Commodities & Energy Sector

Highlights If it can maintain production discipline over the next 2-3 years, OPEC 2.0 will be the oil market’s most important determinant of price levels for years. The massive increase in OPEC 2.0 spare capacity resulting from COVID-19-induced demand destruction, along with its low-cost production, global storage and distribution will allow it to bring crude to market quicker than US shale-oil producers, and to manage an orderly drawdown in global inventories, which remains its raison d'être.  As spare capacity is drawn down over the next couple of years, Brent and WTI forward curves will backwardate in in 1H21, as spare capacity and the slope of the forward curve are inversely related (lower spare capacity leads to higher backwardation). This will keep spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge (Chart of the Week). Parsimonious capital markets will continue to deny funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.  ESG-focused investments will increasingly favor energy producers outside the oil and gas sector.  As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s. We will be updating our oil balances and 2H20 and 2021 forecasts – $46/bbl and $65/bbl for Brent in 2H20 and 2021 – next week.  Feature While the hit to oil producers’ revenues from the demand destruction caused by the COVID-19 pandemic has been severe – particularly for those states comprising OPEC 2.0, which are so heavily dependent on oil exports – it set the stage for the producer coalition to take control of global oil-price dynamics for the next couple of years. If the OPEC 2.0 coalition can maintain its production discipline, its member states could extend this control for years into the future, just as they are attempting to diversify their economies from this dependence on hydrocarbons. Once OPEC 2.0 member states manage to diversify a large part of their economies, the next optimal strategy will be to monetize their reserves and market share. Until then, it is our contention it is in these states' interest to have higher prices via gaining control of supply. The producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia today sits on some 7mm b/d of spare capacity that is a direct result of the global collapse in demand. This gives it a powerful lever to restrain the recovery of production growth in the US shales and elsewhere. Spare Capacity Turns The Tables On Shale Oil The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US Since its inception in late 2016, OPEC 2.0 has accommodated higher US shale production by reducing its output and then expanding it at a slower rate, as US production soared to meet domestic demand and, increasingly, global oil demand (Chart 2). OPEC 2.0 has been in operation since January 2017. Over that period, the coalition reduced its output growth ~ 0.37% for every 1% increase in crude and liquids output ex-OPEC 2.0. Within that adjustment, OPEC 2.0’s output falls by 0.16% for every 1% increase in US output, most of which was accounted for by the unprecedented growth of shale production.1 The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US (Chart 3). Chart of the WeekFalling OPEC 2.0 Spare Capacity Will Backwardate Brent Forward Curves Chart 2OPEC 2.0 Accommodated US Shales Chart 3OPEC 2.0 Would Benefit From Maintaining Spare Capacity At High Levels Along with its low-cost production, global storage and distribution, this spare capacity allows OPEC 2.0 member states to bring crude to market quicker than US shale-oil producers as the need for additional supply becomes apparent. This was demonstrated earlier this year by KSA when it engaged in a brief market-share war with Russia following the breakdown of negotiations to extend OPEC 2.0’s production cuts.2 The spare capacity also allows the coalition to manage an orderly drawdown in global inventories, which remains its raison d'être, by making crude available out of production on short notice. As a result, Brent and WTI forward curves will backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. By keeping forward curves backwardated, the amount of revenue – i.e., price x quantity – hedged is limited by lower forward prices vs. spot prices. This limits the volume of oil a producer can bring to market in the future. Extending OPEC 2.0’s Low-Cost Spare Capacity In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales. The advantage OPEC 2.0 realizes from holding spare capacity – KSA in particular – can be extended at low cost going forward.3 And, if OPEC 2.0 communicates its intent to maintain spare capacity at higher levels than have prevailed recently, as was indicated last week by Aramco’s CEO, who announced KSA intends to raise capacity 1mm b/d to 13mm b/d, this could, at the margin, disincentivize investment in production ex-OPEC 2.0 in the future.4 Developing spare capacity for low-cost producers like Aramco is akin to building a portfolio of deep-in-the-money options to increase output quickly at minimal expense. These options can be exercised – i.e., output can be increased in short order at low cost – before competitors can mobilize to meet the market need. What makes this strategy credible is KSA’s capacity to surge production and put oil on the water in VLCCs at astonishing speed, as noted above vis-à-vis the breakdown in negotiations earlier this year in Vienna to extend production cuts. In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales (Chart 4). This will allow them to begin rebuilding revenues sooner as demand recovers (Chart 5). Any demand increase in excess of OPEC 2.0’s flowing supply – which could be restrained to force refiners to draw storage (Chart 6) – can be met with spare capacity and storage held or controlled by coalition members. Chart 4OPEC 2.0 Supply Recovers Faster Than US Shales Chart 5Rate Of Demand Growth Will Exceed Supply Growth Chart 6Forcing Inventories Lower Capital-Market Parsimony Will Tighten Supply Equity investors have abandoned the oil and gas sector, as can be seen in the collapse in the percentage of the overall market accounted for by energy stocks (Chart 7). Chart 7Energy Share Of Overall Market Collapses This no doubt is fueled by underperformance vs. technology stocks and other alternatives available to investors, and to a migration toward Environmental, Social, and Corporate Governance (ESG) investing (Chart 8). Indeed, as our colleagues in BCA’s Global Asset Allocation Strategy noted, “ESG-related equities have outperformed global benchmarks over the past two years, as well as during the recent equity selloff.” In addition, “green energy” investments account for half of the $300 billion G20 governments have allocated to clean energy policies and renewable energy programs as part of the COVID-19 fiscal stimulus deployed worldwide.5 Chart 8ESG Investment Surge We believe this combination of a long-standing aversion to oil and gas equities and OPEC 2.0’s clear advantage in terms of its spare capacity, low-cost production and global storage and distribution networks will result in under-funding of new E+P, and will lead to a tighter market by the mid-2020s. This is particularly true for oil, which, is not confronting the competitive threat faced by natural gas vis-à-vis renewable energy. We will continue to develop these themes, and subject this thesis to fiery critique, borrowing from Kant’s methodology.6 Risks To Our View There are two major risks to the thesis developed here: OPEC 2.0 breaks down, as it came close to doing earlier this year (discussed above).  A breakdown of the coalition would lead to lower E&P investment via very low oil prices that almost surely would occur if this were to happen. This would be a far more volatile path to higher prices, which also would discourage investment. A battery-technology breakthrough that makes electric vehicles viable – i.e., unsubsidized – competitors to internal-combustion engine technology powering the vast majority of transportation. We expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Bottom Line: OPEC 2.0’s massive spare capacity resulting from COVID-19-induced demand destruction, its low-cost production and global storage and distribution network allow it to take control of crude-oil pricing dynamics over the next couple of years. These endowments also allow it to orchestrate an orderly drawdown in global inventories, which remains its raison d'être. As a result, we expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Parsimonious capital markets and a preference for ESG-focused investment will increasingly favor energy producers outside the oil and gas sector. As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight JKM and TTF natural gas prices are up 49% and 27% over the past four weeks. The price spreads for December 2020 futures contracts between the US and Europe and Asia reached $1.6/MMBtu and $1.9/MMBtu this week. This will support the ongoing recovery in US LNG exports – which was briefly halted last month by Hurricane Laura – during the coming winter season (Chart 9). Separately, Libyan oil exports could be set to rebound following statements by General Haftar – the leader of Libyan National Army (LNA) – that he was committed to lifting the current blockade on the country’s exports, according to the US Embassy in Libya. Base Metals: Neutral China’s expansionary monetary and fiscal stimulus continued in August. The country’s total social financing (TSF) climbed past market expectations of CNY 2.59 trillion to CNY 3.58 trillion (Chart 10). This will provide further support to base metals prices – chiefly copper – over the coming months. The increase in TSF reflects the strong local government bond issuance and reinforces our view that the recovery in copper prices will be policy-driven – i.e. dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in its economy with domestic supply adjusting to demand. Precious Metals: Neutral Palladium prices are up 7% since the beginning of September, supported by rebounding car sales and production in China. In August, vehicle sales grew by 12% y/y. We expect fiscal and credit stimulus in the country will allow car sales to continue growing y/y in the coming months. Ags/Softs:  Underweight Soybean prices remain strongly bid, looking to re-test 2018 highs. The latest weekly USDA crop progress report indicated continued deterioration in the number of soybean crops in good or excellent condition. Investor sentiment is fueled by China maintaining its promise to import record amounts of U.S. agricultural goods this year, as part of the Phase 1 trade deal. Last week, the U.S. Agriculture Department reported that Chinese buyers booked deals to buy 664,000 tonnes of soybeans, the largest daily total since July 22.  Chart 9LNG Chart 10COPPER PRICES       Footnotes 1     These estimates were generated by an ARDL model used to determine the sensitivity of OPEC 2.0 total liquids output to non-OPEC 2.0 production and consumption.  2     For a recap of this market-share war, please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020.  It is available at ces.bcaresearch.com.  Briefly, KSA put millions of barrels on the water in a matter of months after Russia launched its market-share war at the end of OPEC’s March 2020 meeting in Vienna.  This demonstrated an ability to mobilize supply and deliver it that greatly surpassed the eight-month time frame we estimate is required for shale production to reach the market after prices signal the need for additional crude. 3    Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by The King Abdullah Petroleum Studies and Research Center (KAPSARC) July 17, 2018, for a discussion of the global impact of KSA’s spare capacity. 4    Please see Aramco CEO: Saudi Arabia to raise oil production capacity to 13 million barrels per day published by Oil & Gas World Magazine September 9, 2020. 5    Please see ESG Investing: From Niche To Mainstream, published by BCA’s Global Asset Allocation Strategy August 25, 2020.  It is available at gaa.bcaresearch.com. 6    Please see O’Shea, James R. (2012), “Kant’s Critique of Pure Reason, An Introduction and Interpretation,” Acumen Publishing Limited, Durham, UK.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights We remain bearish on the US dollar over the next 12 months. The best vehicle to express this view continues to be the Scandinavian currencies (NOK and SEK). Precious metals remain a buy so long as the dollar faces downside. However, we remain more bullish on silver than gold. Go short the gold/silver ratio (GSR) again at 75. At the crosses, our favorite trade is short NZD against other cyclical currency pairs. These include the CAD, AUD, and SEK. Sterling is selling off as we anticipated, but our timing was offside. That said, the pound is cheap. We will go long cable if it falls below 1.25. Short EUR/GBP at current levels. The Swiss franc will continue to appreciate versus the USD, but will lag behind the euro. EUR/CHF will touch 1.15. We prefer the JPY to the CHF as a currency portfolio hedge. We argued last week that Prime Minster Shinzo Abe’s resignation does not change the yen’s outlook. Feature Our trade basket this year has been centered on a dollar-bearish theme. Since the top in the DXY index on March 19th, we have been expressing this view via various vehicles, most of which have been very profitable. Our favorites have been the Scandinavian currencies, silver, and the AUD, either at the crosses or against the US dollar. So far, these are among the best-performing trades in the G10 currency world (Chart I-1). Chart I-1A Currency Report Card Going into the final leg of 2020, the key question is which currency pairs will provide the most upside. In this report, we revisit the rationale behind our high-conviction trades. The Case For Scandinavian Currencies A review of Q2 GDP across the G10 reveals which countries have been doing relatively better during the pandemic. Norway emerges as the economy that had the best quarter-on-quarter annualized growth (Chart I-2). Swedish growth held up very well in Q1 and even the drop in Q2 still puts it well ahead of the US, the euro area, and the UK. As small, open economies which are very sensitive to global growth conditions, this is a very impressive feat for Sweden and Norway. Part of the reason for this is that over the years, the drop in their currencies, both against the US dollar and euro, has made them very competitive. Chart I-2A Currency Report Card Norway benefited from a few things during the pandemic. First, as a major oil exporter, the sharp fall in the NOK helped cushion the domestic economy against the crash in crude prices. Second, the handling of the pandemic was swift and rigorous, and this has almost completely purged the number of new infections in Norway. Third, aggressive monetary and fiscal stimulus (zero rates, quantitative easing, and the first budget deficit in 40 years) has set the economy on a recovery path. As a result, consumption is rebounding smartly and the Norges Bank expects mainland GDP to touch pre-crisis levels by 2023. Already, real retail sales have exploded higher (Chart I-3). Should global growth continue to rebound, a reversal in pessimism towards energy stocks (and value stocks in general) could see investors reprice the Norwegian stock market (and krone) sharply higher (Chart I-4). Chart I-3Norwegian Consumption Has##br##Recovered Chart I-4A Bounce In Oil & Gas Stocks Will Help The Krone In the case of Sweden, the sharp rebound in the manufacturing PMI also suggests the industrial base is recovering. This will also coincide with a solid bounce in exports, cementing Sweden’s rise in relative competitiveness and its exit from the pandemic-induced recession (Chart I-5). The Riksbank’s resource utilization indicator has stabilized, suggesting deflationary pressures are abating. Meanwhile, home prices are on the cusp of a recovery, which should help boost consumer confidence and support consumption. With our models showing the Swedish krona as undervalued by 19% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. Should global growth continue to rebound, a reversal in pessimism towards energy stocks could see investors reprice the Norwegian stock market (and krone) sharply higher. The bottom line is that both Norway and Sweden are well poised to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to be the best performers versus the USD in the coming year (Chart I-6).  Chart I-5The Swedish Economy Is On The Mend Chart I-6The Scandinavian Currencies Remain Cheap Stay Long Precious Metals, Especially Silver In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. This is especially the case on the back of a central bank that is trying to asymmetrically generate inflation. Gold has a long-standing relationship with negative interest rates, though the correlation has shifted over time. The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income-generating assets such as gold. But more importantly, the correlation is between the rise in gold prices and the level of real interest rates, meaning as long as the latter stays negative, it is sufficient to sustain the gold bull market (Chart I-7). Gold tends to be a “Giffen good,” meaning demand increases as prices rise. This can be seen in the tight correlation between our financial demand indicator (proxied by open futures interest on the Comex and ETF holdings, Chart I-8) and gold prices. The conclusion is that, just like the US dollar, gold tends to be a momentum asset, where higher prices beget more demand – at least until the catalyst of easy money and negative rates vanishes Chart I-7Gold Prices And Real Yields Chart I-8Gold Is A Giffen Good There is reason to believe that the bull market in gold might be sustained for longer this time around. The reason is that central banks have become important (and price-insensitive) buyers. Foreign central banks have been amassing almost all of the gold annual output in recent years. It is remarkable that for most of the dollar bull market this past decade, the world’s major central banks (and biggest holders of US Treasurys) have seen rather stable exchange rates relative to the gold price (Chart I-9). This suggests that gold price risks could be asymmetric to the upside. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and boosts the value of gold foreign exchange reserves. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. During precious metals bull markets, prices tend to move in sequence, starting with gold, then silver. Meanwhile, the gold/silver ratio (GSR) tends to track the US dollar (Chart I-10), since silver tends to rise and fall more explosively than gold. Part of the reason is that the silver market is thinner and more volatile. Silver’s rising industrial use has also led to competition with investment demand in recent years. Chart I-9Central Banks Will Put A Floor Under Gold Prices Chart I-10Silver Should Outperform Gold As The Dollar Falls The next important technical level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did. Globally, the world produces much more gold than silver, with a supply ratio that is 7:1. Meanwhile, the price ratio between gold and silver is near 70:1. Back in the 1800s, Isaac Newton concluded that the appropriate ratio was 15.5:1. We initially shorted the GSR at 100 and eventually took 25% profits when our rolling stop was triggered. We recommend putting a limit sell at 75. More speculative investors can buy silver outright. Stay Short NZD At The Crosses, Especially Versus The CAD Chart I-11Stay Long CAD/NZD In our currency portfolio, trades at the crosses are equally important as versus the USD in terms of adding alpha. Over the past year, we have successfully been playing the short side of the kiwi trade. We closed our long SEK/NZD trade for a profit of 7.8% on March 20, and our long AUD/NZD trade for a profit of 5.2% on June 26. Today, we remain bullish on the CAD/NZD as an exploitable trading opportunity. First, the New Zealand stock market is the most defensive in the G10, while Canadian bourses are heavy in cyclical stocks. Should value start to outperform growth, this will favor the CAD/NZD cross. Second, immigration was an important source of labor for New Zealand, and COVID-19 has eaten into this dividend for the economy. As such, the neutral rate of interest is bound to head lower. And finally, in the commodity space, our bias is that energy will fare better than agriculture, boosting Canada’s relative terms of trade. At the Bank of Canada’s meeting this past Wednesday, the tone was slightly optimistic as it kept rates on hold. Recent data has been rather strong in Canada, especially in housing and goods consumption. This allows for the possibility of the BoC tapering asset purchases faster than the market expects, as argued by my colleague Mathieu Savary. This arbitrage is already being reflected in real interest rates, where they offer a premium of 180 basis points in Canada relative to New Zealand (Chart I-11). What To Do About Sterling? Trade negotiations between the UK and EU are once again hitting a brick wall. The key issue is around Northern Ireland. Ireland wants to remain bound to the EU’s customs and trade regime. The UK is seeking an amendment to be able to intervene, if there is “inconsistency or incompatibility with international or domestic law.” In short, it allows for UK discretion in the movement of goods to and from Northern Ireland, as well as state aid to Northern Ireland. The EU argues this is a clear breach of the treaty agreed to last year.    We remain bullish on the CAD/NZD as an exploitable trading opportunity. As negotiations go on, our base case is that a deal will eventually be reached. This is because neither side wants the worst-case scenario, namely, a no-deal Brexit. Should no deal be reached, the sharp rise in the trade-weighted euro will be exacerbated by a drop in the pound. This is deflationary for the euro area. And while the drop in the pound could be beneficial to the UK in the longer term, it will be very destabilizing since the UK is highly dependent on capital flows. Our roadmap for sterling is as follows: Historically, odds of a “hard” Brexit have usually been associated with cable near 1.20. This occurred after the UK referendum in 2016 and after Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-12). Intuitively, this suggests that maximum pessimism on the pound, driven by Brexit fears, pins cable at around 1.20. A “weak” deal cobbled together at the eleventh hour will still benefit cable. Depending on the details, 1.35-1.40 for cable will be within striking distance. In the case where both the UK and EU come to a “perfect” agreement, the pound could be 20%-25% higher. The real effective exchange rate for the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in size. A good deal should cause the pound to overshoot the mid-point of its historical real effective exchange rate range (Chart I-13). Chart I-12GBP Has Historically Bottomed At 1.20 Chart I-13The Pound Is Cheap The pound is also cheap versus the euro, and we expect the EUR/GBP to start facing significant headwinds near 0.92. It is remarkable that UK data continues to outperform both the US and euro area (Chart I-14). As such, cable should be bought on weakness. Tactically, we would be buyers of the pound in the 1.24-1.25 zone, and our limit sell on EUR/GBP was triggered yesterday at 0.92.   Chart I-14The UK Economy Is Improving Thoughts On The ECB The main takeaways from the European Central Bank (ECB) conference were threefold. First, data in the euro area was better than the ECB expected. Second, the ECB did not give any hints on its policy review or extend forward guidance. Keeping policy easy until inflation is up to, but still below, 2% appears more hawkish than the Federal Reserve, which is now trying to asymmetrically generate inflation. And finally, the ECB said they are monitoring the exchange rate, but fell short of providing any hints that they will actively lean against the currency. The euro took off, both against the dollar and other European currencies. We outlined in last week’s report why we do not believe the euro can fall much from current levels. These include the common currency being cheap and having a large share of exports in the eurozone. A Few Words On The CHF Finally, a few clients have asked what happens to the Swiss franc in an environment where the euro is rising (and the dollar is falling). Our bias is that the Swiss National Bank lets a rising EUR/CHF ease financial conditions in Switzerland, and even leans into it. The Swiss National Bank has been stepping up its pace of intervention since EUR/CHF touched 1.05 this year and will continue to do so (Chart I-15). Unfortunately, there is not much it can do about a falling USD/CHF. This suggests the franc will fall against the euro, but not so much against the dollar. In a world where global yields eventually converge to zero, holding the Swiss franc is an attractive hedge. Chart I-15USD Weakness Will Be A Headache For The SNB   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: On the labor market front, nonfarm payrolls fell to 1371K from 1734K in August. The average hourly earnings increased by 4.7% year-on-year. The unemployment rate declined from 10.2% to 8.4%. Initial jobless claims increased by 884K for the week ending on September 4th.  Finally, the NFIB business optimism index increased from 98.8 to 100.2 in August. The DXY index initially rose to a 4-week high of 93.6 earlier this week with positive data releases, then fell back to 93. Our bias is that while the dollar has been rebounding since the beginning of the month, the rally could prove to be a healthy counter-trend move in the long-term dollar bear market. Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been mixed: The Sentix investor confidence increased from -13.4 to -8 in September. GDP plunged by 11.8% quarter-on-quarter in Q1, or 14.7% year-on-year.  The euro declined by 0.5% against the US dollar this week. The ECB decided to keep its interest rate and PEPP program unchanged on this Thursday. President Christine Lagarde sounded quite hawkish in the press conference, saying that incoming data since the last monetary policy meeting suggest “a strong rebound in activity broadly in line with previous expectations.” We continue to favor the euro against the US dollar. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been mixed: The coincident index increased from 74.4 to 76.2 in July. The leading economic index also climbed up from 83.8 to 86.9 in July. The current account balance widened from ¥167 billion to ¥1,468 billion in July. GDP plunged by 7.9% quarter-on-quarter in Q2, or 28.1% on an annualized basis. Preliminary machine tool orders continued to fall by 23.3% year-on-year in August. Overall household spending contracted by 7.6% year-on-year in July. The Japanese yen appreciated by 0.2% against the US dollar this week. The expansion in Japan’s current account balance is mainly driven by the decline in domestic demand. Exports fell by 19.2% year-on-year in July while imports slumped at a faster pace by 22.3%. This suggests that deflationary forces are returning to Japan, which will boost real rates and buffet the yen. 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 from the UK have been mostly positive: Retail sales continued to increase, rising by 4.7% year-on-year in August, following a 4.3% increase the previous month. Halifax house prices increased by 5.2% year-on-year for the 3 months to August. The Markit construction PMI declined from 58.1 to 54.6 in August. The British pound extended its sell-off this week, depreciating by 2.5% against the US dollar, making it the worst-performing G10 currency. Under ongoing trade negotiations, the possibility of a no-deal Brexit is now putting more downward pressure on the pound after the summer rally. 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 from Australia have been mixed: The AiG services performance index fell from 44 to 42.5 in August. The NAB business confidence increased from -14 to -8 in August while the business conditions index fell from 0 to -6. The Australian dollar appreciated by 0.4% against the US dollar this week. Spending fell sharply during the pandemic, pushing Australia’s savings rate to 19.8% from 6%. Until consumer spending returns in earnest, the RBA is unlikely to raise rates, which puts a cap on how far the AUD can rise. The good news is that household balance sheets are being mended, which reduces macroeconomic risk. 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 from New Zealand have been mixed: Manufacturing sales plunged by 12.2% quarter-on-quarter in Q2. The preliminary ANZ business confidence index increased from -41.8% to -26% in September. The ANZ activity outlook index also ticked up from -17.5% to -9.9%. The New Zealand dollar fell initially against the US dollar, then recovered, returning flat this week. The ANZ New Zealand Business Outlook shows that most activity indicators have increased to the highest levels since the beginning of the pandemic but are still well below pre-COVID-19 levels. We like the New Zealand dollar against the US dollar but believe that it will underperform against other pro-cyclical currencies including the Australian dollar and the Canadian dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: On the labor market front, the unemployment rate declined from 10.9% to 10.2% in August. The participation rate increased from 64.3% to 64.6%. Average hourly wages surged by 6% year-on-year in August. Housing starts increased by 6.9% month-on-month to 262.4K in August, the highest reading since 2007. The Canadian dollar depreciated by 0.3% against the US dollar this week. The Bank of Canada maintained its target rate at 0.25% on Wednesday. It is also continuing large-scale asset purchases of at least C$5 billion per week of government bonds. Moreover, the Bank suggested that the bounce-back in activity in Q3 was better than expected, which bodes well for the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been mixed: FX reserves continued to increase from CHF 847 billion to CHF 848 billion in August. The unemployment rate remained unchanged at 3.4% in August. The Swiss franc appreciated by 1% against the US dollar this week. The SNB Chairman Thomas Jordan said that “stronger currency market interventions relieve over-valuation pressure on the Swiss franc and protect the Swiss economy”. Recent dollar weakness could be another headache for the SNB, accelerating SNB’s currency intervention. While we like the franc as a safe-haven hedge with high real rates, the upside potential is likely to be more gradual as the SNB leans against it. 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 from Norway have been positive: Manufacturing output increased by 1.8% month-on-month in July. Headline consumer price inflation ticked up from 1.3% to 1.7% year-on-year in August. Core inflation continued rising to 3.7% year-on-year from 3.5% the previous month. The Norwegian krone depreciated by 0.5% against the US dollar this week. The increase in headline inflation was mainly driven by furnishings and household equipment (10%), communications (4.9%) and food (3.7%). However, the Norwegian krone is still tremendously undervalued against the US dollar according to our models. 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 from Sweden have been mostly positive: The current account surplus fell to SEK 63.2 billion in Q2 from SEK 75.5 billion in Q1. However, this compares favorably to a surplus of SEK 34.7 billion the same quarter last year. Manufacturing new orders continued to fall by 6.4% year-on-year in July. This is an improvement compared to the 13.1% contraction the previous month. Headline consumer prices inflation increased from 0.5% to 0.8% year-on-year in August. Core inflation also climbed up from 0.5% to 0.7% year-on-year. The Swedish krona appreciated by 0.5% against the US dollar this week. We continue to favor the Swedish krona amid global economy recovery. Moreover, our PPP model shows that the krona is still undervalued by 19% against the US dollar. 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

Highlights China’s surge in refined copper imports allows it to cover a structural short position it has in this critical commodity – mostly in its unrefined state – and ensures the stimulus being deployed to revive its economy ahead of the 100th anniversary of the founding of the Communist Party in July will not falter due to a lack of basic raw materials (Chart of the Week). We expect continued resilience in commodities generally into 2021 – particularly in base metals, iron ore and crude oil – as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its robust economic growth. As with oil, we expect copper demand will benefit from a weaker USD and stronger global trade. The odds of a COVID-19 vaccine being available by year-end or early 2021 remain favorable, which also will support a revival in demand.1 We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 to finish at $3.15/lb. We would not be surprised by higher prices, and are, therefore, getting long December 2021 COMEX copper at tonight's close. Feature The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. COVID-19 may have derailed the Communist Party’s realization of the “Chinese Dream” this year, wherein the leadership vowed real per-capita GDP would double in the decade ending in 2020, but it is unlikely to diminish the celebration of the Party’s 100th anniversary in July.2 Chart of the WeekVol Falls As Know Unknowns Are Resolved The global commodity-demand destruction caused by the COVID-19 pandemic depressed the prices of commodities generally, particularly those which China is structurally short – e.g., copper, iron ore, oil and natural gas. As terrible as the pandemic has been in human terms, it has allowed Chinese firms and the State Reserve Bureau to sharply increase imports of refined copper, which rose 34% in the January-to-July period to 2.5mm MT amid such low prices, which bottomed at $2.10/lb in late March and now are trading above $3.00/lb.3 China accounts for more than 50% of global refined copper consumption and ~ 40% of refined production (Chart 2).4 Chart 2China Dominates Metals Consumption The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. Global copper ore and concentrate supply fell ~ 3% y/y in 2Q20, led by a 28% decline in Peru’s mine production, according to the World Bureau of Metal Statistics (Chart 3). This was a result of containment policies that limited mining activities to slow the pandemic’s spread in Latin America. In Chile, COVID-19 cases stabilized in recent months at around 100 per million people (Chart 4). In Peru, cases have been declining since August, but from an elevated level. Supply is expected to recover rapidly as these economies reopen, but further mine disruptions remain a risk. Chart 3Peru's Copper Ore Supplies Recovering Chart 4COVID-19 Copper Supply Risks Falling Commodity-Demand Indicators Move Higher we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. Global central banks and government stimulus unleashed in the wake of the COVID-19 pandemic, combined with a depreciating US dollar, pushed our commodity-demand indicators higher over the last few months (Chart 5). This supported copper prices, which are up 42% since their March 23 low. Moreover, the pickup in economic activity in China’s major trading partners provided further support to copper demand, given that ~ 17% of China’s copper consumption comes from exports of products containing copper (Chart 6).5 Chart 5Commodity Demand Is Reviving Chart 6Expect Chinese Employment Gains As Economy Continues To Recover For the balance of 2H20, we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. These are key factors driving our positive view on metal – especially copper – prices. Communist Party’s 100th Anniversary Will Boost Commodity Prices China’s buying spree for commodities it is structurally short – particularly copper, iron ore and oil – minimizes the risk fiscal and monetary stimulus deployed to revive its economy will be derailed this year or next. This is particularly important next year: We expect stimulus will continue and will be hitting the economy full force in time for the Communist Party’s centennial celebrations in July. For the infrastructure and construction spending that will be spurred by the massive stimulus, this is critical to spurring employment – a key goal of the Party’s domestic harmony focus – domestic manufacturing, services, and exports (Chart 6).6 This will keep demand for copper – and commodities generally – strong into 2021, as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its world-beating economic performance. And, because stocks of critical commodities are increasing as stimulus is hitting the domestic economy next year, the risk of massively inflating prices while the county is celebrating the Party’s centennial in July – as happened following the Global Financial Crisis (GFC) – is minimized, but not completely eliminated (Chart 7). Chart 7COMEX Stocks Will Move To China That said, we still expect copper to move higher next year. In our modeling of prices, we note world PMIs, EM FX rates, the USD, also drive copper prices, in addition to those factors discussed above specific to China. We expect COMEX high-grade copper prices to end 2020 at $3.00/lb, and to average $3.11/lb next year (Chart 8). On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close, expecting 2021 to end at $3.15/lb. Chart 8Copper Prices Expected To Increase Risks To Our Copper View Geopolitical risks remain the chief threat to our bullish copper view. The US Presidential election campaign rhetoric, in particular, has turned bellicose vis-à-vis China, with President Donald Trump threatening to “decouple” economically from China if he is reelected.7 These sorts of pronouncement threaten to escalate what could now be considered a trade dispute to an all-out trade war, particularly if it includes sanctions against US firms investing in manufacturing and services in China, as Trump promises. At the limit, this would put a long-term bid under the USD, and reverse the nascent recovery in commodity demand resulting from a weaker dollar. Outright military confrontation between the US and China also is a risk, particularly as tensions in the South China Sea and the Asia-Pacific region continue. The most likely confrontation would be an escalation of hostilities resulting from a naval or aerial face-off, the number of which has been steadily increasing. The threat of a second wave of COVID-19 also remains a risk, particularly if it results in another round of lockdowns globally. That said, we believe the odds of this are very low, as the capacity to absorb another shutdown in economic activity in DM and EM economies likely has been exhausted by measures already implemented this year. It is highly unlikely any economy can afford another round of economic shutdown without triggering an economic depression. Bottom Line: China’s surge in refined copper imports allows it to cover its structural short position in the commodity, and, equally importantly, to ensure an expected revival of economic activity into 2021 – when the Communist Party celebrates its 100th anniversary – will not falter because it lacks basic raw materials. We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 prices to average $3.11/lb. On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices dipped below $40/bbl for the first time since mid-June. Prior to this move, prices had been stable in a narrow range around $43/bbl since mid-June. Pessimism is increasing re the outlook for demand, as Saudi Arabia reduced its official selling prices (OSPs) for crude delivered to Asian buyers by $1.40/bbl. The negative sentiment was exacerbated by the selloff in tech stocks that began last Thursday. WTI net speculative positions are down to 20% of total open interests vs. 22% in July, as hedge funds exit oil markets. Base Metals: Neutral The LMEX index is up 4% over the past four weeks, supported by higher metals’ consumption and imports in China. Moreover, mobility trends in Europe, Japan, and the US have begun to turn up again in recent weeks based on Apple mobility data. The recovery in China’s economic activity remains the main pillar of our base metals outlook. However, Europe, Japan, and the US still represent a non-negligible share of global metal demand (e.g. ~ 24% copper consumption). Hence, the recent uptick in mobility data is constructive for base metal prices.  Precious Metals: Neutral Gold prices are down 2% since last week, pressured by a slight increase in the US dollar and real rates. The divergence in COVID-19 cases between the US and Europe increases the risk of a short-term bounce higher if this leads to the US economy outperforming that of the EU (Chart 9). Still, mounting geopolitical risks ahead of the US election, lower-for-longer interest rates, and a resumption of the downward trend in the USD over the medium term should support gold later this year. Ags/Softs:  Underweight Soybean prices remain steady, near 2-year highs. The USDA crop progress report listed 55% of soybeans in good or excellent condition for the week ending September 6, 2020. This is a substantial deterioration compared to 66% in those categories last week and 73% at the beginning of August. Corn futures were supported by similar weak supply fundamentals. The USDA reported 55% of corn crops in good or excellent condition against 62% the previous week. Going forward, it will be important to monitor the DXY as it has been strengthening since the beginning of September and could be a headwind to these commodity prices if it breaks to the upside (Chart 10). Chart 9EU Cases Are Rising Chart 10US DXY Strengthening     Footnotes   1     Please see Lower Vol As OPEC 2.0 Gains Control, published September 3, 2020, for additional discussion of vaccine availability. 2     Please see Iron Ore, Steel Poised For Rally, which we published February 13, 2020, for a discussion of the commodity-market implications of China’s dual policy goals of doubling GDP between 2010 and 2020 and preparing for the celebration of the 100th anniversary of the founding of the Chinese Communist Party in 1921. It is available at ces.bcaresearch.com. 3    Please see China's July refined copper imports surge 90% on year boosted by open arbitrage published by S&P Global Platts September 1, 2020. 4    China also accounts for close to 50% of copper ore imports, according to he Observatory of Economic Complexity (OEC). 5    Please see The Impact of the COVID-19 Pandemic on World Copper Supply, published by the International Copper Study Group on May 21, 2020. 6    For an update of the stimulus measures and China’s economic performance, please see China Macro And Market Review published September 9, 2020, by our China Investment Strategy colleagues. It is available at cis.bcaresearch.com. 7     Please see Trump threatens to ‘decouple’ U.S. economy from China, accuses Biden of ‘treachery’ published by marketwatch.com September 7, 2020.       Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights Oil-price volatility will remain subdued as markets correctly downgrade measurable risks on the supply side and upgrade financial conditions supporting demand (Chart of the Week). OPEC 2.0’s spare capacity – ~ 7mm b/d – presents the producer coalition with an opportunity to gain control of the evolution of global supply, and to restrain price volatility as global storage levels fall. Scaling production and delivery of a COVID-19 vaccine will be challenging, given limited global production and distribution capacity.1 This will slow down – but not derail – a recovery in demand. Lingering policy uncertainty will restrain a speedy return to pre-COVID-19 demand levels. Looming large are US election uncertainty and mounting geopolitical tensions. Our forecast attaches a significantly higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market is discounting in options for December 2021 delivery. Feature As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand. Oil-price volatility will remain subdued, as market participants correctly price in continued OPEC 2.0 production discipline and cohesion within the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. In addition, the coalition’s substantial spare capacity – ~ 7mm b/d, most of which is in KSA – will, as we have argued elsewhere, present OPEC 2.0 with an opportunity to influence production moreso than in pre-COVID-19 markets: It will be able to respond to higher prices quicker than US shale oil producers, as was demonstrated in 2018 when KSA took its production from less than 10mm b/d to 11.1mm b/d between June and November (Chart 2). This means OPEC 2.0 can move quickly to capture economic rents, which will slow the recovery of the shales – already limited by parsimonious capital markets – and increase OPEC 2.0’s global market share (Chart 3).2 Chart of the WeekVol Falls As Known Unknowns Are Resolved Chart 2OPEC 2.0 Quick Response Spare Capacity Advantage Chart 3Ensures Production Restraint As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand (Chart 4). We expect the US Federal Reserve’s monetary policy, which will now focus on reviving the labor market and on achieving a 2% average PCE index core inflation rate, to weaken the USD, which also will be supportive of oil demand.3 Demand also will be supported by expectations – and the realization – of a COVID-19 vaccine, which is expected later this year or early next year. Limited production and logistical constraints will make it difficult to scale delivery of a vaccine globally until infrastructure is built out. This will restrain – but not derail – the recovery in demand we expect (Chart 5). Lingering policy uncertainty – particularly around the upcoming US elections and mounting geopolitical tensions – remain obstacles for the recovery. Chart 4Global Financial Conditions Will Support Demand Chart 5Demand Expected To Recover Smartly Well-managed supply, coupled with steadily improving demand already apparent in the data, will allow storage to draw over the next year without raising oil-price volatility, which typically occurs when spare capacity is low (Chart 6).4 Chart 6Falling Storage Will Not Spike Vol This Time Oil Vol Will Stay Lower Volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market. As the Chart of the Week indicates, a surge in volatility caused by either a supply or demand shock typically is followed by a more tranquil period after markets adjust to the shock. These volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market.5 Following the resolution of the elevated risk conditions prompting the increased option trading, historical volatility, which is calculated using the annualized returns of the underlying assets, typically increases then tails off, as can be seen in the experience of 2019-20 – i.e., pre- and intra-COVID-19 markets (Chart 7). Chart 7Implied Vol Typically Leads Realized Vol Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities. Increases in oil-price volatility also are accompanied by heightened interest in news specific to oil markets or OPEC. Market participants usually expect OPEC countries will adjust output as needed following swift changes in underlying global demand – e.g., the COVID-19 demand shock – and non-OPEC supply. Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities in expectation of supply adjustments from OPEC (Chart 8). The relationship actually has strengthened since 2014, following OPEC’s market-share war and the ensuing OPEC 2.0 agreement to drain the accumulated global oil inventories. Since its formation, OPEC 2.0 has played a crucial role in balancing oil markets. This makes every meeting highly relevant for markets. Moreover, when oil prices move abruptly, internet searches for “OPEC” or “OPEC MEETING” generally move higher as investors seek guidance from the producer coalition to assess where prices will go next. High levels of speculation can affect oil price volatility. Hence, the higher the interest in oil prices from retail and institutional investors, the larger the increase in implied volatility ahead of these meetings.6 Chart 8Implied Vol Follows Google Search Activity Implied Volatility And Efficient Markets Implied volatility, like prices discovered in competitive trading markets, impounds all information available to market participants buying and selling options. As it is an estimate of the standard deviations of returns for the underlying asset against which options are traded, it can be used to estimate the probability market participants assign to the realization of a particular price outcome (Chart 9). As an be seen in Chart 9, the market is pricing more in line with the US EIA’s expectation Brent prices will average $50/bbl next year, as opposed to our estimate of $65/bbl. Based on the settlement values for prices and volatilities on Monday, the December 2021 Brent futures contract has a 15% probability of expiring above $65/bbl (Chart 10). Chart 9Markets Pricing To EIA Assumptions Chart 10BCA Price Forecasts Investment Implications Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. Our econometric modeling gives us a higher expected value for Brent prices next year than what markets currently are pricing in, based on our assessment of the distributions derived from option implied volatilities. This means the cost of gaining exposure to the upside in the Brent market next year is low, relative to our expected value, as vol drives option prices. We remain long 2H21 Brent vs. short 2H22 Brent given our expectation. We also will be looking for opportunities to get long call options or option spreads in 2H21. Bottom Line: OPEC 2.0’s spare capacity of ~ 7mm b/d (OPEC + Russia and its allies spare capacity), will allow it to gain control of global supply growth, and to manage price volatility as global storage levels fall. Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. We remain long Brent exposure next year and look for opportunities to buy calls and call spreads.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices remain in the $40/bbl to $46/bbl range in which it had been trading since mid-June. The Fed’s shift to an average inflation targeting regime makes inflation expectations an increasingly important variable to its monetary policy decisions. This implies commodities – oil in particular – will have a larger effect on interest rates due to their crucial influence on market-based inflation expectations (Chart 11). Base Metals: Neutral The LMEX and copper prices rose 5% and 6%, respectively, in August, supported by rising global manufacturing PMIs. At first glance, China’s manufacturing PMI disappointed last month as it fell to 51 from 51.1 in July. However, the underlying recovery in its industrial sector remains in place according to our China Investment strategists. The New Orders and Export Orders components of the index increased, indicating the demand-side of the economy is picking up. Metals’ prices also continued being supported by further declines in the US dollar index. The USD index ended the month of August below the upward trend line that has supported its lows since 2011.7 Precious Metals: Neutral Gold and silver prices are up 2% and 5%, respectively, since Jerome Powell’s Jackson Hole speech. According to our US and Global Bond strategists “The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past.”8 Consequently, precious metals will benefit from a lower dollar and a prolonged period of depressed interest rates. The Fed’s decision also increased gold’s attractiveness as an inflation hedge. Ags/Softs:  Underweight Soybean prices have rallied to their highest level since June 2018 (Chart 12). Crops were affected by droughty weather in the Midwest during August. The Crop Progress report listed 66% of soybeans in good or excellent condition, compared with 73% of soybeans in those categories at the beginning of the month. Strong demand from China has been supportive of prices. According to the data, for the 2019/20 marketing year, US soybean exports to China are higher than last year, but still account for only half of pre-trade war exports in volume terms. Outstanding sales to China booked for the 2020/21 marketing year are the highest since 2012/13. This is a clear indication of continued commitment to the phase one trade deal. Finally, the weak USD has been yet another tailwind for soybean prices. Chart 11Rising Oil Prices Will Revive Inflation Expectations Chart 12Soybeans Prices Rising     Footnotes 1     Please see The latest in the global race for a COVID-19 vaccine published by the American Enterprise Institute August 25, 2020, which notes that 29 of the 167 vaccines under development are in human trials.  Six of these candidates are in Phase III trials. 2     This outsized spare capacity also gives KSA a potent tool in enforcing production discipline within the OPEC 2.0 coalition, which was demonstrated earlier this year in the brief market-share war initiated by Russia following the breakdown in negotiations to extend the coalition’s production cuts. Please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020. It is available at ces.bcaresearch.com. 3    For an excellent discussion of the Fed’s policy change, which was announced by Chair Jerome Powell last week, please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020. It is available at gfis.bcaresearch.com. 4    For our latest view on oil fundamentals, please see The Oil Markets' Knife Edge, which we published last week. 5    Implied volatility is the estimated standard deviation of returns that solves an option pricing model. This empirical fact was explored in depth in Ogawa, Yoshiki, (1989), “Market Expectations Evident In Crude Oil Futures Options Volatility Measures Since The Opening Of The Option Trading In November 1986,” IFAC Energy Systems. Management and Economics, Tokyo, Japan, pp. 337-341. See also Feedback Loop: Spec Positioning & Oil Price Volatility, which we published May 10, 2018; and Ryan, Bob and Tancred Lidderdale (2009), “Energy Price Volatility and Forecast Uncertainty,” published by the US EIA. 6    Please see Campos, I., Cortazar, G., and Reyes, T. (2017), "Modeling and predicting oil VIX: Internet search volume versus traditional variables," Energy Economics, Elsevier, 66(C): 194-204. 7     Please see BCA Research Daily Insights A Worrying Month of August For The Dollar published August 31, 2020. 8    Please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights EM domestic fundamentals, global trade and commodities prices, as well as global financial market themes are the main drivers of EM financial assets and currencies. The positive effect of improving global growth and rising commodity prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. The odds of a near-term US dollar rebound are rising. This will likely produce a setback in EM currencies, fixed-income markets and equities. However, such a setback will likely prove to be a buying opportunity. Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the asset prices. Feature Chart I-1Unusual Divergences EM risk assets have done well in absolute terms but have underperformed their DM counterparts.  This is unusual given the substantial weakness in the US dollar and the rally in commodities prices since April (Chart I-1). Until early this year, many commentators had argued that monetary policies of DM central banks were the principal drivers of EM financial markets. Given the zero interest rates and money printing that is prevalent in DM, the underperformance of EM equities and currencies is especially intriguing. Is this underperformance an aberration or is it fundamentally justified? What really drives EM performance? Back To Basics As we have argued over the years, EM risk assets and currencies are primarily driven by their domestic fundamentals, rather than by the actions and policies of the US Federal Reserve or the ECB. The critical determinant of EM stocks’ absolute as well as relative performance versus DM equities has been corporate profits. Chart I-2 illustrates that relative equity performance and relative EPS between EM and the US move in tandem, both in common and, critically, local currency terms. Similarly, the main reason why EM share prices in absolute terms have failed to deliver positive returns over the past 10 years is that their profits have been stagnant over the same period, even prior to the pandemic (Chart I-3). Interestingly, fluctuations in EM EPS resemble those of Korea’s exports. This reflects the importance of global growth in shaping EM profit trends. Chart I-2Corporate Profits Drive EM Absolute And Relative Performance Chart I-3EM EPS Has Been Flat For 10 Years   The key drivers of EM risk assets and currencies have been and remain: 1. EM domestic fundamentals that can be encapsulated by a potential risk-adjusted return on capital. The latter is impacted by both cyclical and structural growth trajectories, as well as by the quality and composition of growth. Risks to growth can be gauged based on factors such as (but not limited to): productivity, wages, inflation, fiscal and balance of payment positions, the global economic and financial environment, and the health of the banking system. In EM (ex-China, Korea and Taiwan), the fundamentals remain challenging: The business cycle recovery is slower in these economies than it is in China and advanced economies. Fiscal stimulus has not been as large as in many advanced countries, while the pandemic situation has been worse. Their banking systems were already fragile before the pandemic, and have lately been hit by defaults stemming from the unprecedented recession. These governments have less room than in DM and China, to stimulate fiscally and bail out debtors and banks. Banks in EM (ex-China, Korea and Taiwan) will continue struggling for some time, and their ability to finance a new expansion cycle will, for now, remain constrained (Chart I-4). A restructuring of non-performing loans and a recapitalization of banks will be required to kick-start a new credit cycle in many of these economies. 2. Global growth, especially relating to China’s business cycle and commodities. The recovery in China since April, along with rising commodities prices have been positive for EM (ex-China, Korea and Taiwan). Given the substantial stimulus injected into the Chinese economy, its recovery will continue well into next year (Chart I-5). As a result, higher commodities prices will benefit resource producing economies by supporting their balance of payments and enhancing income growth. Chart I-4EM ex-China: Limited Bank Support For Growth Chart I-5China's Stimulus Entails More Upside In Commodity Prices   3. Global financial market themes: a search for yield and leadership of new economy stocks. Global investment themes have an important bearing on EM financial markets. For example, in recent years, the increased market cap of new economy and semiconductor stocks – due to an exponential rise in their share prices – has amplified their importance for the aggregate EM equity index. The largest six mega cap stocks in the EM benchmark are new economy and semiconductor companies, and make up about 25% of the EM MSCI market cap. The six FAANGM stocks presently account for about 25% of the S&P 500. Hence, the concentration risk in EM is as high as it is in the US. Consequently, the trajectory of new economy and semiconductor stocks globally will be essential to the performance of the EM equity index. On August 20, we published an in-depth Special Report assessing near-term and structural outlooks for global semiconductor stocks. With new economy and semiconductor share prices going parabolic worldwide, we are witnessing a full-fledged mania, as we discussed in our July 16 report. The equal-weighted US FAANGM stock index has risen by 24-fold in nominal and 20-fold in real (inflation-adjusted) terms, since January 1, 2010 (Chart I-6). Chart I-6History Of Manias Of Past Decades In brief, with respect to magnitude and duration, the bull market in FAANGM is on par with the bubbles of previous decades (Chart I-6). Those bubbles culminated in bear markets, where prices fell by at least 50% after topping out. Chart I-7EM ex-TMT Stocks: Absolute And Relative Performance We do not know when the FAANGM rally will end. Timing a reversal in a powerful bull market is impossible. Also, we are not certain about the magnitude of such a potential drawdown. Nevertheless, our message is that the risk-reward tradeoff of chasing FAANGM at this stage is very unattractive. Excluding technology, media and telecommunication (TMT) – as most growth stocks are a part of TMT– EM equities remain in a bear market (Chart I-7, top panel). In relative terms, EM ex-TMT stocks have massively underperformed their global peers (Chart I-7, bottom panel).  Even with a larger weighting of mega-cap growth TMT stocks than the overall DM equity index, the aggregate EM equity index has underperformed the overall DM index. Bottom Line: EM domestic fundamentals, global trade and commodities prices, and global financial market themes are the main drivers of EM financial assets and currencies. What About The Dollar? The high correlation of the trade-weighted US dollar and EM equities is due to the following: (1) the greenback has been a countercyclical currency; and (2) the US dollar’s exchange rate against EM currencies reflects relative fundamentals in the US versus EM economies. When a global business cycle accelerates, the broad trade-weighted US dollar weakens. If this growth acceleration is led by China and other emerging economies, the greenback depreciates considerably versus EM currencies. The opposite is also true. In other words, the US dollar exchange rate’s strong negative correlation to EM equities is primarily due to the fact that the greenback’s exchange rates against EM currencies reflect both the global business cycle as well as EM growth and fundamentals. Chart I-8Divergence Between DM And EM Currencies In recent months, the greenback has: (1) depreciated due to the global economic recovery; (2) tumbled versus DM currencies due to the still raging pandemic and the socio-political instability in the US as well as the Fed’s commitment to staying behind the inflation curve in the years to come; and (3) not fallen much against EM (ex-China, Korea and Taiwan) currencies because their fundamentals have been poor, as discussed above. Bottom Line: Exchange rates in EM (ex-China, Korea and Taiwan) have failed to appreciate versus the dollar despite the latter’s plunge versus other DM currencies (Chart I-8). The positive effect of improving global growth and rising commodities prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. Flows And Cash On The Sidelines Chart I-9Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization What about capital flows? Aren’t they essential in driving EM financial markets? Of course, they are important. However, we view flows as resulting from and determined by fundamentals. Over the medium and long term, we assume that capital flows to regions where the return on capital is high or rising. Thus, we see ourselves as responsible for directing investors to those areas that we have identified as providing a high or rising return on capital (and cautioning investors when the opposite is true). The presumption is that beyond short-term volatility, investment flows will gravitate to countries/sectors/asset classes with high or rising returns on capital, just as they will abandon areas of low or falling returns on capital. In brief, fundamentals drive flows and flows determine asset price performance. Isn’t sizable cash on the sidelines a reason to be bullish? Yes, there is substantial cash on the sidelines. Along with zero short-term rates, this has been the potent force leading investors to purchase equities, credit and other risk assets since late March. Below we examine the case of the US, but this has also been true in many markets around the world. The top panel of Chart I-9 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines - presently stand at $4.2 trillion, having increased by $900 billion since March. Yet, the Fed and US commercial banks have increased their debt securities holdings by $2.9 trillion since March.   Furthermore, the Fed and US commercial banks hold $10.6 trillion of debt securities (Chart I-9, middle panel) – amounting to 18% of the aggregate equity and US dollar fixed-income market value (Chart I-9, bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. Chart I-10Investors' Cash Holdings Ratio Is Still Elevated Excluding debt securities owned by the Fed and commercial banks, we reckon that cash on the sidelines is equal to 8.4% of the value of equities and US dollar debt securities available to non-bank investors (Chart I-10). This is a relatively high cash ratio. Unprecedented purchases by the Fed and US commercial banks have not only removed a considerable chuck of debt securities from the market; they have also created money “out of thin air”. When central or commercial banks acquire a security from, or lend to, a non-bank entity, they are creating new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not affect the stock of money supply. We have deliberated on these topics at length in past reports. In sum, the Fed’s large purchases of debt securities amount to a de facto monetization of public and private debt. These operations have both reduced the amount of securities available to investors and boosted the latter’s cash balances. Hence, the Fed has boosted asset prices not only indirectly, by lowering short-term interest rates, but also directly, by printing new money and shrinking the amount of securities available to investors. We have in recent months argued that global risk assets are overpriced relative to fundamentals. However, investors have continued to deploy cash in asset markets, pushing prices higher. Given the zero money market interest rates and the still elevated cash balances, one can envision a scenario in which cash continues to be deployed in asset markets, pushing valuations to bubble levels across all risk assets. Pressure on investors to deploy their cash amid rising asset prices implies that only a major negative shock might be able to reverse this rally. There have been plenty of reasons to be cautious, including escalating US-China geopolitical tensions, the increasing odds of a contested US presidential election and, hence, elevated political uncertainty, the possibility of a US fiscal cliff, and a potential second wave of the pandemic. However, investors have so far shrugged off all of these and continue to allocate capital to risk assets. Bottom Line: Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the price of risk assets. This would also mean that the role of momentum investing and psychology may increase. Investment Strategy Currencies: The US dollar has become oversold and could stage a rebound in the near term. The euro has risen to its technical resistance (Chart I-11). The EM currency index (ex-China, Korea and Taiwan) has failed to break above its 200-day moving average (Chart I-12, top panel).  The emerging Asian trade-weighted currency index (ADXY) has rebounded to the upper boundary of its falling channel (Chart I-12, bottom panel). Chart I-11A Short-Term Resistance For Euro/USD Chart I-12EM Currencies Have Not Entered A Bull Market   Such technical profiles suggest that EM currencies have not yet entered a bull market despite the greenback’s considerable depreciation against DM currencies. This is a reflection of the poor fundamentals of EM (ex-China, Korea and Taiwan). In short, the odds of a US dollar rebound are rising. This could dent commodities prices and weigh on EM currencies. We continue recommending shorting a basket of EM currencies versus the euro, CHF and JPY. The downside in these DM currencies versus the greenback is limited. The euro could drop to 1.15, but not much below that level. Our basket of EM currencies to short includes: BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Chart I-13EM Local Currency Bonds: Looking For A Better Entry Point Fixed-Income Markets: We have been neutral on EM local currency bonds and EM credit markets (USD bonds) since April 23 and June 4, respectively. The strategy is to wait for a correction in these markets before going long. The rebound in the US dollar and correction in commodities will provide a better entry point for these fixed-income markets (Chart I-13). Equities: On July 30, we recommended shifting the EM equity allocation within a global equity portfolio from underweight to neutral. In the near term, EM share prices will likely continue underperforming their DM counterparts. A bounce in the US dollar, rising geopolitical tensions between the US and China, as well as the continuation of a FAANGM-driven mania in US equities will result in EM equity underperformance versus DM. However, in the medium- to long-term, the balance of risks no longer justifies an underweight allocation. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Recommended Allocation Chart 1Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3).  Chart 2New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3).  Chart 6The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide   Chart 9Bankruptcies Are Surging…   Chart 10...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off   Chart 13Hedge Against A Disputed Election Result Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic   Chart 16Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market   Chart 18EM Stocks Are Cheap   Chart 19Short USD Is Now A Consensus Trade Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation