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Highlights The US election cycle is an understated risk to US equities – and the risk of a left-wing populist outperforming in the Democratic primary election is frontloaded in February. The US-Iran conflict is unresolved and remains market-relevant. Iraq is at the center of the conflict and oil supply disruption there or elsewhere in the region is a substantial risk. Even if war does not erupt, Iran has the potential to give President Trump’s foreign policy a black eye and thus could marginally impact the election dynamic. Feature Stocks have rallied mightily since our August report on Trump’s “tactical trade retreat,” but new headwinds face the market. In this report we call attention to four hurdles arising from US election uncertainty. Then we focus on the status of Iran and Iraq in the wake of this month’s hostilities, which brought the US and Iran to the brink of outright war. We maintain that the Iran risk is unresolved and will remain market-relevant in advance of the US election. Primarily due to the US Democratic primary election, we urge caution on US equities in the near term, along with our Global Investment Strategy, despite our cyclically bullish House View. Four Hurdles In The US Election Cycle The US election cycle is the chief political risk to the bull market this year – and geopolitical risks largely radiate from it. There are four immediate hurdles that financial markets are underestimating: Risks to Trump's re-election: Global investors have come around to our view since 2018 that Trump is slightly favored to win re-election (Chart 1). Bets on the related question of which party will hold the White House have flipped from Democratic to Republican (Chart 2). Everyone now recognizes that Trump will not be removed from office through impeachment. Chart 1Trump Re-election Odds Add To Risk-On Chart 2Republicans Now Favored For White House Yet, anecdotally, investors may be becoming complacent about Trump’s chances. He is not a shoo-in. Subjectively we have argued that his odds of victory are 55%. Our quantitative election model shows that Wisconsin has shifted to the Republican camp since November, but it places the odds of winning that state (and Pennsylvania) at less than 52% (Chart 3). This gives Trump 289 electoral votes, only 19 more than necessary. If both of these states tipped in the opposite direction then investors would be facing a major policy reversal in the United States. Chart 3Our US 2020 Election Model Shows Trump Win With 289 Electoral College Votes Chart 4The US Economy Is Still A Risk To Trump Trump’s low approval rating remains a liability – and in this sense impeachment is still relevant, in that it can either help or hurt his approval, or prompt him to seek distractions abroad that could deliver negative surprises. Moreover the US manufacturing sector and labor market are not out of the woods yet (Chart 4). In short, the election is still ten months away and a lot can happen between now and then. We see Trump as only slightly favored. Moreover other hurdles are more immediate than the benefits of policy continuity upon a Trump win. 2. Risks to Biden's nomination: Throughout last year we maintained that former Vice President Joe Biden was the frontrunner for the Democratic nomination, albeit with very low conviction. In particular, after Vermont Senator Bernie Sanders’s poor showing in the third debate and subsequent heart attack, we expected Massachusetts Senator Elizabeth Warren to consolidate the progressive vote and trigger a policy-induced selloff in US equities. This never occurred because Biden held firm, Sanders recovered, and Warren fell. The risk to equities from a left-wing populist Democratic nominee is frontloaded in February and March. Now, however, the risk to equities is back. The Democratic Party faces a last-ditch effort from its left or “progressive” wing and anti-establishment voters to oppose Biden. With the primary election now upon us – the Iowa Caucus is February 3 – national opinion polls show that Sanders is pushing up against Biden (Chart 5). It is less clear if Sanders is breaking through in the primary polling state-by-state, where multiple candidates remain competitive (Chart 6). But online gamblers are reasserting Biden over Sanders at just the moment when progressives are set to launch their biggest push (Chart 7). Meanwhile New York Mayor Michael Bloomberg is finally gaining some traction – and he eats away at Biden’s support from centrist voters. Everything is in flux, which warrants caution. Chart 5Biden Is The Frontrunner, But Sanders Is Challenger Chart 6Biden Not A Shoo-In For Early Democratic Primary States Biden is still favored to win the nomination, but he has not clinched it. The market faces volatility during the period when Democrats get “cold feet” about nominating another establishment candidate. Moreover the fundamental knock against Sanders – that he is not as “electable” as Biden – is debatable, judging by head-to-head polls against Trump (Chart 8). This means that a shift in momentum – for instance, if Biden lurches from disappointments in early states to underperformance in his bulwark of South Carolina – would have legs. Ultimately a “contested convention” is not impossible. This would be a negative surprise to market participants currently assuming that the world faces the relatively benign choice of two known quantities: an establishment Democrat or a continuation of Trump policies. Chart 7Betting Markets Overlooking Party 'Cold Feet' Over Biden Chart 8Electability Fears May Not Stop Sanders Rally Risks to the Republican Senate: Assuming Biden clinches the nomination, he has a 45% chance of winning the election – and in that case, his chance of bringing the Senate over to the Democrats is higher than investors realize. This is another risk that the market will awaken to later this year. Chart 9Democrats Underestimated In Senate The consensus holds that Republicans will hold the Senate, particularly with Republican senators in Maine and Iowa leading their Democratic challengers in polling. The problem is that for Democrats to unseat an incumbent president they will necessarily have generated strong turnout from key demographic groups: young people, suburbanites, women, and minorities. If that is the case, then the election will not be as tight as expected and Republicans will be less likely to hold the Senate. This would require rising unemployment or some other blow that fundamentally damages the Trump administration’s popular support in key swing states. At least until it becomes clear that the manufacturing sector is out of the woods, the Democrats should be seen as far more likely to take the Senate than the Republicans are to retake the House of Representatives – yet this goes against the consensus (Chart 9). Rising odds of a Senate victory would mean that even a “centrist” Democrat like Biden would have fewer political constraints in office – he would pose a greater threat of increasing taxes, minimum wages, and passing legislative regulation than the market currently expects. In short, Biden would be pulled to the left of the political spectrum by his party and expectations of an establishment Democrat posing a minimal threat to corporate profits would be greatly disappointed. Risks of Trump's second term: Finally, assuming the manufacturing sector rebounds and that Trump’s odds of re-election rise above 55%, market complacency becomes an even bigger concern for a long-term investor. For in his second term Trump would become virtually unshackled with regard to economic and financial constraints, since he cannot run for office again. He would still face the senate, the Supreme Court, and other constraints, but these would certainly not preclude a doubling down on trade war (or confrontations with nuclear-aspirants like Iran or North Korea). We have argued that Trump will not instigate a trade war with Europe, at least until the economy has clearly rebounded, and most likely not until his second term. But we fully expect chapter two of the trade war to begin in 2021 – and this could mean China, Europe, or even a two-front war. Re-election could go to Trump’s head and prompt him to overreach on the global stage. Hence we expect the relief rally on Trump’s re-election to be short-lived and would be looking to sell the news. But the S&P 500 faces more immediate hurdles anyway, and that is why we urge caution in the very near term. Iran is still a major geopolitical risk this year. Bottom Line: None of these hurdles are insurmountable, but the US election cycle is now an understated risk to the equity bull market. We agree with our Global Investment Strategy that it is prudent to shift to a neutral position tactically on US equities, especially for the February and March period when uncertainty rises over the Democratic Party primary. This does not change our view that the underlying global economy is improving, largely on China’s rebound, and that the cyclical outlook is positive. Don’t Bet On Regime Collapse In Iran (Yet) The January 8 Iranian attack on US bases in Iraq was intended to serve as a breather for Iranian leaders. It was meant to put on pause the rapid escalation in US-Iran tensions – allowing Iranian leaders to recover from the assassination of top military commander Qassem Suleimani – all the while appeasing the public through a public show of revenge. As fate would have it, however, the Iranian regime was granted no such respite. Days later, domestic unrest descended on the Islamic Republic as protesters returned to the streets across the country, criticizing the regime’s downing of a civilian airliner and re-stating their long-running complaints against the regime. Civil strife is not uncommon in Iran (Table 1). Economic inefficiencies, corruption, and discriminatory policies which serve to reward regime loyalists while suppressing the private sector are only some of the grievances faced by Iranians.1 Table 1Civil Strife Ongoing Problem In Iran Today’s strife is relevant, however, because it is fueled by US-imposed “maximum pressure” sanctions that have created an even bleaker economic reality. Iranian exports were down 37% in 2019 following an 18% decline the previous year. Oil exports fell to 129 thousand barrels per day in December 2019, down from an average 2.1 million barrels per day in 2017 (Chart 10). Households are facing the brunt, experiencing a 17% unemployment rate and a whopping 36% inflation rate (Chart 11). Chart 10US 'Maximum Pressure' Sanctions On Iranian Oil Exports Chart 11Iranian Households Bear Brunt Of Economic Shock The 2020-21 budget, released in December and described as a weapon of “resistance against US sanctions,” intends to plug the deficit using state bonds and state property sales (Chart 12). However Iran’s fiscal condition is shaky. The International Monetary Fund estimates a fiscal breakeven oil price of $194.6 per barrel for Iran, more than 3 times higher than current oil prices. Chart 12Iran’s Fiscal Condition Is Shaky Chart 13Iran Avoiding Devaluation Under Trump Chart 14Iranians Also Blame Their Government For Malaise The solution of former President Mahmoud Ahmadinejad, the populist hawk who led the government during the US’s previous round of sanctions, was to devalue the official exchange rate. The weaker rial raised local currency revenues for each barrel of exported oil and encouraged import substitution in other industries. However devaluation came at a steep political cost and sparked riots and protests. So far President Hassan Rouhani has eschewed this strategy, instead maintaining a stable official exchange rate, used as the reference for subsidized basic goods and medicine (Chart 13). Nevertheless, the unofficial market rate has weakened 68% since the beginning of 2018. It is no surprise then that Iranians all over the country are taking to the streets. The latest bout of unrest is significant in size, geographic reach, and in that protesters are calling on Grand Ayatollah Ali Khamenei to step down as supreme leader. Despite US sanctions, Iranian protesters are partially blaming Khamenei and the government for the country’s malaise (Chart 14). Even prior to the US withdrawal from the 2015 nuclear deal, Joint Comprehensive Plan of Action (JCPA), Iranians were angry about economic mismanagement. Nevertheless, according to our checklist for an Iranian revolution, the regime is not yet at risk of collapse (Table 2). Although the street movement is picking up pace, it is not organized or unified. There is no alternative being offered against the all-powerful supreme leader, and the political elite are mostly united in preserving the current system. Table 2Iran Regime Stability Checklist The regime has two main options going forward: seek immediate economic relief through negotiations with the United States, or hunker down and wait to see whether President Trump is reelected and able to sustain his campaign of maximum pressure, and go from there. We fully expect the latter. Domestic dissent can still be suppressed for the time being. The parliamentary – or Majlis – elections scheduled for February 21 could in theory offer Iranians an opportunity to voice their discontent through the ballot box. However this democratic exercise conceals the known political reality that the supreme leader holds supreme authority, even in the selection of parliament or the president (Diagram 1). Thus the election result will not drive major policy change. Diagram 1Supreme Leader Controls Iran A case in point was the regime’s 2016 strategy in the parliamentary election. At that time, the conservative-dominated Guardian Council, responsible for screening potential candidates, rejected well-known reformist applicants (Chart 15). As a result, the reformists who were able to win seats were either lesser-known figures or unaligned with liberals in the reformist movement. Thus while the reformist presence in parliament nominally surged, these lawmakers were ineffective, reneging on campaign promises or collaborating with the conservative faction. The 2016 election serves as a blueprint for what to expect in the upcoming elections in February. The Guardian Council ruled that out of around 15,000 candidates, only 60 (relatively unknown) reformist candidates were qualified to run for the election.2 The elections will not change anything, but this means the grievances of the population will fester in the coming years, especially if the US does not change policies. This is where the medium-term risk to regime stability – namely through elite divisions – becomes apparent. The impending leadership succession is a major source of uncertainty. Supreme Leader Khamenei is the main barrier to political change. At 80 years old and reportedly suffering from poor health, a change in leadership is imminent. However, no one has been officially endorsed as his successor. This is an immense source of uncertainty in the coming years. There are several possibilities for the succession.3 A successor is appointed by the Assembly of Experts. Because we exclude Rouhani as a candidate for supreme leader, the potential candidates for Iran’s top position listed below ascribe to Khamanei’s hardline ideology: Hojjat ol-Eslam Ebrahim Raisi, head of judiciary and of the Imam Reza shrine since March 2019. Raisi is reportedly Khamenei’s favorite for succession. He is a hardliner who lost the May 2017 presidential election to Rouhani.4 Ayatollah Sadeq Larijani, the conservative former head of the judiciary and current chairman of the Expediency Discernment Council, which is responsible for resolving disputes among government branches. Larijani is also a member of the Guardian Council.5 Ayatollah Ahmad Khatemi, hardline Tehran Friday prayer leader and senior member of the Assembly of Experts. The Iranian Revolutionary Guard Corps (IRGC) – a military force with immense influence in the regime – may choose to rule itself. We assign a low likelihood of this occurring. The IRGC is more likely to ensure that Khamenei’s successor is someone who supports its hardline ideology and vision for Iran. Some moderate clerics are advocating a change in structure, whereby the position of supreme leader is abolished. This school of thought argues that political leaders should be selected based on popular election rather than appointment.6 We do not assign high odds to this scenario. Until the Assembly of Experts selects the successor, a three-member council made up of the Iranian president, the head of judiciary, and a theologian of the Guardian Council, will assume the functions of supreme leader. Such a “triumvirate” could last longer than expected, or could even be formally decided as an alternative to a new supreme leader. In the context of such extreme uncertainty for the regime’s leadership in the coming decade, it is highly unlikely that the current political leaders will engage in negotiations with President Trump until they are sure of his staying power (Chart 16). First, the Iranians will continue to refuse talks prior to the US election. They will seek to undermine the Trump administration, yet without crossing red lines on the nuclear program (one year till nuclear breakout) or militant activities (killing American citizens). Chart 15Iran’s Guardians Vet Election Candidates Second, if Trump wins, then the shift to negotiations may or may not come, but the subsequent diplomatic process will be prolonged. Trump will have to gain the full cooperation of Europe, Russia, and China – and any new US-Iran deal is an open question and will involve tensions flaring up more than once. Chart 16Iranians Opposed To Talks With Trump Third, even if the Democrats win, the regime will play “hard to get” and will not immediately return to status quo ante Trump, although eventually there could be a restoration of the 2015 Joint Comprehensive Plan of Action or something like it. This process could also involve saber-rattling despite the Democrats’ more dovish disposition toward Iran. Bottom Line: The US maximum pressure campaign is not aimed at regime change in Iran, but if it brings any political change it will be a shift in a more hawkish direction as the regime faces immense internal and external pressures and an uncertain succession in the coming years. Iran’s leaders will continue to suppress unrest and can probably succeed in the near term. The confrontation with the US discredits any political actors who advocate negotiations. The path toward reform and improved relations with the West is closed until after the US election at minimum. Since Iran will seek to undermine both President Trump and the US presence in the Middle East in the meantime, US-Iran tensions remain a market-relevant source of risk in 2020. Iraq Still Poses An Oil Supply Risk Chart 17Iraqis Suffering From Poor Governance Iraq is ground zero for the US-Iran showdown, since the two powers have eschewed direct military confrontation. Iraqis have also been suffering the consequences of an ill-functioning political system (Chart 17). Corruption has prevented the trickle down of oil revenues, resulting in endemic poverty and inequality (Chart 18). Yet unlike its neighbor, Iraq is not ruled by a supreme leader who controls a powerful armed forces to which anger can be directed. Instead, protesters have been blaming the deep seated influence of the Iranian regime, which often results in what Iraqis’ argue to be a prioritization of foreign – i.e. Iranian – objectives over national ones. The demonstrations were successful in forcing the resignation of Prime Minister Adel Abdul Mahdi and the passing of a new electoral law. However Iraq remains in a state of chaos as Iraqis have vowed to remain on the street until all their conditions are met, including the appointment of an acceptable prime minister and early elections. Chart 18Poverty, Inequality, Corruption Plague Iraq This batch of reforms has been challenging for politicians to execute. For one, there is a lack of clarity as to which political group holds the majority of seats in Iraq’s Council of Representatives. Both the Iran-backed al-Binaa bloc as well as the al-Islah coalition led by Muqtada al-Sadr claim this position (Chart 19). A list of candidates for the temporary position of prime minister until early elections are held, proposed by Binaa in December, was rejected by President Barham Salih on grounds that it did not include anyone who would possess the support of the demonstrators. Chart 19Iraqi Parliamentary Control Up For Grabs Iraqi protesters have consistently reiterated their desire for a sovereign state, free from both American and Iranian interference. However, this nationalistic call has been disrupted and overshadowed by the US-Iran conflict. Importantly, the protest movement has now lost its most influential backer within the Iraqi political system: Sadr of the Islah bloc. This year’s Iran tensions and the parliamentary resolution to eject US troops from Iraq have unified the warring Shia political blocs. Sadr has called on the Mahdi army – a notoriously anti-American force also known as the Peace Brigades – to re-assemble. On January 13, in what can only be interpreted as a rapprochement among the main Shia political factions, Sadr met with paramilitary leaders making up the Popular Mobilization Forces in the Iranian city of Qom. They discussed the creation of a “united resistance” and the need jointly to expel foreign troops. Sadr also called for a “million-man march” against US troops in Iraq.7 Sadr’s pivot to Iran has not gone down well in Iraq’s streets, where protesters are accusing him of putting aside national goals for his own personal aspirations. While the protest movement will keep going, it is now largely headless and competing with the unified priorities of the Shia parties. This state of affairs weakens the odds of a sovereign Iraq that curbs Iranian regional influence. The political class is more likely to turn a blind eye to the repression of protesters, which is likely to increase as the system notches up its crackdown on dissent. A return to the status quo ante in Iraq is also now more likely. A new government may be elected. It may include more technocratic politicians in a nod to the protestors, but the pro-Iranian faction has fortified its position as kingmaker. Meanwhile, Sadr has decided that reform should be postponed for a later day. Iraqis who have been camping out on the streets for nearly four months, risking their lives, are unlikely to be easily put down. Instead their frustrations will manifest in more aggressive forms, such as through violence and the sabotage of infrastructure. Saudi Arabia may or may not seek to interfere in Iraq to maintain the pressure on Iranian interests. If it does so, it risks escalating the situation and provoking retaliation from Iran. Iraqi efforts to force a US troop withdrawal will clash with US interests. President Trump wants to reduce commitments but does not want to risk anything remotely resembling a Saigon-style evacuation during an election year. As such, some form of sanctions against Iraq is possible. The US administration may pass up imposing sanctions on oil sales and instead target USD flows to Iraq’s central bank. Blocking or reducing access to Iraqi accounts at the Federal Reserve Bank in New York – to which all revenues from Iraqi oil sales are directed – would debilitate the economy and amplify the risk to stability and hence oil flows. Washington’s decision whether to renew waivers allowing Iraq to import Iranian gas – set to expire mid-February – will signal whether the events earlier this year changed the US’s calculus. Iraq is extremely dependent on Iranian gas to generate power. A decision not to extend the waivers would cause greater friction between the Iraqi street and the ruling elite.8 Bottom Line: Baghdad is getting dragged deeper into chaos. Alignment with Iran, and delays in government formation and economic reform, will aggravate tensions between the street and the political class. Dissent may take on more violent forms going forward. Middle Eastern oil supply will remain vulnerable to instability and sabotage in Iraq and the broader Persian Gulf. Investment Conclusions In the very near term we expect US equities to encounter headwinds due to the over extension of the rally and immediate risks from the US election cycle. We also see global risk appetite suffering due to US uncertainty, as well as to fears about the new coronavirus. These may reach a crescendo in the wake of Chinese New Year travel season. However, China’s stimulative policy trajectory will ultimately be reinforced due to the economic threat from the outbreak. And China’s economy is showing signs of rebounding. This reinforces our constructive view on the global business cycle overall, on commodities, and on select emerging markets that produce oil or are undertaking structural reforms. The US-Iran conflict is ongoing and we expect it to continue injecting a risk premium into oil markets. The two sides are effectively playing Russian roulette.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The IRGC and bonyads – para-governmental organizations that provide funding for groups supporting the Islamic Republic – have access to subsidies, favorable contracts, and cheap loans. Together they run a considerable part of the economy. 2 Questions Loom In Iran As Reformist Factions Lose Hope In Elections," dated January 23, 2020, available at en.radiofarda.com. 3 In an interview with Fars news agency in June 2019, Ayatollah Mohsen Araki, a prominent member of the Assembly of Experts, mentioned that a committee of three members from the Assembly of Experts were working on a list of prospective supreme leaders, which they will present to the full AE when necessary. Please see "Is Iran’s Next Supreme Leader Already Chosen?," dated June 18, 2019, available at en.radiofarda.com. 4 Please see "Ebrahim Raisi: The Cleric Who Could End Iranian Hopes For Change," dated January 5, 2019, available at aljazeera.com. 5 Please see “A Right-Wing Loyalist, Sadeq Larijani, Gains More Power in Iran,” dated January 8, 2019, available at atlanticcouncil.org. 6 Mohsen Kadivar, an unorthodox cleric who was forced to flee Iran due to his political views, and is now an instructor at Duke University is a critic of the system of Velayet-e Faqih, or clerical rule. He claims that since the death of Khomeini, a majority of Iran’s religious scholars hold a “secretive belief” that supreme clerical rule should be abolished as it only leads to despotism. 7 In response to Sadr’s call for a “million man march”, Ayatollah al-Sistani repeated his warning against “those who seek to exploit the protests that call for reforms to achieve certain goals that will hurt the primary interests of the Iraqi people and are not in line with their true values.” 8 The last time Iran reduced electricity exports to Iraq resulted in mass protests in Iraq in July 2018. Thus if the sanction waivers are not renewed the cutoff of gas risks a greater clash between the Iraqi street and government, especially during the hot summer months.

Highlights The Wuhan coronavirus outbreak in China is now being priced into commodity markets, with comparisons to the 2003 SARS outbreak serving as an early benchmark.1 If it follows the SARS trajectory its impact likely will be limited, although oil demand could fall at the margin as global travel falls. The IMF expects growth in EM economies, the engine for commodity demand, to come in at 4.4% and 4.6% this year and next, respectively, down two-tenths of a percent from its previous forecast, but still up from 2019’s 3.7% rate. The Fund’s risk assessment tilts slightly to the upside, nonetheless, in the wake of global monetary and fiscal stimulus. We introduce our 2021 oil balances and price forecasts this week. We expect Brent crude oil to average $70/bbl next year, and for WTI to average $4/bbl below that. We are maintaining our $67/bbl Brent and $63/bbl WTI 2020 forecasts (Chart of the Week). Chart of the WeekCrude Oil Price Forecasts For 2020, 2021 Feature In its latest World Economic Outlook – Tentative Stabilization, Sluggish Recovery? – the IMF flags key risks to EM growth, which will continue to feed the economic policy uncertainty that dogs commodity demand.2 The Fund’s “downward revision primarily reflects negative surprises to economic activity in a few emerging market economies, notably India, which led to a reassessment of growth prospects over the next two years. In a few cases, this reassessment also reflects the impact of increased social unrest.” That said, the Fund sees the balance of risk slightly tilted to the upside versus its earlier assessment in October, in the wake of global monetary and fiscal stimulus. This is in line with our view that the effects of monetary stimulus – deployed over the better part of last year and still expected to remain accommodative this year – will boost growth this year. Our view remains tempered by risks we’ve been highlighting that keep political and economic policy uncertainty elevated – e.g., trade tensions, civil unrest, and the still-underappreciated risks to oil markets arising from US-Iran tensions and social unrest in Iraq, which remains high (Chart 2). The loss of 800k b/d from Libya is significant, but the world does not lack spare light-sweet crude oil production capacity – the US shales, in particular, abound in this type of crude oil. Chart 2Policy Uncertainty Will Trend Lower, But Continues To Dog Commodities Oil Fundamentals Improving As is typically the case, we expect global oil-demand growth this year will be led by EM economies. Crude oil fundamentals continue to favor higher prices: Production management and capital discipline will constrain the rate of growth of oil supplies, and, as discussed above, demand will benefit from policy stimulus globally (Chart 3). Oil demand growth will recover this year, following a lower-than-normal rate of just 830k b/d last year, based on the US EIA’s most recent estimates of historical consumption. We continue to expect demand to grow 1.4mm b/d this year.  For 2021, we expect growth of just under 1.5mm b/d, reaching 103.65mm b/d globally. For its part, the EIA’s estimating growth of 1.34mm and 1.37mm b/d for 2020 and 2021, respectively. As is typically the case, we expect global oil-demand growth this year will be led by EM economies, proxied by non-OECD oil consumption, of 1.26mm b/d. For next year, we expect EM demand growth to come in at 1.34mm b/d, or just over 90% of global oil consumption growth in 2021. On the supply side, we continue to expect OPEC 2.0 output to increase slightly in 2Q20 and return to levels consistent with its previous agreement to cut 1.2mm b/d of production. Our modeling also assumes this level of production remains flat for the rest of 2020. Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices Next year, we assume the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to increase production by 350k b/d in 1H21. In addition, we gradually remove 300k b/d of KSA’s overcompliance of 400k b/d next year, which moves its crude oil output in 2021 to 9.94mm b/d vs 9.76mm b/d this year. For Russia, we anticipate an increase in its condensate production, which it lobbied for last year. This will put our estimate of Russia’s crude and condensate production at 11.4mm b/d in 2020 and 11.64mm b/d in 2021.3 Most of the production cuts realized by OPEC 2.0 – ~ 2mm b/d – come at the expense of Venezuela and Iran, both of which are under sanctions limiting their production imposed by the US. We are holding Venezuela’s production at ~ 700k b/d in 2021, and will be monitoring this closely for any indication it is significantly changing. For Iran, we are keeping its production at 2.10mm b/d this year and next, assuming US sanctions remain in place. Oil production in both countries could be impacted by the outcome of US elections in November, and right now this is a near-impossible call to make. US Shales: No Longer A Growth Story? We continue to see slower production growth in the US than the EIA, particularly in the shales, as we expect capital markets to continue to discipline shale producers by only funding those firms that are able to return capital to shareholders or to deliver steady and increasing dividends. In our modeling, total US onshore production this year and next is expected to rise 800k b/d, and 310k b/d for 2021. We also continue to expect drilled-but-uncompleted (DUC) wells to continue to make significant contributions to overall shale-oil production in the US. Indeed, we expect DUCs to continue to offset part of the decline implied by lower rig counts, as they require less capex than drilling and completing new wells. We add ~ 500k b/d of production from DUCs completion over 2020 and 2021. Future production will depend heavily on the Majors and on productivity and lateral length. Our US crude and condensate production estimates for 2020 and 2021 reflect these constraints, and the slowing rate of growth being imposed by capital markets. For 2020, we expect total US crude and condensate production of 13.16mm b/d, of which 9.20mm b/d will come from the main shale basins led by the Permian.4 Tighter Fundamentals, Steeper Backwardations Our fundamental supply-demand balances are tighter than those assumed by the US EIA and the Paris-based IEA (Table 1). We expect US crude and liquids production to grow 1.6mm b/d this year, and only 500k b/d next year. We see global production growing 1.15mm b/d and 1.39mm b/d in 2020 and 2021, respectively. With demand growing 1.4mm b/d and close to 1.5mm b/d in 2020 and 2021, respectively, against this supply backdrop, our balances point to a deficit this year vs. the surplus expected by the IEA  (Table 2 and Chart 4). Table 1Fundamentals Comparison Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4BCA Research's Balances Estimates Point To Falling Inventories Chart 5Tighter Storage, Steeper Backwardation For this reason, we continue to anticipate a steepening in the Brent and WTI forward curves – i.e., more backwardation – which will support our long 2H20 Brent vs. short 2H21 Brent curve trade (Chart 5). As a result of the steeper backwardation, we expect higher volatility, and will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls (Chart 6). Bottom Line: We continue to expect crude oil markets to tighten, given persistent production restraint by OPEC 2.0, capital-market-imposed restraint on US shale-oil producers, and revived global demand growth in 2020 and 2021. The IMF’s assessment re the balance of risk being tilted to the upside, in the wake of global monetary stimulus, is broadly consistent with our maintained view. While we expect global policy uncertainty to fall following the so-called phase-one US-China trade deal and a definitive Brexit vote in the UK, geopolitical tension remains high, particularly in the Persian Gulf. Chart 6Steeper Backwardation To Higher Implied Volatility We will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. As a result, we are keeping our 2020 Brent forecast at $67/bbl, and are expecting 2021 Brent to trade at $70/bbl; WTI is expected to trade $4/bbl below Brent this year and next, on average. At tonight’s close, we will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices traded sideways ~ $64/bbl since last Tuesday, dismissing the US and China phase-one agreement and disruptions to Libyan production and exports which could total as much as 800k b/d.  Over the weekend, concerns re the Wuhan coronavirus outbreak in China started being priced into commodities, particularly oil.  Separately, the US Treasury Department renewed Chevron’s waiver to operate in Venezuela for another three months.  The company is scheduled to export 1mm barrels of oil produced by PDVSA via a joint-venture, partially dodging US sanctions on Venezuelan oil.5  We expect the country’s output to stabilize close to its current level of 710 kb/d this year. Base Metals: Neutral On Tuesday Beijing reported more than 400 people had been infected with the Wuhan coronavirus, confirming person-to-person transmission of the virus. Concerns that a wider spread over the lunar New Year holidays starting this weekend will impact economic growth in the world’s top metal consumer brought copper prices down 1.8% on Tuesday.  Zinc reached two-month highs this week amidst concerns of low LME warehouses stocks, now close to their 20-year lows at 50,900 MT (Chart 7).  Supply concerns stemming from low iron ore stocked in China’s ports, along with good Chinese macro data, lifted iron-ore prices. Precious Metals: Neutral The US dollar is a key missing piece needed to propel gold prices higher from current levels. The 2.4% decline in the trade-weighted dollar index supported gold’s 5% increase since October 1, 2019 (Chart 8).  We expect the dollar to continue depreciating in 2020, as global growth rebounds and the Fed remains accommodative, keeping gold prices well bid.  Most precious metals have followed gold’s lead this year; palladium and platinum are up 17.63% and 3.15%, respectively. Chart 7 Chart 8 Ags/Softs:  Underweight CBOT Corn and soybeans futures traded lower on Tuesday as markets awaited evidence of China purchasing additional U.S. agricultural goods, fulfilling its commitment to buy $32 billion of agricultural goods over two years per the phase-one deal negotiated between China and the US earlier this month.  Corn traded lower, as US grain elevators have yet to confirm any Chinese buying.  Soybeans, further weakened by expectations of a massive harvest in rival exporter Brazil.  Wheat was the only ag posting gains early in the week on the back of strong Black Sea export demand.     Footnotes 1     Please see CDC SARS Response Timeline, published by the US Centers for Disease Control and Prevention.  The SARS outbreak was identified in February 2003 and lasted six months.  The CDC noted: “Globally, WHO received reports of SARS from 29 countries and regions; 8,096 persons with probable SARS resulting in 774 deaths. In the United States, eight SARS infections were documented by laboratory testing and an additional 19 probable SARS infections were reported.”  According to Chinese officials, there were 440 confirmed cases of the new coronavirus as of Wednesday; nine people were reported to have died thus far.  The World Health Organization met Wednesday to assess the Wuhan coronavirus outbreak.  The 2003 coronavirus outbreak was minor compared to the typical influenza outbreak: by way of comparison, every year there are an estimated one billion cases of influenza, resulting in 290,000 to 650,000 deaths, according to the International Federation of Pharmaceutical Manufacturers & Associations in Switzerland. 2               Economic policy uncertainty is a recurrent theme in our research.  It has been driving safe-haven demand for the USD and gold for months, as we recently discussed in Iran Responds To US Strike; Oil Markets Remain Taut.  It is available at ces.bcaresearch.com. 3     We use World Bank growth estimates to drive our EM demand forecasts.  Earlier this month, the Bank forecast EM GDP growth of 4.1% for 2020 and 4.3% for next year.  This will outpace last year’s growth rate of 3.5%. 4     US production growth, particularly in the Permian and Bakken basins, could be constrained by environmental restrictions, if state regulators crack down on the massive flaring occurring in both states.  Please see Lingering Oil-Demand Weakness Will Fade, published November 21, 2019, where we discuss this risk in more depth. 5     Please see Exclusive: PDVSA's partners act as traders of Venezuelan oil amid sanctions - documents, published by reuters.com January 13, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Overweight US refiners enjoyed a solid run for the better part of 2019, but over the past three months have retraced roughly a third of those relative gains. Nevertheless, we remain overweight the S&P oil & gas refining & marketing (O&G R&M) index for three reasons. First, US gasoline inventories are on the cusp of contracting anew. Whittled down inventories have historically underpinned US refiners’ margins (gasoline inventories shown inverted, second panel). Second, historically rising crack spreads have been synonymous with expanding relative forward earnings growth. Thus, an inventory-led boost to refining margins should continue to underpin relative profit growth (third panel). Finally, the dollar is a key driver behind the entire commodity complex as well as commodity exposed equities. Since the 2015 manufacturing recession, US refiners have been tightly inversely correlated with the greenback and the current message is that the sell-off in the S&P O&G R&M index is near exhaustion (US dollar shown inverted, bottom line). Bottom Line: We remain overweight the S&P O&G R&M index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.

Highlights Duration: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. TIPS: We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. High-Yield: Investors should add (or increase) exposure to the high-yield energy sector, within an overweight allocation to junk bonds. Junk energy spreads are attractive, and exposure to the sector will mitigate the impact of a potential oil supply shock. Feature Only a month ago, investors were becoming more optimistic about a global growth rebound and the US/China phase 1 trade deal was pushing political risk into the background. Both of those factors caused the 10-year Treasury yield to rise throughout December, hitting an intra-day Christmas Eve peak of 1.95% (Chart 1). But since then, softer global PMI data and the US/Iranian military conflict brought global growth concerns and political risk back to the fore, breaking the uptrend in yields. Chart 1Bond Bear On Pause Global growth and political uncertainty are two of the five macro factors that we identify as important for US bond yields.1 And despite the recent setback, we think both factors will push yields higher in the coming months. Global Growth We have found that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index are the three global growth indicators that correlate most strongly with US bond yields. One reason for the recent pullback in yields is the disappointing December data from the Global and US Manufacturing PMIs. The ISM Manufacturing PMI moved deeper into recessionary territory. The Global Manufacturing PMI had been in a clear uptrend since mid-2019, but fell back to 50.1 in December, from 50.3 the month before (Chart 2). The US and Chinese PMIs also declined in December, though they remain well above the 50 boom/bust line (Chart 2, panels 3 & 4). The Eurozone and Japanese PMIs, meanwhile, are still in the doldrums (Chart 2, panels 2 & 5). More worrying than the small tick down in Global PMI is the US ISM Manufacturing PMI moving deeper into recessionary territory, from 48.1 to 47.2. However, we have good reason to think that stronger data are just around the corner (Chart 3). Chart 2Global PMI Ticks Down Chart 3ISM Manufacturing Index Will Rebound First, the difference between the new orders and inventories components of the ISM index often leads the overall index at turning points, 2016 being a prime example (Chart 3, top panel). Much like in 2016, a gap is opening up between new orders-less-inventories and the overall ISM. Second, the non-manufacturing ISM index remains strong despite the weakness in manufacturing (Chart 3, panel 2). With no contagion to the service sector of the economy, we’d expect manufacturing to pick back up. Third, the ISM Manufacturing index has diverged sharply from the Markit Manufacturing PMI, with the Markit index printing well above the ISM (Chart 3, panel 3).2 The ISM index has been more volatile than the Markit index in recent years, and should trend toward the Markit index over time. Fourth, regional Fed manufacturing surveys have generally been stronger than the ISM during the past few months. A simple regression model of the ISM index based on data from regional Fed surveys suggests that the ISM index should be at 49.7 today, instead of 47.2 (Chart 3, bottom panel). Finally, unlike the PMI surveys, the CRB Raw Industrials index has increased quite sharply in recent weeks (Chart 4). We should note that it is not the CRB index itself but rather the ratio between the CRB index and gold that tracks bond yields most closely, and this ratio has actually declined lately due to the strength in gold. Nonetheless, a sustained turnaround in the CRB index would mark a big change from 2019 and would send a strong bond-bearish signal. Chart 4CRB Sends A Bond-Bearish Signal Political Uncertainty The second factor that sent bond yields lower during the past few weeks was the military conflict between the US and Iran. Tensions appear to have de-escalated for now, and we would expect any flight-to-quality flows to unwind during the next few weeks.3 But while we see policy uncertainty easing in the near-term, sending bond yields higher, we reiterate our view that US political uncertainty is the number one risk factor that could derail the 2020 bear market in bonds.4 Specifically, we see two looming US political risks. The first relates to President Trump’s re-election odds. For now, Trump’s approval rating is in line with past incumbent presidents that have won re-election (Chart 5). But if his approval doesn’t keep pace in the coming months, he will try to do something to change his fortunes. That could mean re-igniting the trade war with China, or once again ramping up tensions with Iran. A Bernie Sanders or Elizabeth Warren victory would send a flight-to-quality into bonds. The second risk is that one of the progressive candidates – Bernie Sanders or Elizabeth Warren – secures the Democratic nomination for president. Right now, both trail Joe Biden in the polls and betting markets (Chart 6), but things could change rapidly as the primary results come in during the next few months. The stock market would certainly sell off if an Elizabeth Warren or Bernie Sanders presidency seems likely, sending a flight to quality into bonds.5 Chart 5Trump’s Approval Rating Must Rise Chart 6Democratic Nomination Betting Odds Bottom Line: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. Playing An Oil Supply Shock In US Bond Markets US/Iranian military tensions are easing for now, but could flare again in the future. For that reason, it’s worth considering how US bond markets would respond in the event of a conflict between the US and Iran that removed a significant amount of the world’s oil supply from the market, causing the oil price to spike. The first implication is that US bond yields would fall. Even though it’s tempting to say that the inflationary impact of higher oil prices would push yields up, this effect would not dominate the flight-to-quality into US bonds that would result from the increase in political uncertainty. Case in point, Chart 1 shows that, while the inflation component of yields was stable as tensions flared during the past few weeks, it didn’t come close to offsetting the drop in the 10-year real yield. Beyond the impact on Treasury yields, there are two other segments of the US bond market that would be materially impacted by an oil supply shock: the TIPS breakeven inflation curve and corporate bond spreads. Buy TIPS Breakeven Curve Flatteners Table 1CPI Swap Curve Sensitivity To Oil When considering the impact of an oil supply shock on TIPS breakeven inflation rates, we first look at how the cost of inflation protection is influenced by changes in the oil price. Table 1 shows the sensitivity of weekly changes in different CPI swap rates to a $1 increase in the price of Brent crude oil. We use CPI swap rates instead of TIPS breakeven inflation rates because data are available for a wider maturity spectrum. Our analysis applies equally to the TIPS breakeven inflation curve. Two conclusions are apparent from Table 1. First, the entire CPI swap curve is positively correlated with the oil price, a higher oil price moves CPI swap rates higher and vice-versa. Second, the sensitivity of CPI swap rates to the oil price is greater at the short-end of the curve than at the long-end. This is fairly intuitive given that higher oil prices are inflationary in the short-term but could be deflationary in the long-run if they hamper economic growth. Chart 7Coefficients Stable Over Time Chart 7 shows that our two main conclusions are not dependent on the chosen time horizon. The 2-year CPI swap rate is positively correlated with the oil price for our entire sample period, as is the 10-year rate except for a brief window in 2014. The 2-year rate’s sensitivity is also consistently higher than the 10-year’s. Based on this analysis, we can suggest two good ways to hedge against the risk of an oil supply shock that sends prices higher: Buy inflation protection, either in the CPI swaps market or by going long TIPS versus duration-equivalent nominal Treasuries. Buy CPI swap curve (or TIPS breakeven inflation curve) flatteners.6 But we can introduce one more wrinkle to our analysis. Oil prices can rise because of stronger demand or because a shock suddenly removes supply from the market. It’s possible that the cost of inflation protection behaves differently in each case. Fortunately, the New York Fed has made an attempt to distinguish between those two scenarios. In its weekly Oil Price Dynamics Report, the Fed decomposes Brent oil price changes into demand-driven changes and supply-driven changes.7 It does this by looking at how other financial assets respond to oil price changes each week. Chart 8 shows the cumulative change in the Brent oil price since 2010, along with the New York Fed’s supply and demand factors. According to the Fed, demand has pressured the oil price higher since 2010, but this has been more than offset by greater supply. Chart 8Supply & Demand Oil Price Decomposition Using the New York Fed’s supply and demand series, we look at how CPI swap rates respond to higher oil prices in three different scenarios. First, we identify 252 weeks when demand and supply both contributed to higher oil prices. Second, we identify 95 weeks when higher oil prices were driven solely by demand. Finally, and most pertinently, we identify 92 weeks when higher oil prices were driven only by supply (Table 2). Table 2Weekly Change In CPI Swap Rate When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios are consistent with our results from Table 1. CPI swap rates across the entire curve move higher more than half the time, with greater increases at the short-end of the curve. However, the scenario we are most interested in is the ‘Supply Driven’ scenario. Presumably, a military conflict with Iran that took oil supply off the market would lead to less supply and also a decrease in global demand. Results for this scenario are more mixed. The 1-year CPI swap rate still rises 60% of the time, but rates further out the curve are somewhat more likely to fall. With this in mind, CPI swap curve or TIPS breakeven curve flatteners look like the best way to hedge against an oil supply shock, better than an outright long position in inflation protection. This is good news, since we have previously argued that owning TIPS breakeven curve flatteners is a good idea even without an oil supply shock.8 Corporate bond excess returns respond positively to changes in the oil price. We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. Buy Energy Junk Bonds Table 3Corporate Bond Sensitivity To Oil Corporate bonds are the second segment of the US fixed income market that could be materially impacted by an oil supply shock, particularly bonds in the energy sector. To assess the potential value of corporate bonds as a hedge, we repeat the above analysis but use weekly corporate bond excess returns versus duration-matched Treasuries instead of CPI swap rates. Table 3 shows that investment grade and high-yield corporate bond returns both respond positively to changes in the oil price. Further, we see that energy bonds are more sensitive to the oil price, outperforming the overall index when the oil price rises, and vice-versa. Chart 9 shows that, while oil price sensitivities vary considerably over time, they are almost always positive. Also, energy sector sensitivity has been consistently above that of the benchmark index since 2014. Chart 9Betas Mostly Positive Going one step further, we once again use the New York Fed’s supply and demand decomposition to identify weeks when supply and/or demand was responsible for higher oil prices. Because we have more historical data for corporate bonds than for CPI swaps, this time we identify 340 weeks when both supply and demand drove the oil price higher, 123 weeks when only demand drove it higher and 142 weeks when only supply was responsible for the higher oil price (Table 4). Table 4Weekly Corporate Bond Excess Returns (BPs) When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios show that higher oil prices boost excess returns to both investment grade and high-yield corporate bonds more than half the time. Energy bonds also tend to outperform their respective benchmark indexes in the ‘Demand & Supply Driven’ scenario, but perform roughly in-line with the benchmark in the ‘Demand Driven’ scenario. But once again, it is the ‘Supply Driven’ scenario that we are most interested in. Here, we see that an oil supply disruption that leads to higher oil prices also leads to lower corporate bond excess returns. This is true for both the investment grade and high-yield indexes and for energy bonds in both rating categories. However, we also note that high-yield energy debt significantly outperforms the overall junk index during these “risk off” periods. In contrast, investment grade energy debt is not a clear outperformer. Chart 10HY Energy Spreads Are Very Attractive These results line up with our intuition. When oil prices are driven higher by demand it could simply be a sign of strong economic growth and not any specific trend related to the energy sector. As such, we’d expect all corporate bonds to perform well in those scenarios, but wouldn’t necessarily expect energy debt to outperform. However, supply disruptions in the Middle East directly benefit US shale oil players, whose debt is principally found in the high-yield energy sector. The investment grade energy sector is less exposed to the US shale space, and its documented outperformance in the ‘Supply Driven’ scenario is weaker as a result. We already recommend an overweight allocation to high-yield bonds and a neutral allocation to investment grade corporates. Within that overweight allocation to high-yield bonds, we recommend shifting some exposure toward the energy sector for two reasons. First, high-yield energy was severely beaten-down last year and is ripe for a rebound if global economic growth recovers, as we expect (Chart 10). Second, our analysis suggests that an allocation to energy will help mitigate losses in the event of a renewed flaring of US/Iranian tensions that removes oil supply from the market. Bottom Line: We recommend that investors initiate TIPS breakeven curve flatteners (or CPI swap curve flatteners) and add exposure to the high-yield energy sector. Both positions look attractive on their own terms, but will also help hedge the risk of an oil supply disruption if US/Iranian tensions flare back up in the months ahead.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The others are: the output gap, the US dollar and sentiment. For more details please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 The Markit index is used in the construction of the Global PMI shown in Chart 2, 3 For more details on the politics behind the US/Iran conflict please see Geopolitical Strategy Special Alert, “A Reprieve Amid The Bull Market In Iran Tensions”, dated January 8, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets”, dated September 13, 2019, available at gis.bcaresearch.com 6 In the TIPS market, an example of a breakeven curve flattener would be to buy 2-year TIPS and short the 2-year nominal Treasury note, while also buying the 10-year nominal Treasury note and shorting the 10-year TIPS. 7 https://www.newyorkfed.org/research/policy/oil_price_dynamics_report 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Remain short the DXY index. The key risk to this view is a US-led rebound in global growth, or a pickup in US inflation that tilts the Federal Reserve to a relatively more hawkish bias. Stay long a petrocurrency basket. The latest flare-up in US-Iran tensions is just a call option to an already bullish oil backdrop. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for maintaining a pro-cyclical stance. Feature The consensus view is rapidly converging to the fact that the dollar is on the precipice of a decline, and cyclical currencies are bound to outperform. This is good news for our forecast but bad news for strategy. The fact that speculators are now aggressively reducing long dollar positions, one of our favorite contrarian indicators, is disconcerting (Chart I-1). The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions (Chart I-2). That said, we are not dogmatic. In FX, momentum investors eventually get vilified, while contrarians get vindicated. This suggests revisiting the core risks to our view, especially in light of recent market developments. Chart I-1A Consensus Trade? Chart I-2The Dollar Is A Momentum Currency An Oil Spike: US Dollar Bullish Or Bearish? The latest story on the global macro front is the possibility of an oil spike, driven by escalation in US-Iran tensions. Our geopolitical strategists believe that while Middle East tensions are likely to remain elevated for years to come, a full-scale war is not imminent.1 This view is fomented by a few key factors. First, the Iranian response to the assassination of Qasem Soleimani was relatively muted, given no US lives were claimed. This was also reinforced by the Iranian foreign minister’s claim that the actions were concluded. As we go to press, the Kyiv-bound Ukrainian aircraft that crashed in Tehran is being characterised as an “act of God” so far. In a nutshell, this suggests de-escalation. Second, sanctions against Iran have been causing real economic pain, given rampant youth unemployment and falling government revenues. This means that Tehran will have to be strategic in any confrontation with the US, since the risks domestically are asymmetrically negative. Renegotiating a new nuclear deal seems like a better bargaining chip than an all-out war. The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions. The biggest risk for oil prices is the possibility of a more marked drop in Iranian production, or possibly the closure of the Strait of Hormuz, though this is a low-probability event for the moment (Chart I-3). Our commodity strategists posit that while a closure of the strait could catapult prices to $100/bbl, there are some near-term offsetting factors.2 These include strategic petroleum reserves in both China and the US, as well as OPEC spare capacity that could benefit from the newly expanded pipeline to the port of Yanbu. This suggests that a flare up in US-Iran tensions remains a call option rather than a catalyst on an already bullish oil demand/supply backdrop. Chart I-3The Risk From Iran Risks to oil demand remain firmly tilted to the upside. Oil demand tends to follow the ebb and flow of the business cycle. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers, and heavy trucks to a halt (Chart I-4). Any increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. Not to mention, unplanned outages typically wipe out 1.5%-2% of global oil supply. Any such occurrence in 2020 will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-4Oil Demand And Global Growth Chart I-5Opec Spare Capacity Is Low Traditionally, a pick-up in oil prices has tended to be bearish for the US dollar. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payment dynamics also tend to improve during oil bull markets. Altogether, these forces combine to become powerful undercurrents for petrocurrencies. That said, it is important to distinguish between malignant and benign oil price increases. There have been many recessions preceded by an oil price spike, and rising prices on the back of escalating tensions are not a recipe for being bullish petrocurrencies. That said, absent any escalating tensions or a marked pickup in global demand, which is not our base case, the rise in oil prices should be of the benign variety – pinning Brent towards $75/bbl. OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. In terms of country implications, rising oil prices will go a long way towards improving Canada’s and Norway’s trade balances. In the case of Norway, net trade fell in 2019 due to lower exports of oil and natural gas, but still stands at 5.1% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 4.4% of GDP. On the other hand, the Canadian trade deficit has been hovering near -1% of GDP over the past few years. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices (Chart I-6). We are bullish both the loonie and Norwegian krone, but have a short CAD/NOK trade as high-conviction bet on diverging economic fundamentals. Chart I-6NOK Will Outperform CAD Shifting Correlation Even though rising oil prices tend to be bullish for petrocurrencies, being long versus the US dollar requires an appropriate timing signal for a downleg in the greenback. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, there has been a divergence between the price of oil and the performance of petrocurrencies. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-7).  Chart I-7Shifting Landscape For Petrocurrencies This is especially pivotal as the US inches towards becoming a net exporter of oil. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. The strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar down-leg. Another strategy is to be long a basket of oil producers versus oil consumers. We are long an oil currency basket versus the euro as a dollar neutral way of benefitting from rising oil prices. Chart I-8 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Chart I-8Buy Oil Producers Versus Oil Consumers Risks To The View Above all, the dollar remains a counter-cyclical currency. As such, when global growth rebounds, more cyclical economies benefit most from this growth dividend, and capital tends to gravitate to their respective economies. This holds true for global oil and gas sectors that tend to have a higher concentration outside of US bourses. As such, one key risk is that if the S&P 500 keeps outperforming oil, as has been the case over the past decade, the dollar is unlikely to weaken meaningfully (Chart I-9). We understand this is a call on sectors (US tech especially), rather than relative growth profiles, but what matters for currencies is the impulse of capital flows. That said, improving global growth should allow EM energy consumption (a key driver of oil prices), to pick up. Chart I-9Oil Prices And The Stock Market The second risk is a pickup in US inflation expectations that tilts the Fed towards a relatively more hawkish bias. The economic linkage between US inflation and oil is weak, but financial markets assign a strong correlation to the link (Chart I-10). In our view, given that higher gasoline prices tend to hurt US retail sales, and the consumer is the most important driver of the US economy, higher oil prices can only be inflationary if the overall US economy is also robust (Chart I-11). This combination is unlikely to occur if rising oil prices are being driven by a flare-up in geopolitical tensions.   Chart I-10A Rise In Oil Prices Will Help Inflation Expectations Chart I-11Gasoline Prices And US Consumption A US inflation spike in 2020 is a low-probability event. There have been two powerful disinflationary forces in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. This was further exacerbated by the trade war. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-12). Meanwhile, the recent rise in the dollar and fall in commodity prices are likely to continue to anchor US inflation expectations downward, which should keep the Fed on the sidelines. Chart I-12Velocity Of Money Versus Inflation The gaping wedge between the US Markit and ISM PMIs remains a cause for concern. Given sampling differences, where the Markit PMI surveys more domestically-oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-13). Looking across global PMIs, there has been a notable pickup in Asia, specifically in Korea, Taiwan and Singapore, though weakness in Japan and Europe has persisted. This warrants close monitoring. Chart I-13The Risk To A Bearish Dollar View We continue to view further deceleration in the global manufacturing sector as a tail risk rather than our base case. Trade tensions have receded, global central banks remain very dovish, and Brexit uncertainty has diminished. This should allow global CEOs to begin deploying capital, on the back of pent-up investment spending. More importantly, the slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. On the political spectrum, it has been historically rare for the Fed to raise interest rates a few months ahead of an election cycle, which should allow a weaker dollar to help grease the global growth supply chain. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden.  Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, this remains a tail risk. Housekeeping We will soon be taking profits on our long NOK/SEK position. Reduce the target to 1.09 and tighten the stop to 1.06. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden. Most importantly, the cross will approach a profitable technical level in the coming weeks, on the back of our call a few weeks ago to rebuy the pair (Chart I-14). 2020 will be a year of much more tactical calls. Stay tuned. Chart I-14Take Profits On NOK/SEK Soon   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1  Please see Geopolitical Strategy Special Alert "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Iran Responds To US Strike; Oil Markets Remain Taut," dated January 9, 2020, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: ISM manufacturing PMI fell to 47.2 from 48.1 in December. However, Markit and ISM services PMIs both increased to 52.8 and 55, respectively.  The trade deficit narrowed by $3.8 billion to $43.1 billion in November. ADP recorded an increase of 202K workers in December, the largest increase since April. Initial jobless claims fell from 223K to 214K, better than expected. MBA mortgage applications soared by 13.5% for the week ended December 27th. The DXY index recovered by 0.7% this week from its recent decline. Trump's speech has eased tensions between the US and Iran, making an escalation towards a full-scale war unlikely. Moreover, recent data point to a continued expansion in the US through 2020. That being said, we believe that the global growth will outpace the US, which is bearish for the dollar, but this is an important risk to monitor. Tomorrow’s payroll report will be an important barometer. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Markit services PMI increased to 52.8 from 52.4 in December. Headline inflation jumped to 1.3% year-on-year from 1% in December, while core inflation was unchanged at 1.3%.  Retail sales accelerated by 2.2% year-on-year in November, from 1.7% the previous month. The Sentix investor confidence soared to 7.6 from 0.7 in January. The expectations versus the current situation component continues to point to an improving PMI over the next six months. EUR/USD fell by 0.7% this week. Recent data from the euro area have been consistent with our base case view that the euro area economy is rebounding, and is likely to accelerate in 2020. We remain long the euro, especially against the CAD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been disappointing: The manufacturing PMI fell slightly to 48.4 from 48.8 in December; the services PMI also fell to 49.4 from 50.3 in December. Labor cash earnings fell by 0.2% year-on-year in November. Consumer confidence increased to 39.1 from 38.7 in December. USD/JPY increased by 1.2% this week. The Japanese yen initially surged on the back of US-Iran headlines, then fell as tensions faded after Trump's speech. While we don't expect a full-scale war between the US and Iran for the moment, geopolitical risks will likely persist before the elections later this year. We continue to recommend the Japanese yen as a safe-haven hedge, though our long position is currently out of the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Nationwide housing prices increased by 1.4% year-on-year in December. Halifax house prices also grew by 4% year-on-year in December. Markit services PMI surged to 50 from 49 in December. The British pound fell by 0.4% against the US dollar this week. On Thursday, BoE Governor Mark Carney said in a speech that “with the relatively limited space to cut the Bank Rate, if evidence builds that the weakness in activity could persist, risk management considerations would favor a relatively prompt response.” This has been viewed by the market as dovish and the pound fell on the message. In the long term, we like the pound as Brexit risk fades. In other news, the BoE has announced Andrew Bailey as the successor to Mark Carney, scheduled to take over in March 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: 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 positive: The Commonwealth bank services PMI increased to 49.8 from 49.5 in December. Moreover, the AiG manufacturing index slightly increased to 48.3 from 48.1. Building permits fell by 3.8% year-on-year in November. On a monthly basis however, it increased by 11.8%. Exports increased by 2% month-on-month in November, while imports fell by 3%. The trade surplus widened to A$5.8 billion. The Australian dollar plunged by 1.5% against the US dollar amid broad US dollar strength this week. The Aussie is the weakest currency so far this year.  This is especially the case given demand destruction from the ongoing severe bushfires in Australia. On the positive side, a weaker Australian dollar could support exports and the current account as international trade picks up in 2020. The extent of fiscal stimulus will be an important wildcard for both the RBA and the AUD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly positive: House prices increased by 4% year-on-year in December.  The ANZ commodity price index fell by 2.8% in December. The New Zealand dollar fell by 1% against the US dollar this week. On January 1st, China's central bank announced that it would inject additional liquidity into the economy. This is bullish for global growth along with a "Phase I" trade deal. As a small open economy, New Zealand is one of the countries that will benefit the most from a global growth recovery. We will be monitoring whether the scope for improvement in agricultural commodity prices is bigger than that for bulks, which underscores our long AUD/NZD position. 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 negative: Exports fell slightly by C$0.7 million in November. Imports also fell by C$1.2 million, which led to a narrower trade deficit of C$1.1 billion. Ivey PMI dropped sharply to 51.9 from 60 in December. Housing starts fell to 197K from 204K in December. Building permits also fell by 2.4% month-on-month in November. The Canadian dollar fell by 0.5% against the US dollar along with the decline in energy prices this week, erasing the gains earlier this year. While we expect the Canadian dollar to outperform the US dollar from a cyclical perspective, the CAD is likely to underperform against other cyclical currencies as global growth picks up steam through 2020. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The manufacturing PMI rose to 50.2 from 48.8 in December, the first expansion since March 2019, mainly driven by increases in both production and new orders. Headline inflation shifted back to positive territory at 0.2% year-on-year in December, following negative prints for the past two consecutive months.  Real retail sales were unchanged in November on a year-on-year basis. The Swiss franc was little changed against the US dollar this week, while it rose against other major currencies including the euro on the back of positive PMI and inflation data. More importantly, recent Middle East tensions have reignited safe-haven demand, increasing bids for the Swiss franc. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The unemployment rate fell further to 3.8% from 3.9% in October. The Norwegian krone has been fluctuating with the ebb and flow of US-Iran tensions and oil prices. This week it fell by 0.8% against the US dollar after Trump implied that both the US and Iran are backing off from an escalation into war. Moreover, the bearish oil inventory data from EIA managed to pull down oil prices even further. Despite the recent fluctuation in oil prices, we maintain an overweight stance on a cyclical basis based on a global growth recovery in 2020.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There has been scant data from Sweden this week:  Retail sales increased by 1.3% year-on-year in November. On a month-on-month basis however, it fell by 0.4% compared with October. The Swedish krona fell by 0.8% against the US dollar this week amid broad dollar strength. Despite rising geopolitical tensions, we remain optimistic and expect the global economy to recover this year given the US-China trade détente and increasing stimulus from China. The Swedish krona is poised to rise with global growth and a stronger manufacturing sector. 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