gauge the likelihood of a substantive deal that not only rules out new tariffs but also rolls back the existing ones: Polls: President Trump is focused on his 2020 reelection. As such, he will want to see political gains from the easing of pressure on China, both in the general populace and amongst his GOP base (Chart 5). A slump in the polls, or a threatening turn in the Mueller investigation, may justify a shift in the narrative come March-April and thus end the truce. Chart 5Trump’s Approval Will Affect Trade Talks Big ticket announcements: China is going to have to make big-ticket item purchases. A huge order of Boeing airplanes, a massive ramp-up in the purchase of agricultural products, a raft of direct investments in manufacturing in the heartland … these are the type of announcements that President Trump could use to sell a substantive deal to his base. Structural changes to the Chinese economy: China will have to prove that it is addressing the concerns outlined in the U.S. Trade Representative report. We suspect that Lighthizer issued the report ahead of the G20 summit so as to set the benchmark for what the U.S. wants to see from Beijing. It is a high benchmark as it includes: An end to cyber theft, hacking, and corporate espionage; Substantive, rather than merely “incremental,” improvements to U.S. market access, including increased ownership of ventures; Serious changes to state-subsidized industrial programs that utilize stolen technology, particularly the so-called “Strategic Emerging Industries” program and “Made in China 2025”; An end to China’s state-backed investment campaign in Silicon Valley. No new U.S. embargoes: The public comment period for the newly proposed U.S. export controls ends on December 19. That suggests that high-tech restrictions could emerge over the course of the first quarter of 2019. These could exacerbate tensions. No new geopolitical tensions: Geopolitical tensions, such as over human rights in Xinjiang or the militarization of the South China Sea, would obviously make a deal less likely.  Bottom Line: The trade truce could lead to a substantive trade deal between China and the U.S. However, many impediments remain. Investors have to answer three key questions: is the deal politically useful for President Trump ahead of the 2020 election? Does the deal resolve the concerns laid out in the U.S. Trade Representative’s Section 301 report? And will geopolitical and national security tensions ease? Since 2012, we have had a structurally bearish view of the Sino-American relationship. This view is based on long-term structural factors that we do not think can be resolved over the course of 90 days. That said, every structural view can have cyclical deviations. The question we now turn to is how to play such a cyclical deviation in terms of the markets. What Does The Truce Mean For The Markets? In our view, the trade war has been of secondary importance to global markets. Far more relevant to the BCA House View that DM assets will outperform EM has been our conclusion that U.S. and Chinese economies would experience policy divergence. The U.S. economy has been buoyed by pro-cyclical stimulus, whereas Chinese policymakers have created a macro-prudential framework that has impaired the country’s credit channel. This divergence has led to the outperformance of the U.S. economy over the rest of the world, leading to a substantive USD rally (Chart 6). Chart 6U.S. Outperformance Should Be Bullish USD While this view has worked out well in 2018, it appears to be fraying as the year comes to the end: Chart 7U.S. Growth Weakening? Fed dovishness: Our recent travels to Asia, the Middle East, Europe, and the Midwest have revealed unease among investors regarding the health of the U.S. economy. Some recent data, such as the woeful core durable goods orders (Chart 7) and weak housing, have prompted calls for a more dovish Fed. On cue, Fed Chair Jay Powell delivered what was perceived as a dovish speech. BCA’s Chief Global Strategist, Peter Berezin, makes a strong case for why investors should fade the enthusiasm.4 Specifically, Peter thinks that investors are focusing too much on the unknown – the neutral rate – and not enough on the known – the budding inflationary pressures (Chart 8). Nonetheless, in the near-term, the narrative of a “Fed pause” may overwhelm the data. Chart 8Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Chinese stimulus: Evidence of a broad-based, irrigation-style, credit stimulus is scant in China’s data. Nonetheless, many investors we have met on the road are latching on to higher local government bond issuance (Chart 9) and a positive M2 credit impulse (Chart 10). Moreover, Q1 almost always brings a boost in new lending in China. Our colleague Dhaval Joshi, BCA’s Chief European Strategist, has recently pointed out that the global credit impulse has hooked up, suggesting that EM underperformance is over (Chart 11).5 We do not think that China can turn the corner on a slumping economy without a substantive increase in its total social financing, which remains subdued both in growth terms and as a second derivative (Chart 12). However, we concede that the narrative may have shifted sufficiently in the near term to warrant some tactical caution on our cyclical House View. ​​​​​​​Chart 10China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM Trade truce: Trade concerns have had a clear impact on the outperformance of U.S. equities relative to the rest of the world (Chart 13). As such, a trade truce may alter the narrative sufficiently in the near term to change the direction. In this report, we cite why we are cautious regarding the truce leading to a substantive deal. However, we are biased by our structural perspective that Sino-American tensions are unavoidable. The vast majority of our clients and global investors does not share this view. In fact, the trade war has caught the investment community by surprise. As such, we would argue that investors are biased towards a “win-win” scenario. Therefore, investors may not be cautious, but may in fact project a much higher probability of a final deal into their market decisions. Chart 12China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War Over the course of 2019, we do not think the global risk asset bullishness is sustainable. In fact, a reprieve rally now is going to make global growth resynchronization less likely and continued policy divergence more likely. Why? First, Chinese policymakers will have less of a reason to deploy an irrigation-style credit stimulus if fears of an accelerated trade war abate. Second, the Fed will have less of a reason to back off from its hiking trajectory if both the DXY rally and equity market volatility ease. That said, we are going to close our long DM / short EM trades for the time being. This includes: Our long DM equities / short EM equities, for a gain of 15.70%; Our long U.S. Dollar (DXY) index for a gain of 0.56%; Our long USD / Short EM currency basket for a loss of 0.76%; Our long JPY/GBP call, for a gain of 0.32%. Our hedge of being long China play index ought to outperform on a tactical horizon, so we are leaving it open despite its paltry return so far of 0.32%. Also, we are keeping our long Chinese equities ex. Tech / short EM equities trade, as Chinese assets should rally on the back of the truce. Note that, as outlined above, China’s tech sector is not out of the woods yet. Our decision to close these recommendations is to preserve profits, not change our investment stance. On a cyclical horizon, we remain skeptical that global risk assets will outperform DM, and U.S. assets in particular, over the course of 2019. In the end, we do not believe that a mere narrative shift will be sustainable, especially given the robustness of the U.S. labor market (Chart 14) and the tepidness of Chinese stimulus (Chart 15). Chart 14A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Finally, a word on oil prices. The G20 was crucial for the oil call, as well as the trade war, given that Saudi Arabia and Russia suggested that their OPEC 2.0 union would produce supply cuts at the upcoming Vienna meeting on December 6. This proves that fundamentals were more important than the narrative that Saudi leadership “owed” a favor to President Trump. In particular, the Saudis have fiscal constraints given their budget breakeven oil price is around $80-$85 per barrel. As such, we are reinitiating our long EM energy producers (ex-Russia) / short broad EM (ex-China) equity call. We are excluding Russia from the “long” due to lingering geopolitical concerns – sanctions and Ukraine – and China from the “short,” as we are now tactically bullish on China.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 2      Please see The Federal Register, “Review of Controls for Certain Emerging Technologies,” dated November 19, 2018, available at www.federalregister.gov. 3      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?,” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?,” dated March 28, 2017, available at gps.bcaresearch.com. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018, available at gis.bcaresearch.com. 5      Please see European Investment Strategy Weekly Report, “DM Versus EM, And Two European Psychodramas,” dated November 22, 2018, available at eis.bcaresearch.com. 

Highlights Portfolio Strategy Higher interest rates, with the Federal Reserve tightening monetary policy three more times in the next seven months, will be the dominant theme next year. All four of our high-conviction underweight calls are levered to this theme. The later stages of the U.S. capex upcycle underpin three of our high-conviction overweight calls for 2019. Recent Changes Downgrade the S&P Home Improvement Retail index to underweight today. Trim the S&P Interactive Media & Services index to a below benchmark allocation today.  Table 1 Feature Fed policy will dominate markets next year as the dual tightening backdrop – rising fed funds rate and accelerated downsizing of the Fed balance sheet – remains intact. Two weeks ago we raised the question: is the Fed tightening monetary policy too far too fast?1 In more detail, we put the latest monetary tightening cycle in historical perspective and examined trough-to-peak moves in the fed funds rate since the 1950s (Chart 1). Chart 1Too Far Too Fast? A good friend I call “the smartest man in California” correctly pointed out that 500bps of tightening today is not the same as in the 1970s or 1980s. Chart 2 adjusts for that by including the average nominal GDP growth rate during these tightening episodes and adds more color to each era. As a reminder, the latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect, and above-average nominal output growth. Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median Trying to answer the question, we are concerned that as the Fed remains committed to tighten monetary policy three more times by mid-2019, a yield curve inversion looms, especially if the U.S. economy suffers a soft patch in the first half of next year (please refer to our Economic Impulse Indicator analysis in the October 22ndand November 19th Weekly Reports). This would signal at least a pause, if not reversal, in Fed policy. With that in mind, this week we are revealing our high-conviction calls for 2019. Four of our calls are a play on this tightening monetary backdrop that is one of BCA’s themes for next year.2 The later stages of the U.S. capex upcycle underpin three of our high-conviction calls. Table 22018 High-Conviction Calls Recap However, before we highlight our 2019 high-conviction calls in detail, Table 2 tallies our calls from last year. We had a stellar performance in our 2018 high-conviction calls with an average excess return of 11.6% versus the S&P 500. As the year turns the corner, closing out the remaining calls brings down the average relative return to 7.5%, still a very impressive number, with a total of ten hits and only two misses for the year.    Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com     Software (Overweight, Capex Theme) Software stocks are our first hold out from last year’s high-conviction overweight list, levered to the capex upcycle theme. Chart 3 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment, especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits. Beyond capex, M&A has been fueling software stock prices. It did not take long for the large CA acquisition to get surpassed by RHT and more recently SYMC was also rumored to be in play (Chart 3). Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels. The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. The recovery in the software price deflator (Chart 3), a proxy for industry pricing power, corroborates the upbeat demand backdrop. With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Chart 3Software   Air Freight & Logistics (Overweight, Capex Theme) Air freight & logistics stocks are the second hold out from our high-conviction overweight list, although we added it to list only in late-March. This transportation sub-index laggered is a capex and trade de-escalation play for the first half of 2019. Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 4). On that front, there are high odds that this holiday sales season will be another record setting one, as wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (Chart 4). Firming industry operating metrics also tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures. While the U.S./China trade tussle and the appreciating greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals (Chart 4). The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Chart 4Air Freight & Logistics   Defense (Overweight, Capex Theme) We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory. Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. The recent drawdown offers such an opportunity and we are adding this index to the 2019 high-conviction overweight list. The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate (Chart 5). In fact, the CBO continues to project that defense outlays will jump further next year. While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning takeout premia. A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters. Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 5 on page 7). While interest coverage has been modestly deteriorating, it is twice as high as the overall market (Chart 5 on page 7). Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Chart 5Defense   Consumer Discretionary (Underweight, Higher Fed Funds Rate Theme) We recommend investors avoid the consumer discretionary sector that suffers when interest rates rise. Chart 6 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Recently we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 6). Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged. Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth 23.4%/annum or 1.4 times higher than the overall market. Clearly this is not realistic as it assumes a tripling of EPS in the coming 5 years. Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (Chart 6 on page 9). As a result, the 12-month forward P/E ratio is trading at a 24% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 6 on page 9). Chart 6Consumer Discretionary   Home Improvement Retail (Underweight, Higher Fed Funds Rate Theme) While the probablity of a housing recession remains low, we are concerned that too much euphoria is already priced in the S&P home improvement retail (HIR) index, and there are high odds that next year HIR will suffer the same fate as homebuilders did this year (Chart 7). Thus, we are downgrading the S&P HIR index to underweight and adding it to the high-conviction underweight list for 2019. Fixed residential investment (FRI) as a percentage of GDP is up 50% from trough to the recent peak, whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass as FRI is steadily sinking (Chart 7). Worrisomely, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 7). Lumber deflation will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone. Finally, there is rising supply of new and existing homes for sale already on the market, and that puts off remodeling activity at least until this supply glut clears (months' supply shown inverted, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Chart 7Home Improvement Retail   Short Small Caps/Long Large Caps (Higher Fed Funds Rate Theme) The days in the sun are over for small cap stocks and we are compelled to put the size bias favoring large caps in our high-conviction calls list for 2019. Small caps are severely debt saddled. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 compared with less than 2 for the SPX (Chart 8). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Small and medium enterprises (SMEs) have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. Moreover, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (Chart 8). Small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, middle panel, Chart 8). Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, fourth panel, Chart 8 on page 12). Chart 8Small Vs. Large   Interactive Media & Services (Underweight, Higher Fed Funds Rate Theme) In our initiation of coverage on the S&P interactive media & services index,5 we highlighted three key risks that offset the revenue & profit growth vigor of this group, comprised almost entirely of Alphabet (Google) and Facebook. These were a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar. It is the first of these that has risen most dramatically since that report. Tack on the inverse correlation these growth stocks have with interest rates (top panel, Chart 9) and that is causing us to lower our recommendation to underweight and include this index in the high-conviction underweight list for 2019. Increasing regulatory efforts on technology will be a key theme next year, one we explored this past summer.6 Our conclusion was that both antitrust (particularly in the case of Alphabet) and privacy regulation (particularly in the case of Facebook) added significant risk to these near monopolies; calls for legislating both have dramatically amplified. Tim Cook, Apple’s CEO, recently commented that more regulation for Facebook and Alphabet was inevitable; we agree. While the form such regulation might take remains open to debate (for example, the U.S. could adopt an EU-style General Data Protection Regulation (GDPR)), we fear the associated headline risk (not to mention likely profit headwinds) will impair stock prices in the S&P interactive media & services index. This communication services sub-index is particularly prone to such a risk when it already trades at close to a 40% valuation premium to the broad market (middle panel, Chart 9 on page 14). Adding insult to injury is the PEG ratio that is trading at a 60% premium to the broad market (bottom panel, Chart 9 on page 14). In the face of the Fed’s sustained tightening cycle these extreme growth stocks are vulnerable to massive gravitational pull. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. Chart 9Interactive Media & Services Footnotes 1      Please see BCA U.S. Equity Strategy Report, "Manic Market," dated November 19, 2018, available at uses.bcaresearch.com. 2      Please see BCA The Bank Credit Analyst Report, "OUTLOOK 2019: Late-Cycle Turbulence", dated November 26, 2018, available at bca.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4      Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Special Report, "New Lines Of Communication," dated October 1, 2018, available at uses.bcaresearch.com. 6      Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?", dated August 1, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Informe especial

Highlights Our Special Report on housing betrayed little concern, … : We noted the softness in housing, and its drag on U.S. growth, in our November 19 Special Report, but we concluded that it was not sending a more worrisome message about the U.S. economic outlook. ... which didn’t mesh with several of our clients’ assessments, … : Our conclusion was apparently out of step with a fair proportion of investors. The clients who contacted us are not convinced that the softness so far isn’t just the tip of the iceberg. … so we’ve been discussing it a lot, … : Some BCA strategists are also more uneasy about housing and what it may be saying about the fate of the expansion. The topic continues to be bandied about in our daily meetings, and it probably hasn’t been exhausted yet. … and we’re sharing the conversations with everyone now: Publicly airing our one-on-one discussions gives all clients a chance to listen in and also gives us a chance to expand upon our views. Though we stand by our original conclusion, engaging in dialogue has enhanced our understanding of the issues. Feature The stock market still feels a little shaky, but the S&P 500 bounced smartly off of 2,640 once again, the abbreviated day-after-Thanksgiving session aside. Our Global Investment Strategy colleagues’ MacroQuant model sees more near-term downside, but neither of our teams believes that the bull market is over. The economy is strong; monetary policy remains accommodative; and fiscal stimulus will continue to support growth in 2019, albeit to a lesser degree. We do not see the good times ending for risk assets or the expansion until the Fed intervenes to bring the curtain down. We will discuss our outlook for the coming year, and the way we expect the key cycles will evolve, next week. For now, we turn to the wave of client questions that followed our Special Report on housing two weeks ago. The general view seems to be that we are not taking the potential implications of disappointing housing data seriously enough. The highlights of our follow-up discussions appear below, but we continue to believe that the housing slowdown does not portend larger immediate problems. Q: What about the effect of the new $10,000 cap on the deductibility of state and local taxes in high-tax states? The $10,000 cap on state and local tax (SALT) deductions will hurt housing demand at the margin, as will lower limits on mortgage interest deductibility. People respond to incentives, and several households may choose to rent instead of buy now that homeownership subsidies have been dialed back. The 1986 Tax Reform Act provides a ready antecedent. The mortal wound it dealt real estate tax shelters set the stage for the commercial real estate downturn of the late ‘80s and early ‘90s, and it also contributed to the nearly decade-long stagnation in nominal home prices (Chart 1) that was quite nasty in inflation-adjusted terms (Chart 2). Chart 1The Last Tax-Code Revamp Squeezed Home Values...   Chart 2...Especially On An Inflation-Adjusted Basis The regional disparities in home sales do not suggest that the tax changes have been a primary driver of the softness. Households in states with high income-tax burdens are most likely to go from itemizing their deductions (the mechanism for claiming housing subsidies) to taking the standard deduction. If the SALT rule change were squeezing home sales, one would expect that the states with the highest income-tax rates would be experiencing the biggest declines. We tested that proposition by comparing population-weighted tax rates with the share of home sales in each region. Although the South has the lowest top marginal income tax rate by a mile (Table 1), it has lost nearly two percentage points, or 4%, of its national market share since this year’s peak in home sales (Table 2). The high-tax Northeast, on the other hand, picked up nearly one percentage point, or 9%, of market share. The onerously-taxed West has lost the same proportional share as the South, but its homes are also the least affordable – a family earning the median income barely qualifies for a standard mortgage to buy the median-priced house in that region (Chart 3, bottom panel). Table 1Regional Income Tax Rates   Table 2Regional Share Of National Home Sales   Chart 3Only The West Is A Stretch Bottom Line: Income tax changes reducing homeowner subsidies will surely dampen marginal demand for homes, but they have not yet had an observable effect on the regional data. Q: The decline in activity has been modest so far, but what if it’s the start of something bigger? How do you know it’s not 2006? Housing is an important part of the economy, and residential investment could become a problem if it weakens further. We did not mean to imply that investors can ignore what’s going on in the industry. Residential activity puts a lot of people to work, directly and indirectly, and drives big-ticket consumption of home improvements, appliances and home furnishings. Its status as a rate-sensitive pillar helps provide insight into the effect of monetary policy, a particular flash point right now. From the narrow perspective of whether or not housing is likely to tip the economy into a recession, however, the arithmetic is clear. According to the IMF’s latest projections, fiscal stimulus will add 40 basis points to real GDP in 2019. Merely offsetting the effect of next year’s fiscal thrust would require residential investment, which accounts for 3.3% of GDP, to contract by 12% on an annualized basis. Residential construction would have to grind to a halt to wipe out projected growth of 2.5%. Even following October’s new home sales dud, the housing market is nowhere near oversupplied (Chart 4). The supply/demand balance is night-and-day different from what it was ahead of the crisis. Back then, there was also a decade of excessive mortgage issuance that needed to be unwound. Housing remains an important component of the economy, but it has shrunk to the point that it is not in a position to overwhelm the preponderance of positive macro data. Chart 4Supply Is Tight Bottom Line: We are watching housing, as BCA always has, but the market’s aggregate undersupply gives us confidence that residential activity is not about to fall off of a cliff. Q: The value of the housing stock is so large that it wouldn’t take a bust to have major economic implications. Consumption would immediately be at risk, and the economy with it. It is true that homes account for a sizable portion of household net worth, but the widely-repeated notion that homes are the biggest asset on the aggregate household balance sheet is misleading. When considered in terms of homeowner equity (home value net of mortgage obligations), homes currently account for about 14% of aggregate household net worth. Pension entitlements and equity and mutual fund holdings each account for about a quarter of net worth, and cash and equity in non-corporate businesses each account for about an eighth (Chart 5). Homeowner equity’s share of household net worth has rebounded nicely from its crisis lows, but it is a full third below its 1980s and 2006 peaks. Chart 5Home Values Matter, But They're Far From The Whole Story The point is that a generalized decline in home prices might affect consumption less than investors fear. The wealth effect is real, but fluctuations in home values are not evident to homeowners in real time. While we estimate that consumption falls five cents for every dollar decline in home values, the two series do not always march in lockstep, as in the ‘90s and the initial post-crisis years, when consumption grew even as home prices shrank (Chart 6, bottom panel). With the market in a state of undersupply, we don’t see a reason to expect that home prices are at much risk. Chart 6Consumption And Home Price Appreciation Are Linked Bottom Line: Absent overbuilding, foolhardy lending, or a harmful structural change on the order of the imposition of the passive activity rules, there is no clear catalyst for severe home-price declines. The economy should be able to handle a modest home-price correction without too much ado. Q: Not so fast. The crisis demonstrated that there’s a direct link between housing and credit conditions. It doesn’t take a perma-bear to see how a decline in home prices could cause the banking system to seize up. Our BCA colleagues are quite familiar with our view that homes are the collateral for the U.S. banking system. That view is a broad generalization, but the crisis bore it out. Banks are vastly better capitalized than they were in 2007, however, and it is difficult to see a path to major declines in home prices. Busts follow booms because they’re a necessary cure for unsustainable excesses, but nothing extreme has occurred this time on either the supply or the price fronts. Although we are hardly card-carrying Austrians, we have a lot of sympathy for the view that ZIRP, NIRP and QE programs subjected financial markets to distortions. They abetted a search for yield that allowed questionable credits to attract capital and promoted a widespread relaxation of debt covenants. They additionally seem to have lit a fire under property values in jurisdictions where home prices have become detached from standard value metrics. In the main, however, those jurisdictions are not in the U.S. (Chart 7). Chart 7U.S. Housing Isn't The Problem In talking through the bank exposure issue with a client, we arrived at a simple rule: property markets that haven’t already received their comeuppance are the property markets that threaten wealth, confidence and banking systems. The U.S. got its comeuppance in the crisis: property values plunged, loans went bad en masse, banks and specialty lenders failed, the survivors were chastened, and new regulations were put in place to protect the bankers from themselves and the economy from banks. As the Fed continues on its slow march to remove monetary accommodation, it is entirely reasonable for a macro-minded investor to be on the lookout for wobbly property markets. S/he would be best served by studying the rest of the dollar bloc: Canada, Australia and New Zealand are all vulnerable; the United States is not. Q: The Kansas City market is bifurcated by price. Supply is constrained at lower price points, although the formerly red-hot move-up segment has slowed considerably since mortgage rates spiked. High-end homes are being discounted sharply, and the baby boomers’ 4,000-6,000-square-foot suburban behemoths, untouched since the ‘80s, cost as much as brand-new high-end construction once you factor in the work they’d need to make them appeal to today’s buyers. Meanwhile, the limited supply of homes for first-time buyers has multi-family apartments popping up on every block. A market based on location, location, location is inherently heterogeneous, but a lot of what is happening in Kansas City appears to be playing out nationally. The rapid rise in mortgage rates has dented demand across the board. We’ve been hearing rumblings about easy multi-family credit for a while, most memorably from a Texas client who told us in 2014 that a blueprint was all it took for an apartment developer to get a bank loan. There is no investment idea so good that it can’t be destroyed by too much capital, and it’s entirely possible that some developers, commercial real estate lenders, commercial mortgage-backed securities holders and apartment REITs could be vulnerable if entry-level supply surges. There is no sign right now that it will, however. According to the Harvard Joint Center for Housing Studies, “virtually all” of the nation’s metropolitan areas “had more homes for sale in the top third of the market by price than in the bottom third.” A limited supply of available land and rising construction costs push developers to migrate to higher price points. The trend toward more expensive homes has been in place across the entire 30-year history of the Harvard center’s annual survey: the share of smaller homes (1,800 square feet or less) has slid from 50 percent in 1988 to 36 percent in 2000 and 22 percent in 2017.1 The fate of the boomers’ homes touches on what may be the most compelling long-term issue: to whom will the baby boomers pass the baton? Will the millennials accumulate enough wealth to be able to take it? Will they want to, after living through the formative experience of the financial crisis? Will suburban and exurban homes go vacant as preferences shift to the density and walkability of town and city centers? Are wide swaths of the existing housing stock destined for obsolescence? We are not inclined to think so. Even if homeownership is suppressed by a lessened desire to own, or delays in starting a career in the wake of the crisis, millennials and their families will still need a roof over their heads. We expect that purchase and rental prices will correct for changes in location and decorating preferences; homebuyers will put up with dark cabinets, loud tile patterns and wall-to-wall shag carpeting if the price is right. Lower prices might be what’s needed to help solve a potentially thorny problem raised by a client in the antipodes: the transfer of wealth across generations. He sees barriers to homeownership for the middle class as a social and political powder keg. A transfer of wealth from older generations to younger generations, accomplished by property markdowns instead of punitive income and property taxes, could be far less disruptive for markets and may even help to ease inequality strains. Furthermore, buyers who get a deal on a property have more money available for other consumption, while those who pay up retain less dry powder to help keep the economy humming. Investment Implications Investors are well served to be alert for excesses that cannot be sustained, and it is a near certainty that a 10-year expansion nourished on extreme monetary accommodation would have bred more than a few. From our perspective, however, all of the worst ones exist beyond the borders of the United States. Virtually all of the post-crisis increase in private-sector leverage has been contained in the emerging markets. The wild residential party has been raging in the developed world’s other former British colonies: Canada, Australia and New Zealand face inevitably sharp declines in construction activity and home prices. We are neither congenital Pollyannas nor market cheerleaders. We are bent on sniffing out market and economic inflection points as adroitly as possible, but we’re convinced that investors who are looking for them in U.S. housing are barking up the wrong tree. The Fed is moving steadily toward inducing an inflection point, but it is not yet upon us, and when it arrives, the attendant distress is not going to be centered on the United States, which already underwent its trial by fire ten years ago. We remain vigilant, but we are constructive on the U.S. economy and risk assets, especially in relation to the rest of the world.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1The State of the Nation’s Housing 2018, Joint Center for Housing Studies of Harvard University, p.6.

Overweight An axiom we have noted numerous times is that, as oil prices decline, the share prices of airlines rise and vice versa. As such, the recent spike in airlines share prices (our upgrade of the S&P airlines index a scant 11 days ago1 has already returned 4% relative to the S&P 500) amidst the collapse in energy prices is of no surprise; relative forward EPS should start moving accordingly (second panel). Airlines typically gain outsized benefits (or losses) on rapid moves in energy, given the lag between ticket sales and the consumption of jet fuel. The current fall in jet fuel prices will thus disproportionately benefit the unhedged airlines (DAL, UAL and AAL) relative to the partially hedged airlines (LUV and ALK). Still, consumers will eventually demand some of the savings passed on to them, which may reverse what has been the best fare environment for airlines of the past four years (third panel). A significant offset will be the already very high capacity utilization at airlines (bottom panel) that lower fares will only serve to increase, preserving the bulk of the margin gains lower jet fuel prices will deliver. Bottom Line: Solid demand, tight capacity and input cost deflation all point to earnings outperformance; we reiterate our recent airlines upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.   1      Please see BCA U.S. Equity Strategy Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com.

Informe especial

Highlights We are exploring the key FX implications of the views presented in BCA’s 2019 annual outlook. Global growth is set to weaken further in the first half of the year. As a result, the U.S. dollar should benefit from a last hurrah before beginning a long painful period of depreciation. The euro will mirror these dynamics and should depreciate below EUR/USD 1.10 before appreciating significantly during the second half. The yen is likely to rally against the EUR in the first half of the year, but the JPY will be left very vulnerable once global growth picks up again. The Swiss franc might be a safe-haven currency, but risks are rising that the Swiss National Bank will increasingly fight against the CHF’s upside vis-à-vis the euro. Thus, EUR/CHF has limited downside while global growth slows, and plenty of upside once global growth firms. The GBP could continue to experience some volatility, but we recommend using any additional weaknesses to buy cable. The commodity and Scandinavian currencies will suffer in the first half of the year, but they should prove the stars of the currency market in the second half. Feature Key View From The Outlook This past Monday we sent you BCA’s Annual Outlook, exploring the key macroeconomic themes that we expect will shape 2019. This year, the discussion between BCA’s editors and Mr. X, and his daughter, Ms. X, yielded the following key views:1 The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the Federal Reserve’s willingness to pause hiking rates, even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reforms agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of a sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed-market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s 2% target, stocks will begin to buckle. This means a window exists next year where stocks will outperform bonds. We are maintaining a benchmark allocation to stocks for now but will increase exposure if global bourses were to fall significantly from current levels without a corresponding deterioration in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely so long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been marginal producers in the global oil sector. With breakeven costs in shale at close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. Essentially, global growth is likely to stay weak in the first half of 2019. However, even if it experiences a benign slowdown, the U.S. economy continues to run above trend, and a U.S. recession next year is a low-probability event (Chart 1). This suggests the Fed will continue to increase rates at a gradual pace of one hike per quarter until U.S. financial conditions become tight enough to force a re-assessment of the U.S. growth outlook. This configuration is likely to result in additional market stress globally and a stronger dollar. As a result, a defensive stance in the FX market seems warranted. Chart 1The Fed Isn't Ready To Capitulate However, China has a role to play in this script as well. The Chinese authorities are getting very uncomfortable with the continued deceleration in Chinese activity. They will likely further support their economy, which should cause global growth to trough toward the middle of the year. This will result in a major selling opportunity for the dollar, and a buying opportunity for the most pro-cyclical currencies. Implications For The FX Markets What are the key implications of these views for currency markets? Based on this outlook for global growth and the Fed, the USD should generate a healthy performance in the first half of the year. As Chart 2 illustrates, the dollar is often strong when global growth and global inflation weaken. However, if global growth is indeed set to rebound in the second half of the year, then, at this point, the dollar should depreciate considerably. This is even more likely as speculators are already very long the greenback, and thus there will be ample firepower to sell the USD once macroeconomic conditions warrant it (Chart 3). As a result, a DXY dollar index above 100 could represent an interesting opportunity for long-term investors to lighten up their dollar exposure. Chart 2The Dollar And The Global Business Cycle   Chart 3Fuel For The Dollar's Downside The euro continues to behave as the anti-dollar; since buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, while American growth is showing budding signs of deceleration, slowing global trade and Chinese economic activity have a more pronounced impact on Europe. As a result, euro area growth is underperforming the U.S. Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread does point to a weaker EUR/USD for the opening quarters of 2019, but it also highlights that the euro may rebound toward the end of the second quarter (Chart 4). Chart 4The Euro Will Rebound, But This Will Not Happen Immediately Additionally, since momentum has a great explanatory power for the dollar, it tends to work well for the anti-dollar, the euro. Currently, momentum suggests that the euro has also more downside. Our favored fair value model for EUR/USD – which includes real short rate differentials, the relative slope yield curves, and the price of copper relative to lumber – stands at 1.11 (Chart 5). Since the euro tends to bottom at discounts to its equilibrium, this suggests that the common currency is likely to find a floor toward 1.08. Chart 5The Euro Will Fall Between 1.08 And 1.05 On a long-term basis, the yen is cheap, and therefore, already reflects the fact that the Bank of Japan’s balance sheet has now grown to 100% of GDP (Chart 6). However, this is of little comfort for the next 12 months. Over this period, movements in global bond yields will determine the yen’s gyrations. Since we expect global growth to slow further in the first half of the year, global yields are likely to remain contained until the second half of 2019. The impact on the yen of fluctuating global yields will be magnified by Japan’s incapacity to generate much inflationary pressure, with core inflation stuck at 0.4%. This means that while JGB yields have limited downside when global bonds rally, they only have very limited upside when global yields rise. Hence, during the first six months or so of the new year the yen is likely to experience limited downside against the dollar and may even experience significant upside against the euro (Chart 7). However, the second half of 2019 is likely to witness a significant reversal of this trend, with a weaker yen against the dollar, and a much stronger EUR/JPY. Chart 6The Yen Is Very Cheap   Chart 7Selling EUR/JPY Should Be A Winner In H1 At this juncture, the pound remains the trickiest currency to forecast. We are entering the last innings of the Brexit negotiations, and Prime Minister Theresa May looks particularly frail. Bad news out of Westminster will most likely continue to hit the pound at regular intervals. However, GBP/USD is cheap enough on a long-term basis that after the month of March, it could experience meaningful upside against the dollar (Chart 8). We are therefore reluctant to sell the pound at current levels, and instead are looking to buy cable each time undesirable headlines knock it down. As the probability grows that the ultimate form of divorce agreement will be a “soft Brexit,” this also means that once the ultimate deal between London and Brussels is set to be ratified by the British Parliament, EUR/GBP could experience significant downside as well (Chart 9). Chart 8Start Buying The Pound Chart 9Substantial Downside In EUR/GBP The Swiss franc benefits against the euro when global growth weakens and asset market volatility rises. This safe-haven attribute of the franc lies behind the 5.4% decline in EUR/CHF since April. Therefore, our view on global growth would suggest that EUR/CHF could experience additional downside in the first half of 2019. However, we are not willing to make this bet. The Swiss National Bank continues to characterize the Swiss franc as being expensive, and Swiss inflation, retail sales and industrial production have all decelerated. In fact, the Economic Expansion Survey indicator is plunging at its quickest pace since the Swiss economy relapsed directly after the botched re-evaluation of the franc in January 2015 (Chart 10). This suggests the SNB will likely soon put a cap on the franc’s strength as it is causing potent damage to the country. This means that EUR/CHF has limited downside in the first half of 2019, even if global growth deteriorates, and should have large upside in the second half of the year as global growth perks up. Chart 10The SNB Will Not Seat On Its Hands: Buy EUR/CHF Commodity currencies could perform very well in the second half of the year, once global growth finds a firmer footing. The oil currencies should perform best over that period, as BCA’s oil view remains firmly bullish, with a 2019 target of $82/bbl if OPEC agrees to a deal. Moreover, the CAD and the NOK are still the cheapest currencies within this group. However, in the first half of the year, the commodity currency complex remains at risk. Slowing global growth and a Fed committed to lifting interest rates to levels more consistent with the U.S. neutral rate are likely to cause the volatility of the currency market to trend higher (Chart 11). Historically, commodity currencies perform poorly when this happens. This is because when FX volatility picks up, carry trades suffer, which hurts global liquidity conditions and hampers global growth further (Chart 12). The AUD is particularly vulnerable as it is the currency most exposed to China’s capex and construction cycles. Moreover, the Reserve Bank of Australia is still very dovish, as there are no inflationary pressures in Australia. Chart 11The Global Macro Outlook Points To Higher FX Vol... Chart 12...And Higher FX Vol Hurts Global Growth Via The Carry Trades Scandinavian currencies are traditionally very pro-cyclical. This reflects the high sensitivity of the Swedish and Norwegian economies to the global business cycle. As a result, when global growth weakens and global inflation disappoints, they are likely to perform as poorly as the AUD and the NZD (Chart 13). Chart 13Weak Global Growth Will Hurt Scandinavian Currencies In H1 2019... Despite this clouded outlook for the beginning of the year, the scandies should perform very well in the second half of 2019, once global growth stabilizes. With their economies at full employment and exhibiting growing imbalances, both the Riksbank and the Norges Bank are in the process of slowly moving away from extremely easy monetary policy settings. However, they have a long way to go before reaching tight monetary conditions, which implies plenty of upside for real interest rates in both countries. This means that the boost to the SEK and the NOK from rising global growth in the second half of the year will be magnified by domestic factors. Finally, both the SEK and the NOK are very cheap, adding upside risks to these currencies (Chart 14). Chart 14...But Scandies Will Have A Stellar H2 2019   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnote 1 The full report – a BCA Research Special – titled “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 26, 2018, is available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

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

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