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Highlights The bull market in US-Iran tensions was never resolved, and now a series of suspicious explosions in Iran raises the possibility that tensions will re-escalate. Iran’s interest lies in waiting out Trump so that a Democratic victory in the US election can restore the US-Iran strategic détente agreed in 2015. However, both the Trump administration and US ally Israel are applying “maximum pressure” on Iran and could go on the offensive at a time when Trump’s odds of re-election are collapsing. Israel cannot engage in a full-fledged war with Iran alone but it would have American backing for pressure tactics through the duration of Trump’s term. A “wag the dog” scenario is not inconceivable because the US and Israel have long-term national security interests at stake while Iran is on the verge of economic collapse. Investors should prepare for near-term global equity volatility and safe-haven demand for a number of reasons but a major escalation in Iran would add to the list. Stay long Brent crude oil. Feature Since May 2018 we have argued that US-Iran tensions will remain market-relevant. We downgraded the odds of US air strikes from 40% in June 2019 to 20% in January of this year after Iran’s lackluster retaliation to the US assassination of its top military commander. Now things are heating up again due to a series of extremely suspicious explosions in Iran that may or may not be linked to Israel and the United States. The COVID-19 pandemic, oil price rout, and global recession have reinforced this bull market in US-Iran tensions by weakening and destabilizing the entire Shia Crescent, from Lebanon to Iran. They have also pushed President Trump dangerously close to “lame duck” status, which reduces the constraints on conflict with Iran for the remainder of his term. In this report we update our Iran view by looking at whether the Trump administration or Israel could attempt to “wag the dog,” i.e. provoke a conflict with Iran to boost Trump’s re-election odds or achieve some long-term strategic objectives while Trump is still in power. We have long held the view that Iran poses a market-relevant geopolitical risk and now the mysterious attacks in Iran suggest it could be materializing. Nothing is confirmed, but it is wise for investors to monitor these developments in case they escalate. Geopolitical incidents often cause buying opportunities but they can create substantial equity drawdowns first. Cyber-Rattling In The Middle East A string of mysterious explosions and fires at military and economic facilities have rocked Iran in recent days (Table 1). Table 1Iran Hit By A String Of Mysterious Attacks The most significant of these incidents is the July 2 explosion at the Natanz nuclear facility – Iran’s main uranium enrichment facility, which houses a new centrifuge assembly center.1 The fire resulted in a significant setback to the development and production of advanced IR-6 and IR-8 centrifuges used to enrich uranium – by up to two years. Iranian officials initially downplayed the incidents as unsuspicious accidents. However the Natanz explosion was too significant to cast off. Iran’s state-run news agency IRNA declared that the Natanz incident may be the work of foreign countries, “especially the Zionist regime [Israel] and the US,” and vowed Iranian retaliation if sabotage is proven to be the case. Similarly, the New York Times reported that an anonymous Middle Eastern intelligence official – rumored to be Mossad chief Yossi Cohen – called the incident the work of Israel.2 Israel’s response to these allegations has been oblique, but the accusation is not far-fetched. Israel has a successful history of halting the advancement of nuclear programs in the region. Mossad’s Operation Opera destroyed Iraq’s only known nuclear facility in 1981, and Operation Outside the Box bombed a suspected nuclear reactor at the Kibar site in Syria in 2007. Israeli intelligence has also previously been accused of targeting Iran’s missile program – with the assassination of four Iranian nuclear scientists between 2010 and 2012. Israel is also believed to be involved, with the US, in Operation Olympic Games, the Stuxnet cyber attacks that stunted Iran’s uranium enrichment program circa 2010. Iran’s ballistic missile program and alleged nuclear weapons ambitions remain Israel’s greatest long-term strategic threat in the region. More recently, Iran and Israel have been locked in a series of cyber-attacks. Israel claims to have foiled an Iranian attack on its water facilities in April which attempted a cyber break on water control systems. A May 9 cyberattack on Iranian shipping hub Shahid Rajaae – through which half of Iran’s maritime trade traverses – is seen as Israeli retaliation. Most recently, Israel’s Mossad revealed that it thwarted Iranian attempts to attack Israeli diplomatic missions in Europe. These attacks come as the US increases pressure on UN Security Council members to support the indefinite extension of the UN arms embargo against Iran, which is scheduled to expire on October 18.3 But other signatories to the 2015 Iranian nuclear agreement – China, Russia, Germany, Britain, and France – argue that since the US withdrew from the Joint Comprehensive Plan of Action (JCPA), its threat to invoke a “snapback” provision of the deal to reimpose former UN sanctions on Iran is not legally valid. The other JCPA signatories remain committed to the deal, arguing for its necessity in order to continue IAEA inspections that prevent Iran from developing nuclear weapons. They are biding their time to see if Trump is re-elected before deciding anything. Iran has moved further from the JCPA’s requirements since announcing, on January 5, 2020, that it will no longer comply with restrictions to its nuclear program (Table 2). The risk is that unless controlled, this will eventually significantly reduce Iran’s “breakout time” – the time required to acquire enough fissile material for one bomb. The nuclear deal aimed to maintain at least a one-year breakout time, and this is generally understood to be the US’s “red line.” Table 2Iran No Longer Complying With 2015 Nuclear Deal Despite some non-compliance, Iran is still permitting IAEA inspectors to monitor and verify its nuclear activities. Yet the IAEA Board of Governors passed a resolution, requesting Iran’s cooperation in the investigation into possible undeclared nuclear materials and sites.4 Chart 1Iran's Sphere Of Influence In Collapse As tensions with US and Israel escalate, Tehran has been keen to highlight its military capabilities. Revolutionary Guard Navy Commander Rear Admiral Alireza revealed the existence of onshore and offshore underground missile sites along the Persian Gulf and Gulf of Oman, holding advanced long-range missiles and new weapons, more capable of launching attacks against enemies. Escalating tensions raise the likelihood of retaliation as Iran reconsiders its “strategic patience” policy.5 Tehran had been playing the waiting game, especially since Trump’s decision to assassinate Quds Force chief Qassem Soleimani in January. Iran has an interest in avoiding confrontation in the months ahead of the US election on November 3. Iran’s attack on Saudi Arabia in September 2019 led to a boost in Trump’s approval rating. A major conflict today would cause a patriotic rally around the president at a time when he is beset with negative opinion over the coronavirus response and poor race relations. Iran has an interest in Joe Biden winning the presidency in November. Biden would likely restore the US-Iran deal, which would remove sanctions and allow Iran to open its economy. However, neither the Trump administration nor the Israeli government share that interest. The latest attacks raise the possibility that the US and/or Israel are going on the offensive. This could force Iran to retaliate. Iranian moderates are already suffering domestically. Iran’s hardline parliamentarians were never on board with the nuclear deal and criticized President Hassan Rouhani when President Trump pulled out of it in May 2018. This past weekend Foreign Minister Javad Zarif, an ally of Rouhani whose reputation also rests on the deal, was heckled as he addressed the parliament. As of February, parliament is mostly comprised of hardliners.6 Iran is also on shaky ground in the Shia Crescent. Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – have been experiencing civil unrest. Protesters in both countries initially took to the streets last fall in demonstration of anger over government corruption, the sectarian based political system, and poor economic conditions. The pandemic and recession have breathed new life into these movements. The Lebanese pound collapsed on the parallel market since October, and some groups have called for the disarmament of Iran-backed Hezbollah (Chart 1). Meanwhile a June cabinet decision in Iraq to cap the amount and number of state salaries and pension payments collected – in attempt to buttress the country’s ailing finances – fueled outrage. Iraq’s Prime Minister Mustafa al-Kadhimi is also in a tussle with Iran-backed paramilitary forces as he attempts to curb their influence and bring them under state control.7 Chart 2Iran Has Little To Lose Thus a timid stance by Iran in face of foreign attacks will not go down well. Instead, with oil production having collapsed, the economy in shambles, and its sphere of influence in turmoil, Tehran has little to lose in protecting what is left of its nuclear program and deterring American or Israeli aggression (Chart 2). With few options left, Iran is likely to move further away from its “strategic patience” in response to the uptick in “maximum pressure.” Bottom Line: Tensions are escalating between Tehran and Washington/Tel Aviv. Cyber attacks are likely to increase in the lead up to the expiration of the arms embargo on October 18 and US elections this fall. Iran may be forced to abandon its policy of “strategic patience” if its foes sabotage its nuclear capabilities. Expect the conflict to spillover to Iran’s proxies in the region – Iraq, Lebanon, and Syria. So What? Massive monetary and fiscal stimulus and continued commitment from OPEC 2.0 on the supply side will keep oil prices moving higher this year. Barring a second COVID-19 wave, our Commodity & Energy Strategists expect oil markets to rebalance beginning in 3Q2020, with Brent prices averaging $40/bbl this year and $65/bbl in 2021 (Chart 3). We remain long Brent which is up 70.55% since initiation in March.   The escalation in tensions in the Persian Gulf is an upside risk to this assessment. That said, with major oil producers now operating significantly below capacity in compliance with the OPEC 2.0 production agreement, the net impact on oil prices will likely be muted and short-lived. Production can be increased to fill gaps. As demonstrated by the recent acts of sabotage in Iran and Israel, the increase in geopolitical tensions globally will manifest in cyberattacks, supporting cyber stocks. Our strategically long ISE Cyber Security Index relative to the S&P500 Info Tech sector trade is up 2% since initiation in April (Chart 4). Chart 3Oil Markets On The Way To Recovery Chart 4Buy Cybersecurity Stocks Finally, we should note that Iran is not the only geopolitical risk that could explode amid the US election cycle. China is the greater risk. But President Trump faces fewer financial and economic constraints in a conflict with Iran than he does in a conflict with China. A conflict with Iran could change the game ahead of the election at a time when Trump is beset with the coronavirus and social unrest. His opinion polling would benefit from a rally around the flag, as it did in September 2019. The risk for Trump is that this bump may not last long. Americans are less concerned about Iran than China and Russia and Trump himself has benefited from American weariness of Middle Eastern wars. All we can say for certain is that the US election is of critical strategic importance to several major and minor powers. Trump’s allies and enemies know that the next six months offer their best chance to take actions that either affect the election or exploit the current alignment of US foreign policy relative to a Democratic Party alignment. While China probably prefers Biden, it can deal with either ruling party. Whereas Israel has a unique opportunity to advance its objectives under Trump and Iran has a clear imperative to remove Trump from office.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The damaged building was constructed in 2013 to be a site for the development of advanced centrifuges. Work there was stopped in 2015 as per requirements of the JCPA, but was restarted when the US withdrew from the deal in 2018. 2 Meanwhile a group of dissidents from within Iran’s military and security forces, calling themselves Homeland Cheetahs, claimed responsibility for the Natanz attack. However, it is possible that the claim was made with the intention to mislead. Please see Jiyar Gol, "Iran blasts: What is behind mysterious fires at key sites?" BBC News, July 6, 2020. 3 The draft US resolution bans Iran from supplying, selling, or transferring weapons after the October 18 expiration of the embargo. It bans UN member states from purchasing Iranian arms or permitting citizens to train or provide financial resources or assistance to Iran without Security Council approval. 4 This resolution, introduced by France, Germany, and the UK, refers to an undeclared uranium metal disc, potential fuel-cycle-related activities such as uranium processing and conversion, and suspected storage of nuclear material. Iran’s parliament responded by issuing a statement signed by 240 out of the 290 members which called the resolution excessive and requested that Iran halt voluntary implementation of additional protocol and change inspections 5 Iran’s state-run news agency IRNA published the following commentary in response to the Natanz explosion: "The Islamic Republic of Iran has so far tried to prevent intensifying crises and the formation of unpredictable conditions and situation … the crossing of red lines of the Islamic Republic of Iran by hostile countries, especially the Zionist regime and the US, means that strategy … should be revised." 6 In addition, 120 out of the 290 parliamentarians signed and delivered a motion to the presiding board of the assembly, requesting that Rouhani be summoned for questioning. The presiding board may not issue the summons and is unlikely to result in Rouhani’s impeachment as Khamenei has requested unity amid high foreign tensions. It nonetheless reflects Rouhani’s weakened position ahead of next year’s elections. 7 Hisham al-Hashemi, an advisor to Prime Minister Mustafa al-Kadhimi who had advised the government on reducing the influence of Iran-backed militias in Iraq, was killed on July 6, days after receiving threatening telephone calls from militias.

Bob Farrell famously remarked “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” This could not be truer than today’s market, especially the NASDAQ. Not only are the top five SPX stocks comprising roughly 23% of the index, but the same five tech titans carry a 40% weight in the NASDAQ composite. This seems excessive and carries a lot of risk in case of even a mild disappointment. True, the collapse in interest rates has boosted the NASDAQ forward P/E to the stratosphere, but the longer these high flying stocks defy gravity the more painful the eventual snap will be (bottom panel). Already there are tentative signs of trouble brewing beneath the surface. NASDAQ breadth is sinking like a stone and this has proven a reliable leading indicator in the recent past, warning that a pullback is looming (top panel). Finally, the hypersensitive chip stocks are suffering from exhaustion, unable to outperform the tech titan led NASDAQ (middle panel). Any hiccups in the tech space will negatively reverberate in the SPX: currently the S&P tech sector plus the FANG (FB, AMZN, NFLX & GOOGL) comprise 40% of the S&P 500. Thus as tech goes so does the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.    

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Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart I-1Value/Growth Turns Before The Dollar Chart I-1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart I-2A and Chart I-2B). Chart I-2ACurrencies Follow Relative Equity Performance Chart I-2BCurrencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table I-1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table I-1Sector Weights Across G10 Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart I-3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. Chart I-3Style Tilt Drives Currency Performance This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart I-4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. Chart I-4The Dollar And Funding Stresses A lower dollar also boosts resource prices through the numeraire effect (Chart I-5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart I-6), which has kept their cost of capital low, even as the dollar has risen. Chart I-5Tied To The Hip Chart I-6Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart I-7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart I-7Commodity Bull Markets In Different Currencies This demand has come in the form of Chinese stimulus. Chart I-8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years. Chart I-8China And Commodities A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart I-9A and Chart I-9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart I-9AMarkets Bid Up High Returns To Capital Chart I-9BMarkets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart I-10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart I-11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart I-10A Dearth Of Value Managers Chart I-11Lots Of Value Outside The US Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart I-12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart I-13A, Chart I-13B, Chart I-13C, Chart I-13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart I-14). This suggests some measure of convergence is due. Chart I-13AProspective Returns Higher Outside The US Chart I-13BProspective Returns Higher Outside The US Chart I-13CProspective Returns Higher Outside The US Chart I-13DProspective Returns Higher Outside The US Chart I-14Attractive Growth Stocks Outside The US It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction Chart I-15CAD/NZD And Relative Stocks An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table I-1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart I-15). While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart I-16). As such, the neutral rate of interest is bound to head lower. Chart I-16A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: The ISM non-manufacturing PMI jumped from 45.4 to 57.1 in June, with the new orders component surging from 41.9 to 61.6 and the employment component at 43.1 versus 31.8 earlier. JOLTS job openings increased from 5 million to 5.4 million in May. Initial jobless claims fell from 1413K to 1314K for the week ended July 3rd. The DXY index fell by 1% this week, alongside the outperformance of non-US equities, particularly emerging market stocks. Recent data have shown budding signs of a recovery as many countries gradually reopen their economies. As a counter-cyclical currency, this has pressured the dollar. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit services PMI increased from 47.3 to 48.3 in June. The Sentix investor confidence index rebounded from -24.8 to -18.2 in July. Retail sales fell by 5.1% year-on-year in May. However, this is a 17.8% increase on a month-on-month basis.  The euro increased by 0.6% against the US dollar this week. While recent data have been promising, the Summer 2020 Economic Forecast released by the European Union sounded quite pessimistic this week. The Summer Forecast projects that the euro area will contract by 8.7% in 2020 and grow by 6.1% in 2021, much worse than the spring forecast. That said, a mild second wave could trigger the European Union to revise these estimates higher. Meanwhile, the ECB remains committed to lowering the cost of capital for Eurozone countries. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: The current account balance surged from ¥262.7 billion to ¥1176.8 billion in May, as imports fell faster than exports. The preliminary coincident index fell from 80.1 to 74.6 in May, while the leading economic index increased from 77.7 to 79.3. Machinery orders fell by 16.3% year-on-year in May, following a 17.7% decrease the previous month. Moreover, preliminary machine tool orders in June continued to fall by 32% year-on-year. USD/JPY fell by 0.5% this week. The June Eco Watchers Survey released this Wednesday shows that the current conditions index increased sharply from 15.5 to 38.8. Moreover, the outlook index rose to 44 in June from 36.5 the previous month. The Survey sounded cautiously optimistic and indicated that while COVID-19 continues to be a downside risk, activities are starting to pick up in recent months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit services PMI ticked up marginally from 47 to 47.1 in June. The construction PMI surged from 28.9 to 55.3. Halifax house prices increased by 2.5% year-on-year in June. The British pound jumped by 1.3% against the US dollar this week. The Bank of England chief economist, Andy Haldane, has warned about second, third or even fourth wave of COVID-19 infections. However, he also acknowledged that the UK economy has received a boost since restaurants and bars have reopened. We remain bullish on the pound as an undervalued currency, but are monitoring Brexit developments closely as they continue to add more volatility to trading patterns. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services performance index was flat at 31.5 in June. Home loans fell by 7.6% month-on-month in May, following a 4.4% decline the previous month. The Australian dollar rose by 0.6% against the US dollar this week. On Tuesday, the RBA held its interest rate unchanged at 0.25%, as widely expected. The Bank sounded optimistic about the recovery and the government’s effective measures to contain the virus. That said, with Melbourne returning into lockdown, a dose of skepticism is warranted. We continue to favor the Australian dollar as a key barometer for procyclical trades, but domestic factors could be a risk to this view. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ preliminary business confidence index recovered from -34.4 to -29.8 in July. The New Zealand dollar rose by 0.9% against the US dollar this week. The Q2 NZIER Quarterly Survey of Business Opinion (QSBO) indicated that economic activities plunged sharply in Q2. According to the survey, a net 63% of businesses expect conditions to deteriorate, compared with 70% in the previous survey. While confidence has picked up slightly, business sentiment remains downbeat with less intensions to invest and hire, particularly in the subdued construction sector. As such, a tactical opportunity is opening for short NZD trades at the crosses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The Ivey PMI surged from 39.1 to 58.2 in June. The Markit manufacturing PMI also increased from 40.6 to 47.8 in June. Bloomberg Nanos confidence increased from 46 to 46.2 for the week ended July 3rd. Housing starts picked up from 195.5K in May to 211.7K in June. The Canadian dollar appreciated by 0.5% against the US dollar this week. The BoC Business Outlook Survey was released this week and survey results suggest that “business sentiment is strongly negative in all regions and sectors” due falling energy prices. Most firms believe that production could pick up quickly but sales might take longer to recover. That said, both interest rate differentials and recovering oil prices are bullish for the Canadian dollar for now.  Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: FX reserves increased from CHF 817 billion to CHF 850 billion in June. The unemployment rate declined from 3.4% to 3.2% in June. Total sight deposits increased from CHF 683 billion to CHF 687 billion for the week ended July 3rd. The Swiss franc appreciated by 0.7% against the US dollar this week. The Swiss franc has been quite resilient recently despite the rebound in risk sentiment since the March lows. The expensive franc remains a headache for the SNB and the Swiss economy. We are looking to go long EUR/CHF at 1.055. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Manufacturing output fell by 3% month-on-month in May. The Norwegian krone surged by 1.3% against the US dollar this week. We remain bullish on the krone due to its cheap valuation and signs of a recovery in energy prices. Our Nordic Basket is now around 10% in the money and we also went long a petrocurrency basket including the Norwegian krone last week. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industrial production fell by 15.5% year-on-year in May. Manufacturing new orders plunged by 18.4% year-on-year in May. The Swedish krona surged by 1.3% against the US dollar this week. Like the Norwegian krone, the Swedish krona is tremendously undervalued and remains one of our favorite G10 currencies at the moment. As a small open economy, Sweden relies heavily on exports and imports. While global trade was hit hard during COVID-19, signs of stabilization bode well for the Swedish krona. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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Highlights Our quantitative US election model suggests Trump has a 44% chance of re-election. This presents a risk to our formal subjective view that he has a 35% chance. We are sticking with our subjective odds for now, as Trump is beset with a reviving COVID-19 outbreak, a recession, social unrest, and execution risks for the next round of fiscal stimulus. But we may increase his chances in August if his circumstances improve. In the worst case, the devastated economy will lead to a landslide in which Trump even loses Iowa. But peak political polarization makes that unlikely and suggests that the race will tighten from here. Uncertainty and volatility will rise from here through November and possibly beyond. Feature The BCA Geopolitical Strategy presidential election model was first introduced to our readers in November 2019 in order to predict and quantify the Electoral College vote outcome of the 2020 US presidential election. The election model is a state-by-state model that uses both economic and political variables in order to predict the probability of the incumbent party winning the Electoral College votes in each of the 50 states. We favored predicting the Electoral College vote over the popular vote since the winner of the presidential election is determined by the Electoral College. There have been five cases in history where the popular vote did not determine the outcome and two in recent history (George W. Bush in 2000 and Donald Trump in 2016). The college imposes a significant (and deliberate) constraint on popularity and mass movements. Our sample size includes nine elections over the period 1984-2016, across 50 states, netting 450 observations. One of our four explanatory variables, the Federal Reserve Bank of Philadelphia State Leading Index, was suspended indefinitely amid the COVID-19 crisis. Hence we needed a replacement variable that could capture a similar impact on the predicted outcome, and one that was readily available on a state-by-state basis. Enter our replacement variable: 1. The Federal Reserve Bank of Philadelphia State Coincident Index. The state leading index in our previous election model was an estimate of the six-month growth rate in the state coincident index. Therefore the state coincident index is the natural replacement variable as it will essentially proxy the state leading index, albeit without the forward-looking element. The coincident index for each state combines four of the state’s indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (US city average). We applied several transformations to the data to obtain meaningful results in the modeling process. Transformations included three-month, six-month, and twelve-month changes in the state coincident indexes. Ultimately we decided to use the three-month change of the state coincident index in our updated Version 2 (V2) election model. As before, we took a weighted average of the three-month change of all the monthly state coincident indexes in the presidential term preceding the election. Later months are weighted heavier than earlier months. A significant difference from the first version of our model is that, unlike the state leading indexes, the state coincident indexes do not have leading properties that give a forward-looking “view” on what the economic environment will look like going into Q1 of the post-election year. We acknowledge that past, current, and future economic conditions are likely to weigh on voters’ minds when casting their vote, but we also note the difficulties in accurately weighting one expectation more than another. We assume that prevailing economic conditions matter most to voters (as people’s assessment of their current situation inevitably affects their future expectations, and vice versa), and this bolsters our rationale in using a 3-month change of the state coincident index. Our final calculation of three-month changes to the state coincident indexes occurs in September of the election year, given that most voters make their decision at least one month in advance of the election, as we have previously shown. The October data release will arrive too late in November for inclusion in the election forecast anyway. Our remaining explanatory variables for V2 of our model update: 2. The incumbent party’s margin of victory in the previous presidential election in each state. Same as our original model. 3. A “time for change” variable – a categorical variable indicating whether the incumbent party has been in the White House for one or more terms. Same as our original model. 4. The range of the incumbent president’s job approval rating. Our original model used the level of approval. Our V2 model excludes the average approval level of the incumbent president in July of the election year as it was found to be statistically insignificant at widely accepted significance levels (1%, 5% and 10%) when estimated with the state coincident index (as opposed to the state leading index), no matter the transformation applied to that index. This does not mean we exclude Trump’s approval data from our modeling process. Instead, we include the range of the incumbent president’s job approval rating. This was the only transformed variation in presidential job approval rating data that showed statistical significance when combined with the variables above. For V2 of our model, the range is computed as the maximum monthly average of various job approval polls less the minimum monthly average of such polls throughout a president’s term. Despite Trump’s job approval being low relative to previous presidents, he has maintained consistency. Hence the range of Trump’s job approval is fairly tight relative to previous presidents and should not be ignored in affecting the election outcome. Upside Risk To Trump’s Re-Election Odds? Chart 1 below depicts our revised prediction of November’s presidential election. Chart 1Trump Is Slated To Lose Re-election With 259 Electoral College Votes As it stands, Trump is slated to lose the election with 259 Electoral College votes (45 less than his 2016 victory). This is just ten votes shy of our previous prediction in March this year, but several swing states that were narrowly in Trump’s camp in March are now far less likely to go his way. Our previous prediction, which of course did not account for COVID-19’s economic shock, had Trump tied with the presumptive democrat nominee at the time. But the latest results still point to a tight race come November. Our updated quantitative model gives Trump a 44% chance of winning. The collapse of the state economies is overwhelming Trump’s re-election bid. Poor economic conditions hardly ever favor a sitting president up for reelection. But note that the three-month change in the state indexes will be the first to register the economic rebound this summer and fall (should it continue). This would improve Trump’s probability of victory. Under our V2 model, New Hampshire, Pennsylvania, and Wisconsin are no longer toss-up states. Rather, Florida is the only toss-up state, with a 52% probability of staying with the incumbent party. Minor negative changes to the state indexes could result in more toss-up states, even throwing traditionally red states into toss-up territory. States that are expected to turn from Republican in 2016 to Democratic in 2020 are Michigan, Pennsylvania, and Wisconsin – the entire “Blue Wall” that delivered Trump his surprise victory four years ago. On the whole, the model gives Trump a 44% chance of retaining the White House. Do we uncritically accept these results? No. As with all of our analysis, we provide a qualitative judgment in addition to our quantitative indicators and models. In general the findings make sense. We agree that Florida, Arizona, and North Carolina remain in Trump’s camp at present, if narrowly. Our qualitative estimate, since March, has given Trump a 35% chance of winning, in keeping with the historical win rate of incumbent parties when recessions occurred during the election year (Table 1). Online political betting markets have recently converged to this view (Chart 2). Thus our quant model suggests that the risk to our view, and the new consensus, is a Trump comeback. Table 1Recessions Weigh On Incumbent Win Rates Chart 2A Democratic Victory Is The New Consensus We will not formally upgrade Trump’s odds until we are convinced that his freefall has been reversed. We are concerned about the rise in deaths from COVID-19 in key swing states, including Florida, Arizona, and Texas and the potential for another major economic setback. We also would want to see Trump get the next round of fiscal stimulus passed in order to turn more optimistic on his chances. Therefore we will stick to our 35% odds and will reassess in late August when the Republican and Democratic party conventions are held. Model Performs Well In Back Tests Our V2 model performs well during in-sample back testing when comparing actual Electoral College vote outcomes for each election since 1984. On balance, V2 correctly predicts all election outcomes over our sample period (Chart 3). Chart 3Our Model Predicts All Election Outcomes In Our Sample … The same can be said of V2 during out-of-sample back testing, correctly predicting election outcomes from 2000 - 2016 (Chart 4). Chart 4… And During Out-Of-Sample Back Testing As mentioned, we cannot ignore the impact that Trump’s job approval may have on his re-election. Since no other transformation of Trump’s approval data test significantly in our V2 model, what if we transform the state coincident index by a longer frequency? What would the predicted outcome be? Trump would maintain his current level of predicted Electoral College votes of 259. The major change is that the state of Florida would no longer be a toss-up. Instead New Hampshire would become the only toss-up, with Trump having only a 45% chance of winning it. Transforming the state coincident index by a longer frequency is more favorable for Trump. Florida moves out of toss-up territory and New Hampshire moves in. But no change in Electoral College votes are recorded as neither party flips a state in this scenario. What if we were to exclude Trump’s approval range as a variable entirely – how would Trump fare? This “barebones” or economic-focused variation is the least favorable for Trump, allocating just 180 Electoral College votes. Arizona and – surprisingly – Iowa would become toss-up states with probabilities of Trump victory at 47% and 49%, respectively (Table 2). Table 2The Economy Is Weighing Down On Trump’s Odds Of Re-Election It should be noted that models including Trump’s approval range as an explanatory variable exhibited higher over/under estimation during the sample period when compared to models that excluded Trump’s approval range entirely. Despite larger errors in some election years, these models also predicted two elections with almost no error (1988 and 2004), and one election with zero error (2008). These results suggest that Trump’s job approval should not be ignored. Peak Polarization Chart 5Peak Polarization An interesting takeaway from our V1 model was that it produced a new measure of American political polarization, a phenomenon widely observed by scholars. The model showed that many states would be won or lost with extreme certainty (0% or 100%), i.e. that they are not even competitive. We take this finding as an indication of polarization, in which group loyalty overcomes all other variables. Results of in-sample predictions from our V2 model corroborate this finding (Chart 5). They are virtually the same as in V1, except that they show a higher degree of polarization in 2020, which now matches the previous peak in 2012. This is intuitive and corroborates other evidence that US polarization is reaching or exceeding recent highs. Polarization may or may not rise higher in the next election cycle, but we suspect that we are witnessing peak polarization from a historical point of view. Over five to ten years, polarization should fall. Generational change in the US will produce more domestic policy consensus, while geopolitical struggle with China will unify the nation against a common enemy for the first time since the cold war. Expect uncertainty and market volatility ahead of the election and in the aftermath. Thus the US may continue to export political instability to the rest of the world in the near-term. But eventually it will find an internal equilibrium and external sources of instability will become the bigger geopolitical risk for investors. So What? Our V2 US presidential election model predicts Trump will lose the November reelection, only amassing 259 Electoral College votes. The model implies that Trump has an overall probability of 44% in taking the White House. Florida is the only toss-up state in the latest prediction, with a 52% probability of staying with the incumbent party. Florida accounts for 29 Electoral College votes. Should the states of Michigan, Pennsylvania, and Wisconsin switch back to Republican, Trump would score an additional 46 Electoral College votes. But if Trump has Florida then he only needs to win one of these three states to win the election. Should the states of Michigan, Pennsylvania, and Wisconsin switch back to Republican, Trump would score an additional 46 Electoral College votes which would hand him the win in November. Conversely, the Democrats are expected to win in November with 279 Electoral College votes. As it stands, the Democrats have a 55% chance of victory. For now, we will maintain our subjective 35/65 odds. But the model shows that the risk is to the upside for Trump and that the race will likely tighten from here. We will likely increase his odds in late August if the renewed virus outbreak in Sunbelt swing states gets under control and Congress passes another major stimulus bill by August 10, as we expect. These findings reinforce our long-held view that the election will come down to narrow margins in the swing states. The deluge of bad news for Trump makes it less likely that the election will be narrow. But the fundamentals, as captured in our V2 model, suggest that Florida, at minimum, will still be an extremely tight race. Thus we would reiterate that this election may feature contested results, vote recounts, and Supreme Court interventions, like the year 2000. Investors should prepare for uncertainty and market volatility to rise between now and November 3, and possibly beyond.   Guy Russell Research Analyst GuyR@bcaresearch.com   Statistical Appendix Some clients may be curious about how our V2 election model differs from our V1 model. We discuss the salient differences herein. Chart A1Our Updated Model Offers Reduced Error 1. The modeling method remains the same Firstly, our V1 model was based off a probit regression, where the dependent variable is stated as 1 = incumbent party wins all Electoral College votes in a given state, or 0 = incumbent party does not win any Electoral College votes in this state.1 The probit regression allows us to assign probabilities of the incumbent party winning each state, given that the inverse of the probability is modeled as a linear combination of the model’s predictors. This modeling technique is maintained in V2 of our model. 2. Variable replacement In V1 of our model, we relied on the Federal Reserve Bank of Philadelphia State Leading Index as an economic variable. In V2, due to the state leading index being discontinued, we adopt the Federal Reserve Bank of Philadelphia State Coincident Index. V1 of our model also used the average approval level of the incumbent president in July of the election year. Since this transformation of job approval data proved statistically insignificant, we tested and included the range of the incumbent president’s job approval rating. The approval range variable showed statistical significance at 5% and 10% levels. 3. Predicted error Assessing the predicted error by each election outcome shows that our V2 model, on balance, trends well with our V1 model (Chart A1), and offers reduced error, on balance, post the 2000 election. Our V2 model also has a lower absolute error when compared to our V1 model. Note, and as we pointed out earlier, our V2 model suffers from some large errors mid-way through the sample period but V2’s predictability improves notably over time. Comparing the error of our V2 model with alternative models that we highlighted in Table A1 also shows just how closely they trend together, despite offering some differing results pertaining to Electoral College votes and toss-up states. Table A1Variations Of Our Model Offer Similar Classified Predicted Outcomes Our V2 model has a lower predicted error in the 2012 and 2016 election than an alternative V2 in which the state coincident indicator is transformed by a six-month change (Chart A2). This warrants our decision in choosing V2 as our preferred model. Chart A2Three-Month Change In State Coincident Indicators Reduces Model Error Chart A3Including Trump’s Approval Data Improves The Model’s Robustness Our V2 model versus the “barebones” V2 model (which excludes the approval range variable and thus can be seen as a purely economic model) has higher predicted error in the elections of 1992 and 1996, but lower error from 2000 onwards (Chart A3). Whilst our V2 model does have a higher absolute error in contrast to the “barebones” model, we believe minimizing a model’s error while still including an element of Trump’s approval data provides us with the most robust election model. Model Diagnostics Regression diagnostics for V2 of our model and other variations that we highlighted in Table A1 above, but do not use, show that our updated model correctly classifies predicted outcomes at a rate of 88.21%. The “barebones” model classifies predicted outcomes marginally better, but we take confidence in the fact that predicted error in our V2 model trends lower as we move further into our sample period, and in the lead up to the 2020 election, bolstering our preferred model choice. The V2 model, if we apply a six-month change to the coincident indicator, classifies predicted outcomes the lowest at 87.43%. Summary Our V2 model shows areas of improved robustness when compared to V1. We keep to the same modeling technique as we did in V1 of our model, a probit regression. We replaced the Federal Reserve Bank of Philadelphia State Leading Index with the Coincident Index and through statistical testing. We opted to drop the average approval level of the incumbent president in July and replace it with the range of the incumbent president’s job approval rating. With mostly lower error for election outcomes from 2000-2016, and lower absolute error and higher correctly classified outcomes, V2 is an adequate model in predicting the upcoming presidential election. Footnotes 1 Two states, Maine and Nebraska, do not have a “winner takes all” distribution of Electoral College votes. Instead they give two Electoral College votes to the winner of the statewide election, plus additional Electoral College votes to the winner within each congressional district. Maine has two congressional districts, Nebraska has three. Nebraska’s second district voted for President Obama in 2008 while Maine’s second district voted for President Trump in 2016.

Highlights In this report, we initiate coverage of the EU Emission Trading System’s (ETS) CO2 allowances. We expect this policy-driven cap-and-trade market to become central to the market-driven pricing mechanism for CO2 fundamentals. Futures on EU CO2 emissions allowances will resume their rally – and surpass the €30 level seen in July 2019 – as ETS allowances supplies tighten in September. Global CO2 emissions are projected to fall 8% this year – 2.6 billion MT (2.6 gigatonnes, or Gt) – as a result of the COVID-19 pandemic, based on IEA modeling. If realized, this would be up to six times the decline in CO2 emissions following the Global Financial Crisis (GFC). The speed at which actual CO2 emissions return to pre-COVID-19 levels will be a function of how quickly global growth recovers, and the intensity of “green” investments. Post-COVID-19, the rebound in emissions could be sharply higher, as has been the case with previous global downturns. Following the GFC, CO2 emissions recovered all of the year-on-year (y/y) decline in 2009 by 2010 (Chart of the Week). As with any COVID-19-related projection, uncertainty – to the upside and downside – dominates our outlook. Chart of the WeekCOVID-19 Crushes Global CO2 Emissions Feature The EU’s CO2 emissions market is designed to achieve policy goals – i.e., reducing the carbon footprint of utilities and manufacturers in Europe. As tempting as it may be to view the surge in EU CO2 emission allowances futures as a harbinger of a powerful recovery in European economic growth, such hopes would be misplaced (Chart 2).1 The sharp rally in part reflects the expected decrease in the volume of CO2 emission allowances that will be available for trading over the September 2020 – August 2021 period. In line with its policy mandates, the ETS reduced this volume by 0.33 Gt following a May 2020 meeting, bringing the total volume available for trade in the year beginning in September to ~ 1.32 Gt.2 The EU’s CO2 emissions market is designed to achieve policy goals – i.e., reducing the carbon footprint of utilities and manufacturers in Europe – vs. pricing those emissions purely as a function of supply-demand fundamentals. Chart 2CO2 Allowances Rally Reflects Anticipated Supply Squeeze CO2 Emissions As is the case with industrial commodities – particularly oil, base metals, iron ore and steel – non-OECD markets dominate CO2 emissions. CO2 is the largest greenhouse gas (GHG) emitted into the atmosphere, and the largest share – almost two-thirds – of it is accounted for by fossil fuel use in industrial and transportation processes (Chart 3). CO2 emissions are closely tied to oil consumption. In non-OECD economies, this means they are closely tied to GDP, as the income elasticity of oil consumption for EM economies is ~ 0.65, meaning a 1% increase in income translates to a 0.65% increase in oil demand. In DM, transportation and electric generation drive hydrocarbon usage. In non-OECD and OECD markets, we model emissions as a function of oil consumption and financial variables (Chart 4). Chart 3Fossil-Fuel CO2 Dominates GHG Emissions It comes as no surprise that commodity prices generally are highly correlated with CO2 emissions, given the markets in which they trade are continually responding to supply-demand shifts in industrial and consumer markets. This can be seen in our Global Commodity Factor, which extracts the common factor across 28 real commodity prices (Chart 5). Chart 4CO2 Emissions Trend With GDP, Oil Consumption As is the case with industrial commodities – particularly oil, base metals, iron ore and steel – non-OECD markets dominate CO2 emissions (Chart 6). Chart 5CO2, Commodity Prices Closely Aligned Chart 6Non-OECD Economies Dominate CO2 Emissions Within this category, China accounts for ~ 45% of non-OECD CO2 emissions post-GFC, and close to 28% of global emissions, according to BP’s 2020 Statistical Review.3 China’s heavy reliance on coal-fired power generation and heating drive its CO2 emissions (Chart 7, top panel). Asia as a whole accounts for ~ 19 Gt of CO2 emissions, or 53% of the global total, while the US and Europe account for 18% and 17%, respectively.4 US CO2 emissions are driven by electric generation and transport, as the bottom panel of Chart 7 shows. Chart 7Electric Generation And Heating Drive China’s CO2 Emissions EU CO2 Emission Allowances The ETS also will force the overall number of emission allowances to contract at a 2.2% rate p.a. beginning next year. In the 21st century, ICE EUA futures prices have not followed actual EU CO2 emissions (Chart 8). This is not unexpected, given this market largely is a policy-driven market, not a fundamentally driven market. The ETS runs a cap-and-trade system covering ~ 45% of the EU’s GHG emissions, which limits emissions by more than 11,000 power stations, industrial plants and other heavy energy-use applications. Until 2019, the ETS adjusted supplies of emissions allowances by literally removing surpluses from the market resulting from overallocations of supplies via its free allocations and auctions. Thereafter, the ETS Market Stability Reserve (MSR), began absorbing unallocated emissions allowances to keep prices from falling to the point that investment in CO2 abatement would be disincentivized.5 Chart 8Two Ships In The Night: EU CO2 Emissions and EUA Futures As ETS system surplus allocations are reduced, we expect this market will more closely reflect the actual supply and demand for CO2 allowances. The ETS also will force the overall number of emission allowances to contract at a 2.2% rate p.a. beginning next year, versus the 1.74% p.a. contraction observed over the 2013-2020 period, in order, it says, to keep the GHG emissions falling to policy levels set for 2030. Even with its flaws vis-à-vis a true commodity market driven by supply-demand fundamentals, the ETS’s CO2 emissions allowances market is extremely important as a source of information regarding the state of the world. Last year, Reuters’s Refinitiv service estimated that of the $164 billion worth of CO2 emissions traded globally 90% was accounted for by the European market.6 As ETS system surplus allocations are reduced, we expect this market will more closely reflect the actual supply and demand for CO2 allowances. This will allow it to generate a market-clearing price for emissions allowances, which will be a valuable data point for global markets, especially when it comes to allocating capital to reducing GHG emissions. The ETS is retaining the right to issue free allocations, so that participants in the system are not disadvantaged by other jurisdictions not subject to the stringent requirements imposed by the ETS. Bottom Line: The ETS’s CO2 emission allowances will resume the rally launched in March 2020, as the supply of allowances contracts beginning in September. We are not ready to recommend any positions in this market, but will continue to follow and write about it going forward, expecting it will become not only a viable market but an important source of information of the market-clearing price of CO2 emissions.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI prices have been moving side-ways since June at ~ $41/bbl and $39/bbl, respectively. Fundamentals are tightening but fear of a second wave of COVID-19 infections weighs on prices. Bakken shale-oil producers could struggle to restart drilling and production activities after a court ordered the closure of the basin’s crucial Dakota Access pipeline – responsible for moving ~ 600k b/d – due to insufficient environmental checks. As previously shut-in production comes back on line, regional prices could remain under pressure to incentivize additional crude-by-rail volumes – at close to double the transportation costs – out of the basin, keeping prices below producers’ breakevens (Chart 9). Base Metals: Neutral Copper prices continue moving up as economic activity in China recovers (Chart 10). Prices are now 32% higher vs. March lows. Large metal-producing countries in Latin America have been hit hard by the COVID-19 pandemic. This puts supply at risk and could have lasting impacts as needed investment in new mines is delayed. In fact, Codelco announced it is suspending construction at its El Teniente mine in Chile due to rising COVID-19 cases in the region. Copper could enter a persistent supply-deficit period if demand remains in its upward trend. Precious Metals: Neutral Gold prices crossed $1,800/oz on Tuesday, reaching their highest level since 2011. The yellow metal’s rally continues to be fueled by record Western investment demand. ETFs inflows in June reached 104 tons, pushing gold-backed ETF volumes and AUM to new highs. Globally, ETF holdings’ tonnage increased by 25% ytd. This more than offsets the collapse in physical demand from China and India. Going forward, we expect a lower US dollar will support income growth in EM countries, providing additional demand for gold. Ags/Softs:  Underweight The latest USDA Acreage report surprised the market, with corn producers planting 5 million less acres than their intentions in March. This large decline caused corn futures to rally to 3-month highs. Since then, the market has focused on adverse weather, hoping dryness in major corn producing areas would reduce corn yields. However, that didn’t materialize. Forecasts are showing less intense heat in the Midwest crop belt and futures are losing some ground compared to recent highs. The market is now awaiting Friday’s USDA Supply and Demand report. With exports on pace to come in slightly below the USDA estimate for the year and a much-reduced planting area, we expect corn ending stocks to be well below the June estimate of 3.32 Bn bushels. Chart 9Bakken Crude Prices Are Falling Vs WTI Chart 10China's Economic Growth Supports Copper Prices     Footnotes 1    These futures are the EUA contracts for delivery of Carbon Emission Allowances at the Union Registry, which was set up to account “for all allowances issued under the EU emissions trading system (EU ETS).”  Contracts for delivery of these allowances are traded on ICE Futures Europe’s platform. 2    Please see ETS Market Stability Reserve to reduce auction volume by over 330 million allowances between September 2020 and August 2021 published by the European Commission May 8, 2020. 3    Please see bp Statistical Review of World Energy 2020: a pivotal moment published June 17, 2020. 4    Please see CO2 and Greenhouse Gas Emissions published by Our World in Data, a collaboration between researchers at the University of Oxford, and the non-profit organization Global Change Data Lab, in December 2019. 5    Surpluses have been a feature of the market since 2009.  Please see Market Stability Reserve published by the European Commission. 6    Please see Value of global CO2 markets hit record 144 billion euros in 2018: report published January 16, 2019 by reuters.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades