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Dear Client, Tomorrow we will publish a debate piece on China shedding more light on the ongoing discussions at BCA on this topic. This report will articulate the conceptual and analytical differences between my colleague, Peter Berezin, and I relating to our respective outlooks on China’s credit cycle. Peter believes that the credit boom in China is a natural outcome of a high household “savings” rate. I maintain that household “savings” have no bearing on credit growth, debt or bank deposit levels. Rather, China’s credit and money excesses are pernicious and will precipitate negative macro outcomes. I hope you will find this report valuable and interesting. Today we are publishing analysis and market strategy updates on Russia and Chile. Best regards, Arthur Budaghyan Chief Emerging Markets Strategist Russia: A Fiscal And Monetary Fortress Underpins A Low-Beta Status Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks. First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Chart I-1Fiscal Balance Is In Large Surplus Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Chart I-4Russia: Yield Curve Will Probably Invert Chart I-5Cash Flow From Operations: Russia Versus EM Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). Chart I-6Continue Overweighting Russian Stocks And Bonds To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Chile: Heading Into A Recession? Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. Chart II-1Chile's Central Bank Is Behind The Curve The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Chart II-2More Growth Retrenchment In The Next 6 Months Chart II-3Chilean Economy: Certain Segments Are Contracting Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Chart II-5The Chilean Peso Is Not Cheap Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. The main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1 The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil. 2 Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3 Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Investor surveys show that the majority of investors’ top concerns are political or geopolitical in nature. Yet there is limited research devoted to quantifying these risks. The most prominent techniques involve tallying word counts of key terms that appear…
Highlights So what? Quantifying geopolitical risk just got easier. Why? In this report we introduce 10 proprietary, market-based indicators of country-level political and geopolitical risk. Featured countries include France, U.K., Germany, Italy, Spain, Russia, South Korea, Taiwan, Turkey, and Brazil. Other countries, and refinements to these beta-version indicators, will come in due time. We remain committed to qualitative, constraint-based analysis. Our GeoRisk Indicators will help us determine how the market is pricing key risks, so we can decide whether they are understated or overstated. Feature For the past three months we have been tracking a “Witches’ Brew” of political risks that threaten the late-cycle bull market. Some of these risks have abated for the time being: the Fed is on pause, China’s stimulus has surprised to the upside, and Brexit has been delayed. Other risks we have flagged, however, are heating up: Iran And Oil Market Volatility: Surprisingly the Trump administration has chosen not to extend oil sanction waivers on Iran from May 2, putting 1.3 million barrels per day of oil on schedule to be removed from international markets by an unspecified time. It remains to be seen how rapidly and resolutely the administration will enforce the sanctions on specific allies and partners (Japan, India, Turkey) as well as rivals (China, others). Because the decision coincides with rising production risks from renewed fighting in Libya and regime failure in Venezuela, we expect President Trump to phase in the new enforcement over a period of months, particularly on China and India. But official rhetoric is draconian. Hence the potential for full and immediate enforcement is greater than we thought. In the short term, individual political leaders, and very powerful nations like the United States, can ignore material economic and political constraints. Since the Trump administration’s decision exemplifies this point, geopolitical tail risks will get fatter this year and next. Global oil price volatility and equity market volatility will increase with sanction enforcement actions and retaliation. We would think that Trump’s odds of reelection will marginally suffer, though for now still above 50%, as any full-fledged confrontation with Iran will raise the chances of an oil price-induced recession. U.S.-EU Trade War: Neither the Trump administration nor the U.S. has a compelling interest in imposing Section 232 tariffs on imports of autos and auto parts. Nevertheless the risk of some tariffs remains high – we put it at 35% – because President Trump is legally unconstrained. The decision is technically due by May 18 but Economic Council Director Larry Kudlow has said Trump may adjust the deadline and decide later. Later would make sense given the economic and financial risks of the administration’s decision to ramp up the pressure on Iran.1 But the risk that tariffs will pile onto a weak German and European economy will hang over investors’ heads. U.S.-China Talks Not A Game Changer: The ostensible demand that China cease Iranian oil imports immediately and the stalling of U.S. diplomacy with North Korea are not conducive to concluding a trade deal in May. We have highlighted many times that strategic tensions will persist even if Beijing and Washington quarantine these issues to agree to a short-term trade truce. The June 28-29 G20 meeting in Japan remains the likeliest date for a summit between Presidents Trump and Xi Jinping, but even this timeframe could be too optimistic. Continued uncertainty or a weak deal will fail to satisfy financial markets expecting a very positive outcome. With a 70% chance that U.S. tariffs on China will not increase this year and, contingent on a U.S.-China deal, only a 35% chance that the U.S. slaps tariffs on German cars, we sound optimistic to some clients. But the Trump administration’s decision on Iran is highly market-relevant and portends greater volatility. We expect to see a geopolitical risk premium creep higher into oil markets as well as a greater risk of “Black Swan” events in strategically critical or oil-producing parts of the Middle East. There is limited research devoted to quantifying geopolitical risk. We are late in the business cycle and President Trump has emphatically decided to increase rather than decrease geopolitical risk. Quantifying Geopolitical Risk Geopolitical analysis has taken a bigger role in investors’ decision-making over the last decade. Surveys show that geopolitical risks rank among global investors’ top concerns overall. In the oft-cited Bank of America Merrill Lynch survey, geopolitical and related issues have dominated the “top tail risk” responses for the past half-decade (Chart 1). In other surveys, the most worrisome short-term risks are mostly political or geopolitical in nature, ranking above socio-economic and environmental risks (Chart 2). Despite this high level of concern, there is limited research devoted to quantifying geopolitical risk. Isolating and measuring the range of risks under this umbrella term remains a challenge. As such, for many investors, geopolitics remains an ad hoc, exogenous factor that is often mentioned but rarely incorporated into portfolio construction. For the past four decades the predominant ways of measuring political or geopolitical risk have been qualitative or semi-qualitative. The Delphi technique, developed on the basis of low-quality data sets in social sciences, relies on pooled expert opinions.2 Independently selected experts are asked to provide risk assessments and their responses are then interpreted by analysts to create a measure of risk. Another semi-qualitative method of measuring geopolitical risk ranks countries according to a set of political and socio-economic variables. These variables – such as governance, political and social stability, corruption, law and order, or formal and informal policies – are extremely important but inherently difficult to quantify.3 These results are useful but suffer from dependency on expert opinion, data quality, and institutional biases. More importantly, these methods are slow to react to breaking events in a rapidly changing world. The same goes for bottom-up assessments using political intelligence. The weakness of these methods is that it is highly unlikely that they will produce statistically significant estimates of risk. The odds of getting a “silver bullet” insight from a “key insider” are decent for simple political systems, but not in the complex jurisdictions that host the vast majority of global, liquid investments. Quantitative approaches to measuring geopolitical risk have since become more widespread. The most prominent method is based on quantifying the occurrence of words related to political and geopolitical tensions that appear in international newspapers. These word-counts typically include terms like “terrorism,” “crisis,” “war,” “military action,” etc. As a result, the indices reflect incidents of physical violence or other “Black Swan” events that may not have direct relevance to financial markets. Moreover, while news-based indices accurately capture dramatic one-time peaks at the time of a crisis, they are largely flat aside from these, as they rely on popular topics rather than underlying structural trends (Chart 3). They fail to capture geopolitical developments associated with electoral cycles, protest movements, paradigm shifts in economic policy, or other policy changes.4 Notice, for instance, that the fall of the Soviet Union in late 1991 and the resulting chaos in Russia and many other parts of the emerging world hardly register in Chart 3. Chart 3News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments Introducing BCA’s GeoRisk Indicators The past 70 years have taught BCA Research to listen and respect the market. Why would we suddenly follow the media instead? Most quantitative geopolitical indicators begin with the premise that journalists and the news-reading public have accurately emphasized the most relevant risks and uncertainties. They proceed to quantify the terms of these assessments with increasingly sophisticated methods. This approach solves only part of the puzzle. News-based indices ... fail to capture geopolitical developments associated with underlying policy changes. At BCA Geopolitical Strategy, we aim to generate geopolitical alpha.5 This means identifying where financial media and markets overstate or understate geopolitical risks. We do not primarily aim to predict events or crises. As such, traditional news-based indicators that capture only major events, even those ex post facto, are of little relevance to our analysis. What is needed is a better way to quantify how the market is calculating risks. We start with a simple premise: the market is the greatest machine ever created for gauging the wisdom of the crowd. Furthermore, it puts its money where its predictions are, unlike other methods of geopolitical risk quantification which have no “value at risk.” Chart 4USD/RUB Captures Geopolitical Risk In Russia... To this end, we have introduced market-based indicators over the years that rely on currency movements, which are often the simplest and most immediate means of capturing the process of pricing risk. In 2015, for instance, we introduced an indicator that measures Russia’s geopolitical risk premium (Chart 4). It is constructed using the de-trended residual from a regression of USD/RUB against USD/NOK and Russian CPI relative to U.S. CPI. We can show empirically that it captures geopolitical risk priced into the ruble, as the indicator increases following critical incidents. These include the downing of Malaysian Airlines Flight 17 over eastern Ukraine in 2014; the warnings that Russia aimed to stage a “spring offensive” in Ukraine in 2015; Russian military intervention in the Syrian Civil War later that year; and the poisoning of former intelligence agent Sergei Skripal in the U.K. in 2018 and subsequent tensions. Using similar methods, we created a proxy to capture geopolitical risk in Taiwan, based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 5). The indicator tracks well with previous cross-strait crises. It jumped upon Taiwan’s election of President Tsai Ing-wen and her pro-independence government in January 2016 – and this was well before any tensions actually flared. It even registered a small increase upon her controversial phone call congratulating Donald Trump upon winning the U.S. election. Chart 5...And USD/TWD Captures Geopolitical Risk In Taiwan This year we have expanded on this work, constructing a set of ten standardized GeoRisk Indicators for five developed economies and five emerging economies: U.K., France, Germany, Spain, Italy, Russia, Turkey, Brazil, Korea, and Taiwan. Indicators for the U.S., China, and others will be rolled out in a future report. These indicators attempt to capture risk premiums priced into the various currencies – except for Euro Area countries, where the risk is embedded in equity prices. In each case, we look at whether the relevant assets are decreasing in value at a faster rate than implied by key explanatory variables. The explanatory variables consist of (1) an asset that moves together with the dependent variable while not responding to domestic geopolitical risks, and (2) a variable to capture the state of the economy. This set of indicators differs from our earlier indicators in the following ways: We aim to create a simple methodology that we can apply consistently to all countries, both in the DM and EM universes. We therefore omitted using regression models that can prove to be quite whimsical. Instead, we simply looked at the deviation of the dependent variable from the explanatory variables, all in expanding standardized terms, to create the GeoRisk proxy. We wanted an indicator that would immediately respond to priced-in risks, so we opted for a daily frequency rather than the weekly frequency we used in our initial work. To get as accurate of a signal as possible, we use point-in-time data. Since economic data tends to be released with a one-to-two-month lag, we lagged the economic independent variable to correspond to its release date. All ten indicators are shown in the Appendix. Across all countries, they track well with both short-term events and long-term trends in geopolitical risk. In the case of France, for example, the indicator steadily climbs during the period of domestic tensions and protests in the early 2000s; as the European debt crisis flares up; again during the rise of the anti-establishment Front National and the Russian military intervention in Ukraine; and finally during the U.S. trade tariffs and Yellow Vest protests (Chart 6). Our GeoRisk indicators isolate risks that either originate internally or otherwise affect the country more so than others. Similarly, in Germany, there is a general increase in perceived risk as Chancellor Gerhard Schröder implements structural reforms in the early 2000s; another increase leading up to the leadership change as Angela Merkel is elected Chancellor; another during the global and European financial crises; another during the Ukraine invasion and refugee influx; and finally another with the U.S.-China trade war (Chart 7). Chart 6Our French Indicator Picks Up Domestic And European Unrest Chart 7Greater German Risk Amid The Trade War We have annotated each country’s GeoRisk indicator heavily in the appendix so that readers can see for themselves the correspondence with political events. The indicators are affected by international developments – like the Great Recession – but we have done our best to isolate risks that either originate internally or otherwise affect the country more than other countries. (As a consequence, the Great Recession is muted in some cases.) What are the indicators telling us now? Most obviously, they highlight the extreme risk we have witnessed in the U.K. over the now-delayed March 29 Brexit deadline. We would bet against this risk as the political reality has demonstrated that a “hard Brexit” is very low probability: the U.K. has the ability to back off unilaterally while the EU is willing to extend for the sake of regional stability. In this sense the pound is a tactical buy, which our foreign exchange strategist Chester Ntonifor has highlighted.6 Our U.K. risk indicator has been fairly well correlated with the GBP/USD since the global financial crisis and it suggests that the pound has more room to rally (Chart 8). Chart 8Betting Against A Hard Brexit, the GBP Is A Tactical Buy Meanwhile, Spanish risks are overstated while Italy’s are understated. As for the emerging world, Turkish risks should be expected to spike yet again, as divisions emerge within the ruling coalition in the wake of critical losses in local elections and a failure to reassure investors over monetary policy and the currency. Brazilian risks will probably not match the crisis points of the impeachment and the 2018 election, at least not until controversial pension reforms reach a period of peak uncertainty over legislative passage. Both our new Russian indicator and its prototype are collapsing (see Chart 4 above). This captures the fact that we stand at a critical juncture in Russian affairs, where President Putin is attempting to shift focus to domestic stability even as the U.S. and the West maintain pressure on the economy to deter Russia from its aggressive foreign policy. Given that both Putin’s and the government’s approval ratings are low amid rising oil prices, the stage is set for Russia to take a provocative foreign policy action meant to distract the populace from its poor living conditions. Venezuela is the obvious candidate, but there are others. Moscow will want to test Ukraine’s newly elected, inexperienced president; it may also make a show of support for Iran. With Russia equities having rallied on a relative basis over the past year and a half, and with the Iranian waiver decision already boosting oil prices as we go to press, the window of opportunity to buy Russian stocks is starting to close. (We remain overweight relative to EM on a tactical horizon; our Emerging Markets Strategy is also overweight.) Going forward, we will update these risk indicators regularly as needed and publish the full appendix at the end of every month along with our long-running Geopolitical Calendar. We will also fine-tune the indicators as new information comes to light. In other words, here we present only the beta version. We hope that these indicators will help inform investors as to the direction, and even magnitude, of political risks as the market prices them. Our GeoRisk indicators are not predictive, as establishing a trend is not a prediction. The main purpose of this exercise is to answer the critical question, “What is already priced in?” How is the market currently calculating geopolitical risk for a country? After that, it is the geopolitical strategist’s job to unpack this question through qualitative, constraint-based analysis. It is when our qualitative assessments disagree with what is priced in that we can generate geopolitical alpha. Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1 See Sean Higgins, “Auto tariffs decision could be delayed, Kudlow says,” Washington Examiner, April 3, 2019, www.washingtonexaminer.com. 2 Norman C. Dalkey and Olaf Helmer-Hirschberg, “An Experimental Application of the Delphi Method to the Use of Experts,” Management Science, Vol. 9, Issue: 3 (April 1963) pp. 458- 467. 3 Darryl S. L. Jarvis, “Conceptualizing, Analyzing and Measuring Political Risk: The Evolution of Theory and Method,” Lee Kuan Yew School of Public Policy Research Paper No. LKYSPP08-004 (July 2008). William D. Coplin and Michael K. O'Leary, "Political Forecast For International Business," Planning Review, Vol. 11 Issue: 3 (1983) pp.14-23. The PRS Group, “Political Risk Services”™ (PRS) or the “Coplin-O’Leary Country Risk Rating System”™ Methodology. Daniel Kaufmann, Aart Kraay, and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues,” World Bank Policy Research Working Paper No. 5430 (September 2010). 4 Scott R. Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” The Quarterly Journal of Economics, Volume 131, Issue 4, November 2016 (July 2016) pp.1593–1636. Dario Caldara and Matteo Iacoviello, “Measuring Geopolitical Risk,” Board of Governors of the Federal Reserve Board, Working Paper (January 2018). 5 Please see BCA Research Geopolitical Strategy Special Report, “Five Myths On Geopolitical Forecasting,” dated July 9, 2018, available at gps.bcaresearch.com. 6 Please see BCA Foreign Exchange Strategy Weekly Report, “Not Out Of The Woods Yet,” April 5, 2019, available at www.bcaresearch.com. Appendix Appendix France Appendix U.K. Appendix Germany Appendix Italy Appendix Spain Appendix Russia Appendix Korea Appendix Taiwan Appendix Turkey Appendix Brazil What’s On The Geopolitical Radar? Geopolitical Calendar
Our Commodity & Energy Strategy team believes that Russia’s threat of a market-share war is a feint: A market-share war would damage the Russian economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or…
Highlights The political economy of oil will become even more complicated, following remarks by Russian Finance Minister Anton Siluanov over the weekend, which suggested policymakers there are considering another market-share war to crash prices to limit the growth of U.S. shales. The logic appears to be that by abandoning OPEC 2.0’s production-cutting deal and pushing Brent prices below $40/bbl once again for a year or so, Russia will severely reduce investment flow to the U.S. shale-oil patch, allowing it to retake global market share ceded mostly to Texas oil producers.1 The threat of a market-share war was proffered on top of stepped-up rhetoric by senior government officials – ranging from Igor Sechin, head of state-owned Rosneft Oil, to Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF) – indicating Russia will be pushing for higher production by OPEC 2.0 in 2H19 at the coalition’s upcoming June meeting. We agree with this assessment: The market will require OPEC 2.0 to lift production in 2H19, given our assessment of supply-demand balances. In our estimation, OPEC 2.0’s position has been strengthened considerably by policy-induced disruptions to the oil market.2 As such, we believe Russia’s threat of a market-share war is a feint, particularly since Russia has benefited greatly from higher prices (see below). Our balances and price forecasts this month are largely unchanged (Chart of the Week). We continue to expect Brent to average $75/bbl this year. For 2020, we expect Brent to average $80/bbl. WTI will trade $7 and $5/bbl lower (Chart 2). The balance of price risk has shifted slightly to the left side of the distribution, driven by policy risk and potential miscalculation by the dramatis personae on the international stage, chiefly leaders in the U.S., Russia and China. Chart of the WeekMarkets Continue To Track BCA Balances... Chart 2...While Prices Continue Tracking BCA Forecasts Highlights Energy: Overweight. Tensions in Libya could keep ~ 300k b/d of supply from reaching global markets via its Zawiya port near Tripoli. We closed our long June 2019 $70/bbl vs. short $75/bbl call spread last Thursday with a gain of 87.7%.3 Base Metals: Neutral. China’s latest credit data confirms our view the country’s credit cycle bottomed earlier this year: March Total Social Financing (TSF) increased CNY 2.8 trillion month-on-month vs. consensus expectation of CNY 1.7 trillion. This will support base metals in the coming months. We continue to expect Chinese authorities to expand credit in 2H19.Our long copper trade is up 0.7% since inception on March 7, 2019. We are closing out our tactical iron-ore trade – long 65% Fe vs. short 62% Fe at tonight’s close; it was up 22.9% at Monday’s close. Precious Metals: Neutral. Gold fell 4% from its February high on easing inflation concerns and as fears of an equity correction subsided. March U.S. PCE ex-food and -energy dropped to 1.79% yoy from 1.95% in February, while global equities rose 14% YTD. Our long gold recommendation is down 2.4% since last week, but is still up 3.6% since inception on May 4, 2017. Agriculture: Underweight. U.S. corn and wheat farmers are behind schedule in their spring planting, according to USDA data. The top four American corn-producing states had not started planting by last week, while spring and winter wheat producing states are 11% and 3% behind schedule, mostly due to weather conditions. While delays in planting are always cause for concern, we are still early in the planting season, which gives farmers time to catch up. Feature Policy uncertainty vis-à-vis global oil supply was elevated by Russian Finance Minister Anton Siluanov’s comments indicating policymakers are considering reviving an oil market-share war directed at U.S. shale-oil producers. Siluanov said prices could fall to $40/bbl or less, in the event. Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now His remarks come on the back of statements from Russian government and oil company officials lobbying for higher output. These comments suggest there is a heavyweight Russian contingent fully supporting these demands for OPEC 2.0 to increase production in 2H19 when it meets in June. Otherwise, the threat implies, Russia will seriously consider leaving OPEC 2.0, and will launch its own market-share war against U.S. shale-oil production, led by the fast-growing Permian Basin in Texas. Thus far, Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now – nicely above $70/bbl in the Brent market. He also wants to maintain cooperation with OPEC 2.0, particularly its other putative leader, KSA. We continue to believe, however, KSA and Russia become less comfortable with Brent prices moving sharply above $80/bbl.4 Nonetheless, the threat posed by the U.S. shales is non-trivial: In our latest balances estimates, we raised our 2H19 U.S. output estimates to 12.53mm b/d, and slightly decreased our 2020 estimates to 13.35mm b/d”, led by a 1.17mm b/d and 0.84mm b/d increase in shale output this year and next (Chart 3). Chart 3U.S. Oil Production Estimate Higher For Shales However, Russia – and OPEC 2.0 generally – may be overestimating the rate of growth from U.S. shales going forward: In future research, we will be exploring the extent to which capital markets will restrain growth in the U.S. shales, as investors continue to demand higher returns. The days of growing shale production at any cost may be coming to an end. Russia’s Threat Is A Feint We believe Russia’s threat of a market-share war is a feint: A market-share war would damage the Rodina’s economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or two of their production. The threat needs to be understood in the context of the deterioration of Russia’s position in Venezuela; the increasing tempo of U.S. military operations in its near abroad; and rapidly evolving global oil and gas trade flows, all of which are working against Russian interests and investments.5 The threat appears to be a not-too-subtle reminder of the havoc Russia still can create globally, should it choose to do so, as Vladimir Rouvinski noted recently re Russia’s Venezuela policy.6 Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. Russia’s GDP elasticity to oil prices is more than twice that of KSA’s, which we demonstrated last week.7 This means, from an economic standpoint, it benefits more from higher prices than the Kingdom, based on our modeling. Russia’s oil is exported to refiners and trading companies who pay whatever price is clearing the market, versus KSA, which relies more on direct investments in end-use markets to serve captive demand, and whose GDP has a higher sensitivity to EM economic growth. Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. The coalition’s production-cutting deal this year has reduced global supplies by 1.0mm b/d since the beginning of the year, lifting price from below $50/bbl to more than $70/bbl, in line with our forecast. These production cuts have been supported by strong global demand this year this, which, we expect, will persist in 2020. Of course, Russia could abandon the production-cutting deal with KSA, in the hope of severely reducing investment in U.S. shale-oil production. However, it also would accelerate the loss of foreign direct investment (FDI) in its own hydrocarbons sector, along with those of other OPEC 2.0 member states (Chart 4). Bottom Line: A Russian market-share war aimed at U.S. shale producers would run the very real risk of tanking Russia’s GDP and those of the rest of OPEC 2.0’s member states, as these economies lack the resilience and diversification of the U.S.’s GDP, particularly Texas’s. Even if its fiscal balances are in better shape now, Russia’s economy remains highly sensitive to Brent crude oil prices – moreso than KSA’s, and far moreso the U.S.’s (Chart 5).8 Chart 4Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Chart 5Russia Benefits More Than KSA From Higher Oil Prices BCA’s Balances Mostly Unchanged Our updated balances reflect the lower Venezuelan and Iranian output reported by OPEC’s survey of secondary sources (Table 1). As we have noted previously, we believe OPEC 2.0’s spare capacity is sufficient to cover the loss of Venezuelan output, and the limited losses on Iranian exports imposed by U.S. sanctions (Chart 6). Beyond that, however, the market will be severely stretched if an unplanned outage removes significant production from global supply. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) On the supply side, we continue to expect OPEC and Russia to lift supply in 2H19, following the successful draining of global inventories (Chart 7). We expect OPEC ex-Iran, Libya and Venezuela, led by KSA, will lift 2H19 supply by ~ 400k b/d vs. 1H19 levels, while we expect Russia’s output to rise 200k b/d. Chart 7Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 We continue to expect oil demand to be supported by the renewed easing of monetary policy globally, which will redound to the benefit of EM demand, which also will benefit from the bottoming of China’s credit cycle. Indeed, the EIA added 130k b/d to its estimate of non-OECD demand for this year, on the back of stronger expected growth. We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, with EM growth accounting for 1.1mm b/d of growth this year and 1.3mm b/d next year. In levels, global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. Waivers On U.S. Iran Sanctions Will Be Extended We continue to expect waivers on U.S. sanctions of Iranian oil imports will be extended on May 2, owing to the still-tight supply conditions globally with Venezuela output collapsing and ~ 1mm b/d of Iranian oil already forced off the market. This has, as we’ve noted in our discussions of the New Political Economy of oil, strengthened OPEC 2.0’s hand. This will become apparent when the coalition meets in June to consider whether to increase production in 2H19, in line with our expectation. KSA, Russia and OPEC 2.0 member states will have sufficient data on hand to determine whether and by how much to lift output, in a manner that supports their GDPs. Indeed, on Wednesday, Russian Energy Minister Alexander Novak said, “We should do what is more expedient for us.”9 KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. We also expect U.S. President Donald Trump to try to jawbone OPEC 2.0 into increasing production again, as he did in 2H18. However, we expect those demands to fall on deaf ears, unless fundamental supply dislocations warrant such action. Bottom Line: OPEC 2.0’s strategy is working – it will have maximum flexibility re how it handles its production in 2H19, following the U.S. decision on waivers to its Iran oil-export sanctions on May 2. As we noted last month, KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 OPEC 2.0 is the name we coined for the OPEC/Non-OPEC oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It agreed in November to remove 1.2mm b/d off the market, in order to balance global supply and demand and reduce inventories. Please see “Russia, OPEC may ditch oil deal to fight for market share: Russian minister,” published April 13, 2019, for a re-cap of Siluanov’s remarks. 2 Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019; and “OPEC 2.0: Oil’s Price Fulcrum,” published March 21, 2019. It is available at ces.bcaresearch.com. 3 Please see “Oil steadies as market focuses on supply risks,” published April 15 2019 by reuters.com 4 Please see “Putin Says No Imminent Decision on Oil Output Cuts,” published April 10, 2019, by The Moscow Times. 5 Please see for example, “Pentagon developing military options to deter Russian, Chinese influence in Venezuela,” published by cnn.com April 15, 2019; “Destroyer USS Ross Enters Black Sea, Fourth U.S. Warship Since 2019,” published by news.usni.org April 15, 2019; and “U.S. LNG exports pick up, with Europe a major buyer,” published by reuters.com March 7, 2019. 6 Please see “Russian-Venezuelan Relations at a Crossroads” by Vladimir Rouvinski, published by the Wilson Center’s Kennan Institute in its February Latin American digest. 7 Please see “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” published by BCA Research’s Commodity & Energy Strategy April 11, 2019. It is available at ces.bcaresearch.com. 8 We discuss the impact of higher oil prices on Russia’s economy in last week’s report, which is cited in footnote 6 above. Russia’s GDP in 2017 was ~ U.S. $1.6 trillion, according to the World Bank, while the GDP of Texas was ~ $1.7 trillion, American Enterprise Institute. 9 Please see “Russia’s Novak: early to speak about options for oil output deal,” published reuters.com April 17, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights OPEC 2.0 will meet in June to decide whether to continue its production cuts into 2H19. Once again, the leaders are sending conflicting signals – KSA is subtly indicating OPEC 2.0’s 1.2mm b/d of production cuts will need to be extended to year-end. Russia, not so much. Much will depend on whether the U.S. extends waivers on Iran oil-export sanctions when they expire May 2. Not surprisingly, Trump administration officials also are not providing much in the way of forward guidance to markets, other than to insist they want Iran’s exports at zero. Our modeling indicates OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – will need to raise production in 2H19, as markets tighten on the back of Venezuela’s collapse, continued unplanned outages (most recently in Libya) and still-strong demand. This aligns our view somewhat with that of Russia. That said, OPEC 2.0’s leaders – and member states – all benefit from higher prices, as we show below. Some, like Russia, more so than others – e.g., KSA, hard as that is to reconcile with their respective stances on production cuts. But none benefits if EM demand is crushed by high prices. It’s a delicate balancing act, given the aggregate GDP of EM commodity-importing countries exceeds that of commodity-exporting countries (Chart of the Week).1 Chart of the WeekEM Commodity Importers Dominate Aggregate EM Oil Demand We continue to expect Brent to trade at $75/bbl this year and $80/bbl next year, given our expectation for global supply and demand. KSA and Russia remain the fulcrum of the oil market, as we argued recently, and anticipating their decision-making process remains the critical task for understanding the new political economy of oil.2 Highlights Energy: Overweight. U.S. Secretary of State Mike Pompeo demanded opposing forces in Libya cease fighting this week. The country recently lifted oil production over 1mm b/d, but renewed fighting threatens this output. Base Metals: Neutral. China’s National Development & Reform Commission (NDRC) earlier this week tee’d up markets to expect higher infrastructure and transportation spending, which lifted steel and iron ore markets. Markets continue to tighten on the back of the Vale high-grade iron-ore supply losses, which could lift prices above $100/MT in the short term. Precious Metals: Neutral. Central banks continued buying gold in February, the World Gold Council reported this week. Central-bank holdings rose a net 51 tonnes in February bringing total additions to 90 tonnes in the first two months of the year. Agriculture: Underweight. The USDA lifted its estimate of global ending stocks for corn by 5.5mm tons for the 2018/19 crop year. With total use estimates unchanged at 1.13 billion tons, this raises ending stocks-to-use estimates, which will continue to exert downward pressure on prices. Feature KSA and Russia share a common feature in that both are petro states, and thus heavily dependent on crude and product exports to fund their governments and economies. Both suffered a near-death experience during the 2014-16 oil-market-share war launched by OPEC, and both have seen their GDPs slowly recover, following the successful production-cutting agreements they jointly engineered to drain excess inventories and restore balance to the market beginning in 2017 and renewed this year (Chart 2). Russia’s GDP gets more than twice the lift from higher Brent prices than KSA’s does. At first blush, it would be logical to assume KSA’s and Russia’s GDPs are driven by the same economic forces of oil supply and demand. In broad terms, they are. Both benefit from higher oil prices, given they are predominantly petro-economies, although Russia tends to benefit more as prices rise (Chart 3). In the post-GFC era, we find that a 1% increase in Brent prices lifts Russia’s GDP ~ 0.07%, while KSA’s goes up ~ 0.03%. Another way of saying this is Russia’s GDP gets more than twice the lift from higher Brent prices than KSA’s does. Chart 2KSA, Russia GDPs Recover, Following OPEC 2.0 Production Cuts Chart 3Russia Benefits More From Higher Brent Prices Looking a bit deeper into KSA’s and Russia’s GDPs’ sensitivities to Brent prices, we modeled income growth for both using our Brent forecast (Table 1), the futures markets’ forward curve and compare both to the World Bank’s expectation (Chart 4, bottom panel). KSA tends to benefit more from higher EM oil demand, with its GDP rising almost 1% for every 1% increase in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Given our expectation for EM GDP growth (Chart of the Week), we expect KSA’s GDP to show relatively strong growth with GDP up ~ 5.4% this year and ~ 3.5% next year, propelled partly by higher oil prices (Chart 4, top panel). KSA tends to benefit more from higher EM oil demand, with its GDP rising almost 1% for every 1% increase in EM oil demand. Russia’s GDP goes up ~ 0.25% for every 1% increase in EM oil demand. We expect Russia’s GDP to dip then recover in 4Q19, then rise 3.5% by the end of 3Q20 before tapering off toward the end of 2020. This is not surprising given the trajectory for Brent prices in our forecasts and in the futures curves, and the sensitivity of Russia’s GDP to oil prices.We found a similar impact of EM oil demand on Russia and KSA GDPs when controlling for EM FX rates instead of Brent prices (Chart 5).3 Chart 4Higher Oil Prices Will Lift KSA's And Russia's GDPs Chart 5While KSA Benefits More From Higher EM Demand U.S. Waivers Dictate OPEC 2.0’s Decision On Production KSA has indicated it sees a need to extend OPEC 2.0’s production-cutting deal into 2H19, when the coalition’s ministers meet in June. Of late, Khalid al-Falih, KSA’s oil minister, is indicating no further cuts in the Kingdom’s output are needed, however. Russia’s a bit of a cipher. President Vladimir Putin this week stated Russia will continue to cooperate with KSA vis-à-vis managing production, although his energy minister, Alexander Novak, has indicated he sees no reason for extending OPEC 2.0’s production deal. Both sides are waiting on fundamental data, and the decision of the U.S. on its waivers on Iranian oil-export sanctions. There’s also the ever-likely collapse of Venezuela to consider, and renewed violence in Libya, both of which argue against letting the waivers expire. The Trump administration has no incentive to risk inducing an oil shock on the global economy. The countries granted waivers on U.S. sanctions against Iranian crude oil imports appear to be exercising their option to lift additional barrels, based on data showing loadings out of Iran increased for the fourth consecutive month (Chart 6 and Table 2).4 Loadings out of Iran rose to 1.30mm b/d in March, from 1.24mm b/d in February. Table 2Iran Exports By Country 2018-2019 (‘000 b/d) Bottom Line: We continue to expect U.S. waivers on Iranian oil sanctions will be extended to year end in some form. The collapse of Venezuela and renewed violence in Libya show how tenuously balanced oil markets are at present. Going into a general election in the U.S. next year, the Trump administration has no incentive to risk inducing an oil shock on the global economy. When they meet in June, ministers from OPEC 2.0 member states will be ideally set up to respond to the Trump administration’s decision on waivers for Iranian oil imports, which expire May 2. We are closing our June 2019 $70 vs. $75/bbl call spread, as the position is close to expiry. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 In the post-GFC world, we find total EM oil demand rises ~ 0.4% for each 1% rise in EM commodity-importers’ GDP, while it only rises ~ 0.3% for each 1% rise in EM commodity exporters’ GDP, based on our modeling. According to World Banks’ constant 2010 USD series, EM commodity importers’ GDP represented 66% of total EM GDP in 2018, up from 56% in 2010. The EM income elasticity of oil demand has remained at roughly ~ 0.60 from 2000 to now, meaning a 1% increase in EM GDP – hence EM income – lifts oil demand by ~ 0.6%. This has been remarkably stable pre-GFC, post-GFC and from 2000 to now. 2 The new political economy of oil is a continuing theme in our research. For an extended discussion of this theme, please see “The New Political Economy of Oil,” and “OPEC 2.0: Oil’ Price Fulcrum,” published by BCA Research’s Commodity & Energy Strategy on February 21 and March 21, 2019. Both are available at ces.bcaresearch.com. 3 When using EM FX rates instead of Brent prices as an explanatory variable, we find KSA’s GDP still increases a little more than 1% for every 1% increase in EM oil demand, but Russia’s rises closer to 0.6%. NB: All GDP measures use historical World Bank data, and BCA Research estimates using the Bank’s projections in constant 2010 USD. We proxy EM oil demand using non-OECD oil consumption. KSA’s production is crude oil only, while Russia’s production is crude and liquids. 4 For a discussion of the waivers’ optionality, please see our BCA Research’s Commodity & Energy Strategy Weekly Report “OPEC 2.0: Oil’ Price Fulcrum,” published on March 21, 2019, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Clearly the president will benefit from being vindicated in such an authoritative way. He will not only avoid any mushrooming scandal, which can hurt a president seeking reelection, but will also gain sympathy from at least some voters for having been falsely accused. While Mueller technically did not exonerate Trump from charges of obstruction of justice, he also did not make any such charges. This means that House Democrats could conceivably still use the Mueller report’s evidence of potential obstruction to impeach Trump. But if they do they will fail. Attorney General Anthony Barr and his deputy, Rod Rosenstein, have both determined that there was no obstruction. With the special counsel having ruled out any collusion or even coordination with Russia, Trump will remain secure among grassroots Republicans. Hence the senators in his party will not convict him and any impeachment trial will be a charade. Thus to some extent Trump’s odds of reelection must be going up. Right? Wrong. The problem is that any positive impact on Trump’s reelection odds from the Mueller report ultimately matters much less than the inversion of the yield curve on March 22. This curve is the most reliable indicator of forthcoming economic recession. If the inversion is deep and persistent then it makes an election year recession probable. Presidents can survive a grand scandal, but they live or die by recessions. There have only been two presidents in the post-Civil War era who won reelection despite a recession in the calendar year of the election. These were William McKinley in 1900 and Theodore Roosevelt in 1904. Yet in 1900, the recession was drawing to a close and economic conditions were better than when McKinley first took office in 1896. And in 1904, the recession technically ended in August, before the fall campaign began. In ten other cases the ruling party has lost the White House amid a recessionary environment. In recent decades yield curve inversion precedes recessions by anywhere from five to sixteen months. The average is eleven months. This means that if the 10yr/3mo signal proves accurate once again, Trump would get extremely lucky to see the economy rebounding by the fall campaign. Granted, the yield curve could send a false signal. For instance, some take the view that the term premium is historically low for structural reasons and that this makes inversion easier and less indicative than in the past. However, when it comes to politics, President Trump cannot afford to assume that this time is different. It is already clear from his waivers on Iranian oil sanctions and trade negotiations with China that he lives in great fear of the business cycle expiring before November 3 next year, when it will be very long-in-the-tooth. Trump is also more vulnerable to recession than the usual president. He is a self-styled commercial leader – a CEO president and Washington outsider who staked his credibility on the claim that he will create jobs and grow the economy. Trump can possibly survive an election with a large trade deficit or a surge in immigrants on the southern border because these developments would highlight the very policy concerns that he did so much to emphasize: they would not necessarily invalidate his approach. But if unemployment is rising, it is hard to see how this president, let alone any other, could wriggle out of it. If he tries to shift the blame to the Federal Reserve or China in any concrete way, the equity market will riot and exacerbate the downturn. The takeaway is, first, that we should continue to see President Trump show relative risk aversion on market-relevant matters like Iran, China, and the “stimulus cliff” affecting the U.S. budget next fiscal year. Second, that if the current economic wobbles pass and the economic expansion gets a new breath of life, then Trump’s chances of retaining the White House will soar. Trump’s reelection odds have important investment consequences. His reelection will entail policy continuity and the maintenance of a low-tax, deregulatory environment that encourages animal spirits and pads corporate earnings. The more likely it appears that Trump will lose the White House, the more animal spirits will sag. A Democratic win will mean yet another violent vacillation in U.S. policy, like 2016, which will cause a spike in policy uncertainty. It will also bring a probable increase in taxes (including possibly the corporate rate) and regulations across a range of sectors. If a Democrat wins in 2020, he or she will most likely have a fairly left-wing agenda, due to trends in the party, and whoever takes the White House will likely also take the Senate. Since the same goes for the House, a presidential win will deliver full Democratic control of the executive and legislative branches: a window of minimal political constraints in which a sweeping piece of legislation can be enacted, like in 2009 or 2017. In short, a Trump loss would not only mean the end of the status quo but likely a united government in favor of a rather left-leaning Democratic agenda. If the market has reason to believe a recession is looming, and that a recession will occasion a lurch to the “anti-business” side of the Left, then the impact on investment decisions and capex intentions will be negative and immediate. Economic policy uncertainty has nowhere to go but up. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com
Trepidation engulfs commodity markets like a fog weaving through half-deserted streets. Central bankers huddle in muttering retreats, growing more cautious by the day. EM growth concerns – particularly slowing trade volumes, and the drama surrounding Sino – U.S. trade negotiations – contribute to this. Europe’s slowdown as Brexit approaches, and a U.S. government that seems forever at loggerheads also sap investor confidence. Nonetheless, the level of industrial commodity demand – oil and copper in particular – continues to hold up. By our reckoning, EM growth still is positive y/y. And central bank caution – along with less-restrictive policies – provides a supportive backdrop for industrial commodities down the road. The production discipline we expect from OPEC 2.0 this year sets the stage for a continued rally in oil prices. Given our view on EM growth, we continue to favor staying long oil exposure, and remaining exposed to industrial commodities generally via the S&P GSCI position we recommended on December 7, 2017. Highlights Energy: Overweight. We are closing our open long call spreads in 2019 Brent, having lost the ~ $1/bbl premium in each. We are opening a new set of similar positions in anticipation of the next up-leg in Brent. At tonight’s close of trading, we will go long Brent $70 Calls vs. short $75 Calls in June, July and August 2019. Base Metals/Bulks: Neutral. Metal Bulletin’s benchmark iron ore price index for China traded through $90/MT earlier this week, as supply concerns continue to weigh on markets in the wake of evacuations from areas close to tailings dams used by miners.1 Precious Metals: Neutral. Bullion broker Sharps Pixley reported the PBOC’s gold reserves total almost 60mm ounces, up 380k ounces from end-2018 levels. Russia’s state media outlet RT proclaimed: “China on gold-buying spree amid global push to end US dollar dominance” on Tuesday. Ags/Softs: Underweight. Last week’s USDA WASDE report estimates world ending stocks for grains will be up slightly for the 2018-19 crop year at 772.2mm MT vs 766.6mm MT previously estimated in December. A January report was not issued due to the U.S. government shutdown. Feature In discussions with clients in the Middle East last week, few contested the assertion OPEC 2.0 is determined to keep supply below demand this year, in order to draw down global oil and refined product inventories.2 This strategy worked well for the coalition after it was stood up in November 2016. Back then, production cutbacks, an unexpected collapse of Venezuelan output, and random outages in Libya and elsewhere combined with above-average global demand to keep consumption above production. This led to a drawdown in OECD inventories of 260mm barrels between January 2017 and June 2018. OPEC 2.0 is off to a strong start on its renewed effort to rein in production and draw down inventories. OPEC (the old Cartel) cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d.3 The largest cut once again came from KSA, which reported it reduced output by just over 400k b/d m/m in January. This follows a 450k b/d reduction in December 2018 reported by the Kingdom in last month’s OPEC Monthly Oil Market Report. For March, KSA already is indicating it plans to drop production to 9.8mm b/d – 1.3mm b/d less than it was pumping in November 2018. There are some signs of discord within OPEC 2.0. Rosneft CEO Igor Sechin once again is arguing against the coalition’s production-cutting strategy, this time in a letter to Russian President Vladimir Putin.4 This is not the first time such disagreements were aired: In November 2017, leaders of Russia’s oil industry walked out of a meeting with Energy Minister Alexander Novak following a disagreement with the government on extending OPEC 2.0’s production-cutting deal launched at the beginning of the year. In the end, the deal was extended after President Putin weighed in.5 A Deeper Look At Demand Uncertainty These supply-side issues are not trivial, and pose significant risks to our price view. All the same, Russia does benefit from higher oil prices, in that inelastic global demand in the short-to-medium term produces a non-linear price increase when supply is reduced. Russia’s OPEC 2.0 quota calls for production to fall from 11.4mm b/d production basis its October 2018 reference level (11.6mm b/d at present) to 11.2mm b/d in 2019. As long as Russia’s participation in the OPEC 2.0 coalition advances its economic and geopolitical interests – i.e., higher revenues than could be expected without having a direct role in global production management, and in deepening its ties with KSA – we expect it to remain a member in good standing in OPEC 2.0. At the moment, the bigger issues center on the state of global demand for industrial commodities. Unlike the situation that prevailed during the first round of OPEC 2.0 cuts, global markets no longer are seeing a synchronized global recovery in aggregate demand. Rather, EM commodity demand growth – the engine of global growth – has been trending down at a slow and constant pace since the beginning of 2018. This is not news: It shows up in our new Global Industrial Activity (GIA) index, and we’ve been writing about it and accounting for it in our metals and oil demand projections for months (Chart of the Week). Chart of the WeekCommodity Demand May Be Bottoming BCA’s GIA index is heavily weighted to EM commodity demand. Based on our estimates, it appears to be close to or in a bottoming phase and ready to turn up within the next quarter. It is worthwhile pointing out that even with the slowdown over the past year or so, BCA’s GIA index still stands significantly higher than the level registered during the manufacturing downturn of 2015-16. This also adds color as to why the OPEC market-share war launched in November 2014 was so devastating to prices – demand was contracting while supplies were surging from OPEC 2.0 states and from U.S. shale-oil producers. Pessimism Is Overdone We have maintained for some time commodity markets are overly pessimistic on the global growth outlook, mainly because of their gloomy view on the Chinese economy, and anticipated knock-on effects for EM growth arising from this view. Our colleagues at BCA’s Global Fixed Income Strategy succinctly capture the current mood pervading global markets: “… this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors.”6 We continue to expect the slowdown in EM to persist in 1H19 based on our modeling and actual consumption data. Part – not all – of this is due to the slowdown in China, where policymakers are moving to reverse earlier financial tightening with modest fiscal and monetary stimulus in 1H19. We continue to expect the Communist Party leadership in China will want to start increasing stimulus later this year or in 1H20, so that it hits the economy full force in 2021 in time for the 100th anniversary of the founding of the CCP. Such stimulus will bolster industrial commodity demand. Still, this is difficult to call, particularly the form stimulus will take. President Xi appears committed rebalancing China’s economy – i.e., supporting consumer-led growth – and may want to keep policy powder dry, so to speak, to counter a recession in 2020 or thereafter. Stimulating the consumer economy in China could boost consumption of gasoline, and demand for white goods like household appliances at the expense of heavy industrial demand. Oil and base metals used in stainless steel would benefit in such an environment. Timing this rebound remains difficult. It appears to us that oil and, to a lesser extent, base metals have undershot their fair-value levels (based on our modeling) on the back of negative expectations and sentiment. If we are correct in this assessment, this should limit the negative surprises going forward and open upside opportunities for commodity prices (Chart 2). Chart 2Technically, Oil's Oversold Under The Hood Of BCA’s Newest Model Because demand is so difficult to capture, we continually are looking for different gauges to measure it and cross-check against each other. We developed our Global Industrial Activity index to target the actual performance of commodity-intensive activities globally. Each component is selected based on its sensitivity to the cycle in global industrial activity, hence on the cycle of global commodity demand. This is different from the BCA Global Leading Economic Indicator (LEI), which uses a GDP-weighted average of 23 countries’ LEI. By relying on GDP, the LEI weights in the indicator favor DM countries and do not account for the growing share of the service sector in these economies (Chart 3).7 Chart 3GIA Captures Commodity Demand Our GIA index focuses on commodity demand, which is fundamentally different from proxies of global real GDP growth or global economic activity. Nonetheless, we included the BCA global LEI with a small weight (~ 10%) in our index to capture DM economies. This inclusion does add information to our new gauge. Our GIA index correlates with Emerging Markets’ GDP, copper and oil prices with lags of one to three months. This index is designed to measure the strength of the underlying demand for commodities. It does not account for the supply side and other idiosyncratic shocks that affects each commodity. For instance, our index captures ~ 55% of the variation in the y/y movement in oil prices; adding our oil market supply and sentiment indicators on top of the demand variable raises this to more than 80% (Chart 4). Chart 4Combined Indicators Work Best The index is divided into four main components, which gauge the demand-side impacts of (1) trade; (2) currency movements; (3) manufacturing demand; and (4) the Chinese economy, given its importance to overall commodity demand. The GIA index’s Trade Component combines EM import volumes and an estimate of global dry bulk shipping rates to gauge demand. Readers of the Commodity & Energy Strategy are familiar with our use of EM trade volumes as a proxy for EM income.8 This week, we introduce a new proxy for shipping rates using the Baltic Dry Index (BDI) as a proxy of global economic activity. Our methodology is based on the approaches taken by James D. Hamilton and Lutz Kilian in their respective models that use the BDI to proxy global growth.9 We created two alternative measures based on each of their approaches and average them to come up with our own proxy of the cyclical factor of global shipping rates driven by demand. Both of our alternative measures use a rebased version of the real BDI, which uses the U.S. CPI to deflate the nominal value. Because it picks up the surge in shipping activity in 2H18 resulting from the front-running of tariffs in the Sino – U.S. trade war, the Trade Component of our GIA index gives the most positive readings of all the components (Chart 5, panel 1). By the end of this month, we expect the effects of this front-running to avoid tariffs will wash through the gauge, and we will have greater clarity on the state of global trade. Chart 5Performance Of GIA Components The Currency Component uses a basket of currencies that are sensitive to global growth – i.e., the currencies of countries heavily engaged in trade – and the Risky vs. Safe-haven currency ratio built by BCA’s Emerging Market Strategy.10 This allows us to capture the information regarding the state of global economic activity contained in the highly efficient and forward-looking currency markets. This component collapsed in March 2018, but seems to have bottomed recently (Chart 5, panel 2). The Manufacturing Component looks at the PMIs and various business conditions and expectations surveys for countries that have large industrial exposures to the economic health of EM.11 Currently, this component signals a continuation of the downward trend first observed at the beginning of 2018 (Chart 5, panel 3). Lastly, the Chinese Economy Component uses two indicators of the country’s industrial output: the Li Keqiang Index, and our China Construction Indicator. Despite the fact that the slowdown in China is at the center of investor pessimism re global demand, this component is still holding well (Chart 5, panel 4). It has a moderate negative trend, but is not alarming for commodity demand. Moreover, we expect some stimulus in the second half of the year, which should keep this component supportive for commodity prices. Industrial Commodity Demand Still Holding Up Our GIA index proxies demand for industrial commodities, which is closely aligned with EM GDP – as GDP grows, demand for industrial commodities grows (Chart 6, panel 1). The GIA index is more correlated with copper prices than with oil prices, but it still provides an excellent snapshot of the state of demand for these commodities (Chart 4). Chart 6GIA, Meet Dr. Copper Also, it is interesting to note there appears to be only one large specific supply shock that affected the copper market’s relationship with global demand (Chart 6, panel 2). Our new index supports the Market’s “Dr. Copper” argument, in the sense that copper prices are pretty much always aligned with global industrial activity. We also note that the recent Sino – U.S. trade tensions have pushed copper below the value that is explained by our demand proxy. Bottom Line: The resolve of OPEC 2.0 to reduce production is not in doubt. OPEC (the old Cartel) reported this week its member states cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d. On the demand side, new GIA index indicates things are not as bad as sentiment and expectations would indicate. If anything, we expect the combination of OPEC 2.0’s resolve and rising demand for industrial commodities – oil and copper in particular – to lift prices as the year progresses. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1 Please see “Brazil evacuates towns near Vale, ArcelorMittal dams on fears of collapse,” published by reuters.com on February 8, 2019. 2 OPEC 2.0 is the name we coined for the producer coalition of OPEC states, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC states, led by Russia, which recently agreed to cut production by ~ 1.2mm b/d to drain commercial oil inventories and re-balance markets globally. 3 Please see the February 2019 issue of OPEC’s Monthly Oil Market Report, which is available at opec.org. 4 Please see “Exclusive: Russia’s Sechin raises pressure on Putin to end OPEC deal,” published by uk.reuters.com February 8, 2019. 5 Please see “Russian oil unsettled by talk of longer production cuts,” published by ft.com November 15, 2017. 6 Please see “A Crisis Of Confidence?” published by BCA Research’s Global Fixed Income Strategy, published February 12, 2019. It is available at gfis.bcaresearch.com. 7 The components of the global LEI are also different from our GIA index, and more market-oriented. For details on each series included in the LEI, please see “OECD Composite Leading Indicators: Turning Points of References Series and Component Series,” published February 2019. It is available at oecd.org. 8 Please see BCA Research’s Commodity & Energy Strategy Weekly Report “Trade, Dollars, Oil & Metals ... Assessing Downside Risk,” where we discussed the relationship between EM imports volume, EM income and commodity prices, published August 23, 2018, and is available at ces.bcaresearch.com. 9 The best approach is still debated in the literature. For more details on Hamilton and Kilian’s measurements, please see James D Hamilton, “Measuring Global Economic Activity,” Working paper, August 20, 2018 and Lutz Kilian, “Measuring Global Real Economic Activity: Do Recent Critiques Hold Up To Scrutiny?” Working paper, January 12, 2019. By selecting EM only import volumes and our proxy shipping rate based on the BDI, we narrow our Trade Component to factors that are mainly linked to industrial activity and commodity-intensive sectors. 10 Our basket of currencies includes Korea, Sweden, Chile, Thailand, Malaysia and Peru. The risky vs. safe-haven currency ratio average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). 11 This includes Korea, Singapore, Sweden, Germany, Japan, China and Australia. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed in 2018