Commodities & Energy Sector

Highlights The dollar is on the verge of a significant breakdown. If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The most recent catalyst – fiscal support in the euro zone – has been good news on the “anti-dollar” front. Agreement on the EU recovery fund has underscored a powerful centripetal force for the euro. Because it is a reserve currency, a breakdown in the dollar will amplify the global liquidity surge. This will lead to a self-reinforcing spiral of better global growth, and a weaker dollar. Our long Scandinavian currency basket and long silver versus gold positions have benefitted tremendously from the shift in sentiment. Stick with them. While our technical indicators are flagging the dollar as oversold, any bounce from current levels should be shorted.  Our FX model remains dollar bearish, and is recommending shorting the DXY for the month of August. Feature Chart I-1On A Precipice The Great FX Rotation The Great FX Rotation The DXY index is punching below key support levels and on the verge of a significant multi-year decline. Up until March, the dollar was trading in a narrow band (Chart I-1). With that support now breached, the next key test for the DXY index will be the 93-94 zone, defined by the upward-sloping trend line, in place since the 2011 lows. As the breakdown becomes more broad-based, especially vis-a-vis emerging market currencies, this will cement the transition from easing financial conditions to improving global growth. Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold. As Chart I-2 shows, while gold and the safe-haven currencies remain this year’s frontrunners, the more industrial metals such as silver and platinum will likely take over the baton by year end. Within the G10 universe, cyclical currencies such as the Australian dollar and the Norwegian krone are now in the technical definition of a bull market. Such a rotation usually signals a genuine and potentially meaningful breakdown in the dollar. Chart I-2The Great FX Rotation The Great FX Rotation The Great FX Rotation Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold.  Technical indicators suggest the dollar is likely to consolidate losses in the weeks ahead. Our intermediate-term indicator is in the lower decile of its range, and speculators are very short the cross (see US dollar section on page 14). That said, any bounce should be used as an opportunity to establish fresh short positions, contrary to the “buy-on-the-dip” strategy that has worked well over the last decade.  DXY Breakdown: What Has Changed? US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are well into their reopening phases. Meanwhile, new infections in the US are proving rather sticky. As a result, economic momentum is higher outside the US. This partly explains why the euro is outperforming both the US dollar and the yen (Chart I-3). Money velocity is rising faster outside the US, suggesting animal spirits are being rekindled at a faster pace abroad (Chart I-4). This is evident in capital flows, where some non-US markets have started to outperform. In the classical equation MV=PQ,1 a rise in M has historically been accompanied by a collapse in V, suggesting the economy remained in a liquidity trap. With the fiscal spending spigots now open almost everywhere, a rise in both M and V will be explosive for nominal output. Chart I-3Positive COVID-19 Trends For Europe Positive COVID-19 Trends For Europe Positive COVID-19 Trends For Europe Chart I-4Money Velocity Outside The US Money Velocity Outside The US Money Velocity Outside The US There was significant progress towards a European fiscal union this week, with leaders agreeing to a €750 billion recovery fund. Assuming the agreement is ratified, this will underscore a powerful centripetal force for the common-currency union. As the “anti-dollar,” this is positive for the euro (and negative for the greenback). More on this later. The US economy had been relatively resilient compared to the rest of the world, at least until late. This was in part driven by a late start to state-wide shutdowns. With various US municipalities and states now reversing reopening plans, economic activity abroad is now improving relative to the US. Chart I-5 shows the economic surprise index between the Eurozone and the US is inflecting sharply higher from very depressed levels. Historically, this has usually put a floor under the euro. Similarly, G10 PMIs have bottomed relative to the US. These trends should continue in the months ahead. Chart I-5EUR/USD And Relative Growth EUR/USD And Relative Growth EUR/USD And Relative Growth How High Can EUR/USD Rise? Agreement on the EU recovery fund was a historic event, not due to the size of the package but because of revealed preferences toward euro membership. For over two decades, the standard dilemma plaguing the euro area was that centralized monetary policy was never a panacea for desynchronized business cycles.2 The lack of fiscal transfers between member nations amplified this problem. With Italian and Spanish bond yields now collapsing towards those in the core, liquidity is flowing to where it is most needed, significantly curtailing euro break-up risk. The key components of the agreement are €360 billion in the form of loans and €390 billion in the form of grants. The money will be borrowed via bonds issued by the European Commission, with maturities of three to 30 years. Repayment will not be due until 2027. The most important component of the deal, the grants, is a de facto fiscal transfer. Going forward, the next catalyst for euro strength must be growth differentials between the euro zone and the US. This will translate into an improvement in the equilibrium rate of interest between the two blocs (Chart I-6). This is quite plausible in a post-COVID-19 world. As a relatively closed economy, the US has tended to have a higher services component to GDP. However, the service sector has been hit much harder by the pandemic due to social distancing measures that will likely remain in place for a while. A more drawn-out services recovery raises the prospect that countries geared more towards manufacturing, such as Europe, Japan and China, could experience better growth (Chart I-7). Chart I-6EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate Chart I-7Service Industries Could Stay Weak For A While Service Industries Could Stay Weak For A While Service Industries Could Stay Weak For A While Chart I-8The European Periphery Is Competitive Again The European Periphery Is Competitive Again The European Periphery Is Competitive Again Internally within the euro zone, a powerful adjustment has already occurred. Unit labor costs in Greece, Ireland, Portugal and Spain are well off their peak. This has effectively eliminated the competitiveness gap with the core that had accumulated over the previous two decades (Chart I-8). Italy remains saddled with a rigid and less-productive workforce, but overall adjustments have still come a long way in plugging a key fissure undermining the common-currency area. The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at very cheap multiples. Part of the reason is that most Eurozone bourses are heavy in cyclical stocks that are well into a 10-year relative bear market.3  A re-rating of cyclical stocks, especially banks and energy, relative to defensives could be the catalyst that carries the next leg of the euro rally. This could push the EUR/USD towards 1.20. As higher-beta, the Scandinavian currencies will also benefit. For now, most analysts remain very pessimistic about European profits relative to those in the US, but that could change if the dollar enters a structural bear market (Chart I-9). Chart I-9Relative Profit Revisions Lead EUR/USD Relative Profit Revisions Lead EUR/USD Relative Profit Revisions Lead EUR/USD Cyclical Or Structural Move? If the DXY punches through 94, it will likely mark the beginning of a structural bear market.  If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The dollar tends to run in long cycles, driven by fundamentals but also confidence. In our report last week, we suggested three indicators for gauging a shift in confidence. The total return of US bonds versus gold: Gold and US Treasurys are competing assets (Chart I-10), with the dollar being the key arbiter, as we argued last week. The TLT/GLD ratio has dropped from over 1.16 to 0.96, putting it at the precipice of bear-market territory. The USD/CNY exchange rate: Tensions are flaring up between the US and China, with the latest being the US government’s closure of China’s Houston consulate. Yet USD/CNY is still holding around 7. As the key arbiter between the dollar and emerging market currencies, a firm yuan limits upward pressure on the greenback. The gold-to-silver ratio (GSR): This correlates well with the dollar, and has absolutely collapsed (Chart I-11). Given similar moves in gold versus copper and oil, it is fair to assume that the global economy is not in a liquidity trap. Chart I-10Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Chart I-11The Gold-To-Silver Ratio Has Collapsed The Gold-To-Silver Ratio Has Collapsed The Gold-To-Silver Ratio Has Collapsed The more important point is that there is a nascent, concerted push by both institutional investors and central banks to diversify out of dollar assets: The S&P 500 usually moves inversely to gold, but both have been moving in sync since the March lows (Chart I-12). This suggests investors have been using gold rather than US bonds to hedge their equity long positions. The dollar proved to be the best safe-haven asset during the March drawdown. With the Federal Reserve having flooded the system with dollars, gold (and precious metals) are the next logical choice. Since 2014, central banks have been aggressively diversifying out of their dollar holdings. This is not only evident in the official TIC data that continues to show foreign officials are selling Treasurys, but within IMF reserve data well. Part of these flows have gone into other currencies, especially the yen, but a huge portion has been to gold (Chart I-13). This has been driven by emerging market countries such as Russia and China, the same concerns in the middle of geopolitical confrontations with the US. Chart I-12Gold And The S&P 500 Are Moving Together Gold And The S&P 500 Are Moving Together Gold And The S&P 500 Are Moving Together Chart I-13Central Banks Are Loading Their Gold Vaults Central Banks Are Loading Their Gold Vaults Central Banks Are Loading Their Gold Vaults Within our service (and together with our Commodity & Energy colleagues), we have been highlighting that precious metals will be a huge beneficiary from the Fed’s reflationary efforts, even though they are overbought. As a hedged bet, we have been long silver versus gold, a trade that continues to perform well.   As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers.  Chart 14 shows that precious metals such as silver and platinum are much cheaper from a historical perspective. As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers. Chart I-14Silver And Platinum Remain Relatively Cheap Silver And Platinum Remain Relatively Cheap Silver And Platinum Remain Relatively Cheap In a nutshell, remain long silver, SEK, NOK and petrocurrencies. Currency traders can also add platinum to the list. These top picks will continue to benefit from global reflation, dollar weakness and a breakout in the euro. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been positive: Existing home sales surged by 20.7% in June compared with May, the highest monthly gain on record. This followed a strong increase in building permits and housing starts last week. The University of Michigan consumer sentiment declined from 78.1 to 73.2 in July, while the Chicago Fed national activity index ticked up from 3.5 to 4.1 in June. Initial jobless claims increased by 1416K for the week ended July 17th, higher than the 1307K increase the previous week. The DXY index continued to edge lower, falling by 1% this week. Our bias is that the US dollar is likely to begin a long depreciation should the global economy continue to rebound.   Report Links: A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mixed: The current account surplus narrowed from €14.4 billion to €7.95 billion in May. Headline inflation was flat at 0.3% year-on-year in June. Core inflation also remained at 0.8% year-on-year in June. Preliminary consumer confidence marginally fell from -14.7 to -15 in July. The euro appreciated by 1.4% against the US dollar this week, climbing to the highest level in almost two years, alongside European equities. The catalyst was the €750 billion rescue fund (around 5.5% of EU GDP) announced this Tuesday. The fact that member countries reached an agreement is encouraging for the sustainability of the euro.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: The trade deficit narrowed from ¥601 billion to ¥424 billion in June. Exports fell by 26.2% year-on-year while imports fell by 14.4% In June. National headline CPI remained flat at 0.1% year-on-year in June, while core inflation was also unchanged at 0.4%. The Jibun Bank manufacturing PMI increased from 40.1 to 42.6 in July. The Japanese yen rose by 0.2% against the US dollar this week. In the monthly report released this Wednesday, Japan’s Cabinet Office reported improvement in 6 out of 14 economic categories, including consumer spending, exports, production and public investment. However, capital spending, corporate profits and employment remain weak due to the pandemic. That said, we are long the Japanese yen as a  safe-haven hedge.   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 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index rose by 3.7% year-on-year in July, up from 2.1% the previous month. CBI industrial trends survey orders recovered from -58% to -46% in July. The British pound appreciated by 1.6% against the US dollar this week. Near-term volatility around Brexit negotiations is a negative for the pound, but it is cheap and unloved.   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 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Retail sales rose by 2.4% month-on-month in June, following 16.9% increase the previous month. NAB business confidence fell to -15 from -12 in Q2. The Australian dollar jumped by 2.3% against the US dollar this week. The recent RBA meeting minutes suggested that there is no need to adjust its policy measures in the current environment and reiterated that negative interest rates remain “extraordinarily unlikely”.   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 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data from New Zealand this week: The New Zealand business index surged from 37.5 to 54.1 in June. The New Zealand dollar rose by 1.8% against the US dollar this week. Following weak inflation data last week , the Westpac Economic Bulletin suggests consumer prices will remain subdued on weakened demand. This raises the prospect of further stimulus from the RBNZ.   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 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Retail sales increased by 18.7% month-on-month in May. Auto sales were particularly strong. The new house price index increased by 1.3% year-on-year in June.  The Teranet/National Bank house price index rose by 5.9%. Headline inflation increased from -0.4% to 0.7% year-on-year in June, as oil prices recovered. Core inflation also rose from 1.6% to 1.8% year-on-year in June. The Canadian dollar rose by 1.3% against the US dollar this week. The inflation data were stronger than expected, led by gas, food and shelter prices. Going forward, a recovery in energy prices will be important for the performance of the CAD. In general, we like petrocurrencies.   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 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The trade balance widened marginally from CHF 2.7 billion to CHF 2.8 billion in June. Exports rose by 6.9% month-on-month while imports jumped by 7.3%. Total sight deposits continued to increase from CHF 688.6 billion to CHF 691.5 billion for the week ended July 17th. The Swiss franc appreciated by 1.3% against the US dollar this week. Switzerland has seen a trade recovery in recent months. Notably, luxury goods exports like Swiss watches increased by 58.9% month-on-month in June, though well below pre-COVID-19 levels.   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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: Exports and imports both improved in June, especially with rebounding oil prices. The trade surplus widened from NOK2.7 billion to NOK3.2 billion. The Norwegian krone appreciated by 1.3% against the US dollar this week. Our Commodity & Energy team holds the view that global fiscal stimulus to combat COVID-19 will support global oil demand. Moreover, both OPEC and the US are likely to continue production cuts. Their bias is that oil prices will continue to grind higher, which is bullish for the Norwegian krone. Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: The unemployment rate rose to 9.8% in June, up from 9% the previous month and 7.2% the same month last year. The Swedish krona surged by 2% against the US dollar this week. The latest Labor Force Survey released this week showed that the labor market in Sweden continues to deteriorate. In June, employment fell by 148,000. Average hours worked per week fell by 8.4%. That said, the Swedish krona remains cheap and will benefit from a global economic recovery.   Footnotes 1Where M = money supply, V = velocity of money, P = price level and Q = output. 2Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest", dated June 14, 2019. 3Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Vs Growth Debate", dated July 10, 2020.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The EU’s €750 billion fiscal package, along with another round of US stimulus likely exceeding $1 trillion, will support global oil demand. On the supply side, OPEC 2.0’s production discipline likely holds, and US shale output will remain depressed. These fundamentals, along with a weakening USD, will continue to support Brent prices, which are up 129% from their lows in April. China’s record-setting crude-oil-import surge during the COVID-19 pandemic – averaging 12.7mm b/d in 1H20, up 28.5% y/y – is at risk of slowing in 2H20, as domestic storage fills. Supply-side risks are acute: Massive OPEC 2.0 spare capacity – which could exceed 6mm b/d into 2021 – will tempt producers eager to monetize these to boost revenue. On the demand side, COVID-19 infection rates are surging in the US. Progress on vaccines notwithstanding, politically intolerable public-health risks in big consuming markets could usher in demand-crushing lockdowns again. Economic policy uncertainty remains elevated globally, but the balance of risks continues to favor the upside: We expect 2H20 Brent prices to average $44/bbl, and 2021 prices to average $65/bbl, unchanged from last month’s forecast. Feature We are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June. Marginal improvements to preliminary supply and demand estimates earlier in the COVID-19 pandemic support the thesis that fundamentals will not derail the massive oil-price rally that lifted Brent 129% from its April 21 low of $19.30/bbl. A weakening US dollar, and the expectation this trend will continue, also is supportive to commodities in general, oil in particular. As a result, we are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June (Chart of the Week). The three principal oil-market data providers – the US EIA, IEA and OPEC – raised demand estimates at the margin for 1H20, particularly for 2Q20, the nadir for global oil consumption. The EIA’s estimate for 2Q20 demand shows an upward revision of 550k b/d from last month’s estimate. On the supply side, the EIA estimates global output fell -8.1mm b/d in 2Q20, a -300k b/d downward revision vs. its estimate from last month (Chart 2). Chart of the WeekOil Price Rally Remains Intact Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 2OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI. After accounting for this better-than-expected fundamental performance, we now expect global supply to fall 5.9mm b/d in 2020 and to increase 4.2mm b/d in 2021. On the demand side, we now expect 2020 demand to fall 8.1mm b/d vs. 8.9mm b/d last month, and for 2021 demand to rise 7.8mm b/d vs 8.5mm b/d in June (Chart 3). This will keep the physical deficit we’ve been forecasting for 2H20 and 2021 in place, allowing OECD storage to fall to 3,026mm barrels by year-end and to 2,766mm barrels by the end of next year (Chart 4). Chart 3Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Chart 4... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI (Chart 5). One caveat, though: We are watching floating storage levels closely, particularly in Asia: The current structure of the Brent forwards does not support carrying floating inventory, but it’s been slow moving lower (Chart 6). This could reflect a slowing in China’s crude-oil import surge, which hit record levels in May and June. Chart 5... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... Chart 6… Even As Floating Storage In Asia Remains Elevated Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside China’s Crude-Import Binge Ending? There is a non-trivial risk China’s crude-buying binge during the COVID-19 pandemic, which supported prices during the brief Saudi-Russian market-share war in March and the collapse in global demand in 2Q20, may have run its course (Chart 7).1 At the depths of the global pandemic in 2Q20, China’s year-on-year (y/y) crude imports surged 15%. According to Reuters, China’s crude oil imports totaled 12.9mm b/d in June, a record level for the second month in a row.2 Much of this was converted to refined products – chiefly gasoline and diesel fuel – as China’s demand recovered from the global pandemic (Chart 8). China’s 208 refineries can process 22.3mm b/d of crude, according to the Baker Institute at Rice University in Houston.3 Refinery runs in June were estimated at just over 14mm b/d by Reuters. Chart 7China's Crude Import Binge Stalls China's Crude Import Binge Stalls China's Crude Import Binge Stalls Chart 8China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. China imports its oil into 59 port facilities, which can process ~ 16mm b/d. Storage is comprised of 74 crude oil facilities holding ~ 706mm barrels, and 213 refined-product facilities with capacity to hold ~ 357mm barrels of products (Map 1). By Reuters’s count, ~ 2mm b/d of crude went into storage in the January-May period, while close to 2.8mm b/d was stored in June. Official storage data is a state secret, so it is not possible to determine whether China’s crude and product storage is full. However, if crude oil imports remain subdued – and floating storage in Asia remains elevated – we would surmise the Chinese storage facilities are close to full. Additionally, any sharp and sustained increase in refined product exports would indicate storage is brimming. Map 1Baker Institute China Oil Map Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. We expect the latter condition to obtain, in line with our expectation of a global recovery in demand, even though China remains out of sync with the rest of the world presently. China was the first state to confront the pandemic and first to emerge out of it; its trading partners still are in various stages of recovery (Chart 9). Chart 9China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy OPEC 2.0’s Remains Sensitive To Demand Fluctuations OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months. The asynchronous recovery in global oil demand poses a unique problem for OPEC 2.0 this year and next. OPEC 2.0 will be easing production curtailments to 7.7mm b/d beginning in August from 9.6mm b/d in July, on the advice of its Joint Ministerial Monitoring Committee (JMMC). This is a decision that will be closely monitored, amid rising concern over the speed of demand recovery in the US and EM economies, due to mounting COVID-19 cases (Chart 10). The surge in US infections relative to its trading partners is of particular concern, given the size of US oil demand (Chart 11). In 2H20, we expect US demand will account for close to 20% of global demand, much the same level it was prior to the pandemic (Table 1). Chart 10COVID-19 Infections Surge In The US Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Chart 11US COVID-19 Infections Are A Risk To Global Commodity Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months, bringing the actual increase in production closer to 1-1.5mm b/d. Together, Iraq, Nigeria, Kazakhstan, and Angola, over-produced versus their May and June targets by ~ 760k b/d. In our balances estimates, as is our normal practice, we haircut these estimates and use a lower compliance level that those stated in the official OPEC 2.0 agreement. In the case of these producers, we assume they will compensate for ~ 70% of their overproduction, bringing the adjusted cuts to ~ 8.3mm b/d. This should be sufficient to maintain the current supply deficit in oil markets that continues to support Brent prices above $40/bbl. However, the reliance on laggards’ extra cuts to balance markets adds instability. There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The JMMC is continually assessing supply-demand balances and remains focused on making sure the totality of the cuts does not fall on a small group of countries. It reiterated its position that “achieving 100% conformity from all participating Countries is not only fair, but vital for the ongoing rebalancing efforts and to help deliver long term oil market stability.” In June, OPEC 2.0’s overall compliance was 107% – mostly reflecting over-compliance from KSA, the UAE, and Kuwait.4 There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The US EIA estimates that within the original OPEC cartel spare capacity will average close to 6mm b/d this year, the first time since 2002 that it has exceeded 5mm b/d. On top of this, there’s the looming downside risk of a new Iran deal if Democrats win the White House and Congress in US elections in November, and a possible restart of Libyan exports this year. Watch The DUCs In The US With WTI prices averaging $41/bbl so far in July, we continue to expect part of previously shut-in US production to come back on line in July, August and September. Nonetheless, the negative effect of the multi-year low rig count will be felt heavily in 4Q20 and 1Q21 and will push production lower. The rig count appears to be bottoming but is not expected to increase meaningfully until WTI prices move closer to $45-50/bbl. On average it takes somewhere between 9-12 months for the signal from higher prices to result in new oil production flowing to market in the US. As the rig count moves back up in 2021, its effect on production will be apparent only in late-2021. However, the massive inventory of drilled-but-uncompleted (DUC) wells in the main US tight-oil basins will provide a source of cheaper new supply, if WTI prices remain above $40/bbl. DUCs are 30-40% cheaper to complete compared to drilling a new well from start. We expect DUCs completion will begin adding to US crude output in 1Q21, and that this will continue to be a source of supply beyond 2021. Bottom line: Global economic policy uncertainty remains elevated, albeit off its recent highs (Chart 12). We expect this uncertainty to continue to wane, which will allow the USD to continue to weaken. This will spur global oil demand, and will augment the fiscal and monetary stimulus to the COVID-19 pandemic undertaken globally. Chart 12Global Policy Uncertainty Remains High, Which Could Support USD Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Nonetheless, the global recovery remains out of sync, which complicates OPEC 2.0’s production management, and markets’ estimation of supply-demand balances. Uneven success in combating the pandemic keeps the risk of lockdowns on the radar in the US. Policy is driving oil production at present, and, given the temptation to monetize spare capacity, the supply side remains a risk to prices. We continue to see upside risk dominating the evolution of prices and are maintaining our expectation Brent prices will average $44/bbl in 2H20 – lifting the overall 2020 average to $43/bbl – and $65/bbl next year. Our expectation WTI will trade $2-$4/bbl below Brent also remains intact.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight Canadian oil production averaged 4.6mm b/d in 2Q20 vs. 5.5mm b/d in 2Q19, based on EIA estimates. The lack of demand from US refiners – crude imports from Canada fell by 420k b/d y/y during the quarter – and close to maxed-out local storage facilities pushed prices below cash costs, forcing the shut-ins of more than 1mm b/d of crude production. Canadian energy companies started releasing their 2Q20 earnings this week and analysts expect the results to be one of the worst ever recorded, reflecting the extent of the pain producers felt during the COVID-19 shock. Base Metals: Neutral High-grade iron ore prices (65% Fe) were trading above $120/MT this week, on the back of forward guidance from the commodity’s top exporter, Brazilian miner Vale, which suggested exports will be lower than had been previously estimated this year, according to Fastmarkets MB, a sister service of BCA Research. This is in line with an Australian Department of Industry, Science, Energy and Resources analysis in June, which noted, “The COVID-19 pandemic appears to have affected both sides of the iron ore market: demand disruptions have run up against supply problems localised in Brazil, where COVID-19-related lockdowns have derailed efforts to recover from shutdowns in the wake of the Brumadinho tailings dam collapse” (Chart 13). Precious Metals: Neutral Our long silver position is up 17.5% since it was recommended July 2. We are placing a stop-loss on the position at $21/oz, our earlier target, given the metal was trading ~ $22/oz as we went to press. The factors supporting gold prices – chiefly low real rates in the US, a weakening dollar and global monetary accommodation, also support silver prices. However, silver also will benefit from the recovery in industrial activity and incomes we anticipate in the wake of global fiscal and monetary stimulus, which will drive demand for consumer products (Chart 14). Ags/Softs:  Underweight Lumber prices have more than doubled since April lows. The uncertainty brought by the COVID-19 health emergency altered the perception of future housing demand and, by extension, lumber demand, to the point that mills responded by substantially decreasing capacity utilization rates. However, in the wake of global monetary and fiscal stimulus, housing weathered the storm better than expected. Furthermore, a surge in DIY projects from individuals working from home at a time of reduced supply contributed to the current state of market shortage. Chart 13Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Chart 14Silver Favored Over Gold Silver Favored Over Gold Silver Favored Over Gold         Footnotes 1     In our reckoning, a non-trivial risk is something greater than Russian roulette odds – i.e., a 1-in-6 chance of an event occuring. Re the ever-so-brief Saudi-Russian 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. 2     Please see COLUMN-China's record crude oil storage flies under the radar: Russell published by reuters.com July 20, 2020. 3    The Baker Institute’s Open-Source Mapping of China's Oil Infrastructure was last updated in March 2020. The map is “a beta version and is likely missing some pieces of existing infrastructure. The challenge of China’s geographic expanse — it is roughly the same area as the U.S. Lower 48 — is compounded by a lack of transparency on the part of China’s government,” according to the Baker Institute. 4    In our supply-side estimates, we used IEA estimates of cuts for June this month. This doesn’t change the overall estimate of cuts from our earlier analysis; however, it slightly changes how the 9.7mm b/d was split between OPEC 2.0 members. the official eased cuts are 7.7mm b/d from 9.7mm b/d in May-June-July, but it actually is closer to 8.3mm b/d accounting for the compensation from the countries mentioned above.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside

Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 4AIG Energy Risk Profile IG Energy Risk Profile IG Energy Risk Profile Chart 4BIG Integrated Risk Profile IG Integrated Risk Profile IG Integrated Risk Profile Chart 4CIG Independent Risk Profile IG Independent Risk Profile IG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile IG Oil Field Services Risk Profile IG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile IG Midstream Risk Profile IG Midstream Risk Profile Chart 4FIG Refining Risk Profile IG Refining Risk Profile IG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth IG Energy Debt Growth IG Energy Debt Growth Chart 5BIG Integrated Debt Growth IG Integrated Debt Growth IG Integrated Debt Growth Chart 5CIG Independent Debt Growth IG Independent Debt Growth IG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth IG Oil Field Services Debt Growth IG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth IG Midstream Debt Growth IG Midstream Debt Growth Chart 5FIG Refining Debt Growth IG Refining Debt Growth IG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 7AHY Energy Risk Profile HY Energy Risk Profile HY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile HY Independent Risk Profile HY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile HY Oil Field Services Risk Profile HY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile HY Midstream Risk Profile HY Midstream Risk Profile Chart 7EHY Refining Risk Profile HY Refining Risk Profile HY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth HY Energy Debt Growth HY Energy Debt Growth Chart 8BHY Independent Debt Growth HY Independent Debt Growth HY Independent Debt Growth Chart 8CHY Oil Field Services Debt Growth HY Oil Field Services Debt Growth HY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth HY Midstream Debt Growth HY Midstream Debt Growth Chart 8EHY Refining Debt Growth HY Refining Debt Growth HY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Appendix B High-Yield Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy  

Highlights Exogenous risks will remain more of a threat to grain prices than out-of-whack fundamentals, which are closer to balance than not, as the USDA’s World Agricultural Supply and Demand Estimates (WASDE) indicate. COVID-19-induced public-health risks leading to renewed lockdowns – particularly in the US, where infection rates are rampaging ahead of its trading partners’ – remain at the forefront of these exogenous risks (Chart of the Week). Headline-grabbing grain purchases notwithstanding, fraying Sino-US trade, diplomatic and military relations again threaten these markets, particularly soybeans. China promises to retaliate against actions taken by US President Donald Trump in response to a new security law Beijing foisted on Hong Kong at the end of June, which sharply curtails freedom and autonomy. Sino-US military tensions in the South China Sea remain elevated. Countering these risks, a weaker USD – in line with our House view – would boost demand for grains as EM income growth picks up. Still, global economic policy uncertainty will remain a formidable headwind to a weaker USD. Feature Grains generally are closer to balance than not globally, which suggests the next market-moving developments – outside weather – will be caused by news exogenous to fundamentals (Chart 2). Chart of the WeekCOVID-19 Infection Surge In US Could Lead To Renewed Lockdowns Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge The four key markets tracked by the UN’s Agricultural Market Information System (AMIS) – corn, wheat, rice and soybeans – are in “a generally comfortable global supply situation. However, in many parts of the world, local markets brace for the looming impacts of COVID-19, amid uncertainties related to demand, logistics and even access to food.”1 Chart 2Grain Markets Close To Balanced Grain Markets Close To Balanced Grain Markets Close To Balanced The USDA sees corn markets tightening in the coming 2020-21 crop year beginning in September, with US production down 995mm bushels on the back of lower plantings and harvests.2 Output ex-US is expected to be largely unchanged, while Chinese corn demand will pick up in response to higher soybean feed usage. Stocks in China, Argentina, the EU, Canada, and Mexico, are expected to be lower leading to a net decline in global inventories. US soybean stocks are expected to increase, but this will be offset by declines in Brazil and China, reducing global bean inventories by some 1.3mm tons to 95.1mm, based on USDA estimates. The USDA’s soybean export commitments to China (i.e., outstanding sales plus accumulated exports) are 1.8mm tons higher than last year at 16.2mm tons, but still are well below historic levels (Chart 3). The US slack has been picked up by Brazilian exports, which have been aided by a weak BRL and record bean crops. A weaker USD and a resumption of Sino-US bean trade would reverse this. Wheat and rice stocks are expected to increase globally. Wheat inventories are expected to hit record highs globally, with China accounting for a little more than half of these stocks, and India accounting for 10%. Rice supplies are expected to increase more than demand globally, lifting ending stocks for the 2020-21 crop year to a record 186mm tons; China and India account for 63% and 21% of these inventories, respectively, in the USDA’s estimates. Chart 3Sino-US Trade Tensions Reduce Soybean Exports Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Chart 4Rising US COVID-19 Infections Are A Risk, But Won’t Derail Global Recovery Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Sources Of Market-Moving News The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly. With markets largely in line with fundamentals, the three most likely sources of market-moving “new news” affecting grain markets – outside weather – will come from public-health developments, particularly in the US; political developments affecting global trade, particularly the escalating Sino-US diplomatic tensions; and FX-market developments, which will continue to process these developments in real time. The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly (Chart 4). While we do not except a repeat of the massive lockdowns earlier this year, rising infection rates do place increasing strains on public-health resources, which could force officials to reimpose lockdowns locally. The global recovery from the pandemic remains uneven, with China’s recovery apparently ahead of most other states in terms of returning its economy to normal. China was first to be hit by the virus and first to largely recover, due to its more extensive lockdowns. Rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. For grain markets, China remains an attractive destination for exporters, given the premium grains and soybeans trade at relative to other destinations (Chart 5). This should keep China’s imports of grains robust in the near future, particularly for corn (Chart 6). Chart 5China Grains Prices Are Attractive To Exporters China Grains Prices Are Attractive To Exporters China Grains Prices Are Attractive To Exporters While economics favor movement of grains – and other commodities – to China, rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. Chart 6China Should Remain Well Bid For Corn Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge A new security law foisted on Hong Kong by Beijing at the end of June limiting freedom and autonomy drew sharp responses from the US and EU. President Trump this week signed an order ending Hong Kong’s preferential status as a US trading partner in the wake of the new law, and threatened direct sanctions against Chinese officials involved in enforcing the law.3 The European Union issued a statement on July 1, which decried the passage of the law by the Standing Committee of China’s National People’s Congress, expressing “grave concerns about this law which was adopted without any meaningful prior consultation of Hong Kong’s Legislative Council and civil society.”4 In addition to this political turmoil, the US and China are engaged in a war of words over China’s territorial claims on the South China Sea, which is contested by states surrounding the sea and branded as illegal by the US.5 The US and China carried out simultaneous large-scale naval exercises earlier this month, raising concerns of an unintended military confrontation.6 Weaker USD Will Buoy Grain Markets We are aligned with our House view expecting a weakening of the USD, driven by the massive fiscal and monetary stimulus from the US; lower real rates in the US, and America’s apparent inability to successfully contain the COVID-19 pandemic to the degree other states (e.g., China) have (Chart 7). This implies the US is at a greater risk of a marked slowdown in its ongoing economic recovery. These factors will support flows to markets ex-US, pressuring the USD lower. For grain markets this will be bullish for demand. A weaker USD lifts EM GDP growth, which boosts industrial activity (Chart 8). Higher income boosts demand for protein, which drives demand for corn and soybeans used as animal feed, and grain consumption (wheat and rice).7 Chart 7USD Weakness Expected As Real Rates Fall, Deficits Rise USD Weakness Expected As Real Rates Fall, Deficits Rise USD Weakness Expected As Real Rates Fall, Deficits Rise Chart 8Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand   On the supply side, a higher (lower) US dollar decreases (raises) the local costs of production for ag exporting countries with a certain lag. A persistently high (low) dollar will incentivize (disincentivize) crop planting in these countries – allowing producers to increase local currency profits from USD-denominated ag exports. This pushes up (down) global supply at the margin. Hence, over relatively long periods, ag prices and the US dollar tend to trend in opposite directions. We cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress. Longer term, disparities in monetary and fiscal policies, interest rates, and economic activity between the US and other DM economies will dominate the evolution of the dollar. In our simulations for the USD’s trajectory between now and the end of the year, a 5% depreciation of the USD would lift the CCI grains and oilseed index 13%, while a 5% strengthening of the dollar would push the index down by -8% by December 2020 (Chart 9).8 Should this weakening in the USD materialize, we can expect US grains’ stocks-to-use ratios to fall, which would reinforce price strength in grains (Chart 10). Chart 9USD Weakness Will Buoy Grains USD Weakness Will Buoy Grains USD Weakness Will Buoy Grains While the weaker-dollar scenarios are our favored evolution, we cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress (Chart 11). Chart 10Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Chart 11USD's Safe-Haven Status Could Keep Dollar Well Bid USD's Safe-Haven Status Could Keep Dollar Well Bid USD's Safe-Haven Status Could Keep Dollar Well Bid Bottom Line: Global grain markets are closer to balance than not, leaving exogenous risks – i.e., a COVID-19 second wave, renewed Sino-US trade and military tensions, and a stronger USD – as the key threats to grain prices. The impact of these exogenous risks will be filtered through to grain markets – and commodities generally – via FX markets. While we expect a weaker USD to prevail, in line with our House view, we cannot gainsay the dollar’s safe-haven role and its attraction during times of tension and crisis.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight As we go to press, Brent prices are steady at ~ $43/bbl as market participants await OPEC 2.0's Joint Ministerial Monitoring Committee decision on next month's output levels. The group is reportedly set to ease production curtailment to 7.7mm b/d starting next month from 9.7mm b/d in July. This would add to the growing concerns about the impact on oil demand of mounting COVID-19 cases in the US and in EM economies. Still, Saudi Arabia’s Energy Minister reiterated the effective cuts would be deeper as countries that overproduced in May/Jun will have to compensate with extra cuts over the coming months. Our global oil balances point to a supply deficit in 2H20. Thus, prices will recover if a correction were to occur. Base Metals: Neutral Copper prices surged by 5% since last week and have now completely recovered from the damaging COVID-19 shock – up 4% ytd. Fears of strike over wages at Antofagasta’s Zaldivar mine in Chile – following unionized workers rejection of a pay offer – and of virus-related mine disruptions in Latin America, combined with strong imports numbers out of China for the month of June supported the recent rally.9 In USD terms, Chinese imports growth recovered to 2.7% from -16.7% in May as stimulus programs start impacting the real economy (Chart 12). Precious Metals: Neutral Gold and silver prices are up 19% and 9% ytd. Silver rose to $19.5/oz as of Tuesday’s close, pushing the gold-to-silver ratio down to 93 after several weeks at ~ 100. Silver prices are supported by both safe-haven and industrial demand at the moment, which is pushing its equilibrium value higher, based on our silver price model (Chart 13). Our long Dec/20 silver futures trade is up 6.4% since inception on July 2, 2020. Ags/Softs:  Underweight On Tuesday the corn market shrugged off the biggest Chinese single-day purchase of U.S. corn and the USDA’s report of a 2% decline in corn crop conditions rated good to excellent. Despite this arguable bullish news, corn prices were still down on prospects of large carryovers both this season and the next marketing year, which begins in September. Going forward, the USDA cattle on feed inventory figure as well as ethanol demand will be key to assessing the evolution of corn carryovers. Feed and residual use of corn went down in the latest WASDE report, with year-to-date cattle on feed inventory lower than 2019, due to consumer stockpiling during the pandemic. With the beginning of grilling season well on its way re-stocking will be a challenging task. Chart 12Chinese Stimulus Will Lift Import Growth Chinese Stimulus Will Lift Import Growth Chinese Stimulus Will Lift Import Growth Chart 13Higher Equilibrium Value of Silver Higher Equilibrium Value of Silver Higher Equilibrium Value of Silver     Footnotes 1     Please see the UN’s AMIS Market Monitor for July 2020. 2     Please see World Agricultural Supply and Demand Estimates (WASDE) published by the USDA July 10, 2020. 3    Reuters reports that per the executive order signed by Trump this week, “U.S. property would be blocked of any person determined to be responsible for or complicit in ‘actions or policies that undermine democratic processes or institutions in Hong Kong.’”  In addition, the order requires US officials to “revoke license exceptions for exports to Hong Kong.”  Hong Kong passport holders no longer will be accorded special treatment under the order as well.  Please see China vows retaliation after Trump ends preferential status for Hong Kong published by reuters.com July 14, 2020. 4    Please see Declaration of the High Representative on behalf of the European Union on the adoption by China’s National People’s Congress of a National Security Legislation on Hong Kong. This was issued by the EU July 1, 2020. 5    Please see South China Sea dispute: China's pursuit of resources 'unlawful', says US published by bbc.com July 14, 2020.  See also China Pushes Back Against U.S. Statement on South China Sea Claims, ASEAN Stays Silent published by news.usni.org July 14, 2020. 6    Please see U.S. Carriers Send a Message to Beijing Over South China Sea published by foreignpolicy.com July 9, 2020. 7     In our modeling, we find that ag prices are generally less responsive to short-term changes in the US dollar compared to oil or base metals, but that they follow a common trend with the dollar over the long term. 8    These percent changes scale linearly in percentage terms, so a 10% weakening of the USD would lift the index 26%. 9    Please see Workers at Antofagasta's Zaldivar copper mine in Chile vote to strike: union published by reuters.com on July 10, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge

Highlights The EM equity benchmark’s concentration in the top six stocks – that in turn correlate with US FAANGM – has risen substantially. Hence, the outlook for US mega-cap stocks will continue to significantly impact the EM equity benchmark. US FAANGM stocks have been closely tracking the trajectory of – and share many other similarities with – previous bubbles. Hence, it is risky to dismiss the mania thesis. That said, it is impossible to know how long this equity mania will last, how far it will go and what will trigger its volte-face. Odds of a repeat of the 2015 boom-bust cycle in Chinese equities are low. The rally in Chinese stocks and commodities might be due for a pause. Feature Concentration Risk Chart 1EM: Mega-Caps Stocks Versus The Equal-Weighted Index EM: Mega-Caps Stocks Versus The Equal-Weighted Index EM: Mega-Caps Stocks Versus The Equal-Weighted Index The EM equity index's hefty gains since the late-March lows have largely been at the hands of about six stocks: Alibaba, Tencent, TSMC, Samsung, Naspers and Meituan-Dianping (Chart 1). The latter is a Chinese web-service platform company, while Naspers derives 75% of its revenue from its equity ownership in Tencent and 25% from a Russian internet company. For ease of reference, we refer to the big four (Alibaba, Tencent, Samsung and TSMC) as EM ATST. Table 1 illustrates that the top six companies combined account for about 24.3% of the MSCI EM equity market cap. For comparison, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) account for 25% of the S&P 500 market cap. The remainder of the EM equity universe – including all Chinese, Korean and Taiwanese stocks other than the six mega caps listed above – has rallied less (Chart 1). This is very similar to the dynamics in the US equity market, where the equally-weighted index has substantially diverged from the FAANGM index (Chart 2). Table 1Market Cap Weights & Performance Since March Lows EM Equities: Concentration And Mania Risks EM Equities: Concentration And Mania Risks Chart 2US: FAANGM Versus The Equal-Weighted Index US: FAANGM Versus The Equal-Weighted Index US: FAANGM Versus The Equal-Weighted Index   Table 2MSCI EM Stocks: Country Weights EM Equities: Concentration And Mania Risks EM Equities: Concentration And Mania Risks The EM ATST’s exponential rise has also boosted their respective country weightings in the MSCI EM equity benchmark. Table 2 demonstrates that China, Korea and Taiwan together account for 65% of the EM benchmark, India for 8% and all other 22 countries combined for 27%. Note that the market cap ($1.7 trillion) of the remaining 22 countries is almost as large as the market cap of the top six EM individual stocks. On the whole, concentration in the EM benchmark is as high as ever. Apart from global trade and Chinese growth, there are two other forces that will define the direction of EM mega-cap stocks: (1) rising geopolitical tensions between the US and China, and (2) a continuous mania or bust in “new economy” stocks. We discuss the latter in the following section. Escalating tensions between the US and China, including North Korea’s potential assault on South Korea, pose risks to Chinese, Korean and Taiwanese stocks. This is one of the critical reasons why we have been reluctant to chase these markets higher, despite upgrading our outlook on Chinese growth. If these bourses relapse, their sheer weight in the EM benchmark will pull the index down. The EM equity index’s outperformance in recent weeks has been due to the surge in both EM mega-cap stocks and Chinese share prices more broadly. Bottom Line: The EM equity benchmark concentration has risen substantially due to outsized gains in several “new economy” stocks. What’s more, the EM equity index’s outperformance in recent weeks has been due to the surge in both EM mega-cap stocks and Chinese share prices more broadly (we discuss the latter below). If the global mania in “new economy” stocks persists, EM ATST could well drive the overall EM equity index higher. Conversely, if “new economy” shares roll over for whatever reason, the EM equity benchmark’s advance will reverse. A Bubble Or Not? An assessment of the sustainability of the rally in US FAANGM stocks is critical for investors in the EM equity benchmark if for no other reason than the concentration hazard. We present the following considerations in assessing whether the FAANGM and EM ATST rally is or is not a mania: First, the exponential rally in FAANGM stocks is not a new phenomenon: It has been taking place over the past 10 years. Our FAANGM index – an equal-weighted average of six stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft) – has increased 20-fold in real (inflation-adjusted) US dollar terms since January 2010. Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index in the 1990s and Walt Disney in the 1960s, and well exceeds other bubbles, as illustrated in Chart 3. All price indexes on Chart 3 are shown in real (inflation-adjusted) terms. Chart 3Each Decade = One Mania EM Equities: Concentration And Mania Risks EM Equities: Concentration And Mania Risks All these manias and bubbles started with excellent fundamentals, and price gains were initially justified. Toward the end of the decade, however, their outsized gains attracted momentum chasers and speculators, catapulting share prices exponentially higher. Second, a financial mania requires: (1) solid past performance; (2) a story that can capture investors’ imaginations, and (3) plentiful liquidity. The “new economy” stocks fit all of these criteria: They have delivered super-sized performance over the past 10 years; They easily capture ordinary people’s imaginations – the average person on the street knows that FAANGM and EM ATST stocks benefit from people working from home and spending more time online; The Federal Reserve and many other central banks are injecting enormous amounts of liquidity into their respective economies. Third, there is a striking similarity between the FAANGM rally and previous bubbles: The mania-subjects of the preceding decades assumed global equity leadership early in their respective decade, rose steadily throughout, and went exponential at the very end of the decade. The latest parabolic surge in FAANGM stocks along with its duration (10 years of global equity outperformance and leadership) and magnitude (20-fold price appreciation in real inflation-adjusted terms) conspicuously resembles those of previous bubbles. Interestingly, the majority of previous bubbles peaked and tumbled around the turn of each decade, the exception being Walt Disney – the Nifty-Fifty bubble of the 1960s – which rolled over in 1973. Given FAANGM stocks have been closely tracking the trajectory of previous bubbles, it will not be surprising if 2020 ends up marking the peak for “new economy” stocks. Fourth, the last exponential upleg in the tech and telecom bubble of 1999-2000 occurred amid a one-off demand surge for tech hardware and software. The Y2K scare – worries that computers and networks around the world might malfunction on the New Year/new millennium eve – spurred many companies to order new hardware and upgrade their systems and networks. As a result, there was a one-off boom in orders in the global technology industry in the fourth quarter of 1999 and first quarter of 2000. Chart 4Orders For Computers And Electronics Have Remained Resilient Orders For Computers And Electronics Have Remained Resilient Orders For Computers And Electronics Have Remained Resilient Investors extrapolated this one-off demand surge into the future, mistaking it for recurring growth. As a result, they assigned extremely high valuations to these tech stocks in the first quarter of 2000. Similarly, since March, working and shopping from home has sharply increased demand for web services, online shopping, cloud computing and tech hardware. The top panel of Chart 4 demonstrates that US manufacturing orders for computers and electronic products did not contract in the March-May period, while orders for capital goods have plunged since March. Similarly, Taiwanese exports – which are heavy on tech hardware – are holding up well despite the crash in global trade (Chart 4, bottom panel). Some of this demand strength is structural, but part of it is one-off and non-recurring. Certainly, one should not extrapolate their recent growth rates into the future. However, investors are prone to extrapolation and chasing winners. Fifth, valuations of US FAANGM and EM ATST are elevated. Trailing P/E ratios for EM ATST stocks are shown in Table 3. Table 3Price-To-Earnings For Top 6 EM Stocks EM Equities: Concentration And Mania Risks EM Equities: Concentration And Mania Risks All in all, provided both US FAANGM and EM ATST consist of admirable companies with great competitive advantages and business models, it is tempting to dismiss the bubble argument. Nevertheless, there are enough similarities with previous manias to compel investors to be vigilant. Even great companies have a fair price, and substantial price overshoots will not be sustainable. We sense a growing number of investors deem US FAANGM and EM ATST stocks as invincible. When some stocks are regarded as unbeatable, their top is not far. Our major theme for the past decade – elaborated in the report, How To Play EM In The Coming Decade1 published in June 2010 – has been as follows: Sell commodities / buy health care and technology. Until 2019, we were recommending being long EM tech/short EM resource stocks. Unfortunately, since 2019, the corrections in EM “new economy” stocks have proved to be too short and fleeting, and we were unable to buy-in. Their share prices have lately gone parabolic: They are now in a full-blown mania phase. As to global equity leadership change from growth to value stocks, we maintain that major leadership rotations typically occur during or at the end of an equity selloff, as we elaborated in our October 3, 2019 report (Charts 5 and 6). Chart 5EM vs DM: Leadership Rotation Requires Market Turbulence EM vs DM: Leadership Rotation Requires Market Turbulence EM vs DM: Leadership Rotation Requires Market Turbulence Chart 6Growth vs Value: Leadership Rotation Requires Market Turbulence Growth vs Value: Leadership Rotation Requires Market Turbulence Growth vs Value: Leadership Rotation Requires Market Turbulence Apparently, the February-March selloff did not produce a shift in equity leadership. Barring a major selloff, “new economy” stocks will likely continue to lead. Chart 7Fed Rate Cuts Did Not Prevent The S&P 500 Bubble From Unravelling Fed Rate Cuts Did Not Prevent The S&P 500 Bubble From Unravelling Fed Rate Cuts Did Not Prevent The S&P 500 Bubble From Unravelling Finally, easy money policies encourage speculation and contribute to the build-up of manias. However, when a bubble starts unravelling, low interest rates are often unable to avert the bust. For example, when the tech bubble began bursting in 2000, the Fed cut rates aggressively and US bond yields plunged. Yet, low interest rates did not prevent tech share prices from deflating further (Chart 7). Bottom Line:  It is impossible to know how long this equity mania will last, how far it will go and what will trigger its volte-face. One thing is certain: there is a lot of froth – particularly in terms of valuation and positioning – in these “new economy” stocks. Yet, these excesses could last longer and get larger. A Mania In Chinese Equities? Many commentators have rushed to compare the latest surge in Chinese stocks with the exponential advance in the first half of 2015. We do not think this rally will go on without interruption for another five months like it did back then. Our rationale is as follows:   The Chinese authorities are much more vigilant now, and they will try to induce periodic corrections to avoid another mania and bust similar to those that occurred five years ago. The Chinese authorities are much more vigilant now, and they will try to induce periodic corrections to avoid another mania and bust similar to those that occurred five years ago. Both China’s MSCI Investable and CSI 300 equity indexes are retesting their previous highs (Chart 8). In the past they failed to break above these levels, and this time is likely to be no different, at least for now. The latest spike is more likely to be the final hurrah before a setback. Critically, the 12-month forward P/E ratio for China’s MSCI Investible index has also risen to its previous peaks (Chart 9, top panel). This has occurred with little improvement in the 12-month forward EPS (Chart 9, bottom panel). In short, share prices have run ahead of the business cycle and are already pricing in a lot of profit recovery. Chart 8Chinese Stocks Are At Their Previous Highs Chinese Stocks Are At Their Previous Highs Chinese Stocks Are At Their Previous Highs Chart 9Chinese Investable Stocks: A Rally Driven By P/E Expansion Chinese Investable Stocks: A Rally Driven By P/E Expansion Chinese Investable Stocks: A Rally Driven By P/E Expansion Chart 10Chinese Onshore Stocks: A Two-Tier Market Chinese Onshore Stocks: A Two-Tier Market Chinese Onshore Stocks: A Two-Tier Market Most of the rally since the March lows has been due to “new economy” stocks. Share prices of “old economy” companies did not do that well before July. Tech stocks in the onshore market have gone parabolic (Chart 10, top panel). This contrasts with lackluster performance of materials, industrials, and property stocks (Chart 10, bottom panels). Critically, in the onshore market, tech stocks are trading at the following trailing P/E ratios: the market cap-weighted P/E is 155, and the median P/E is 60. Needless to say, these valuations are outright expensive.   Bottom Line: Odds of a repeat of the 2015 boom-bust cycle are low. The rally in Chinese stocks might be due for a pause. On June 18, we upgraded Chinese stocks to overweight from neutral within the EM benchmark, a recommendation that remains intact. We have a much lower conviction on the absolute performance of Chinese stocks in the near-run. China And Commodities An important question to address is whether the rally in commodities in general and copper in particular are signals of a sustainable recovery in the mainland economy. Without a doubt, economic conditions in China have been improving, and infrastructure spending has been accelerating. However, the magnitude of the upswing in copper prices is excessive relative to the strength of the Chinese economy. The spike in resource prices in general and copper in particular has been due to three forces: (1) China’s unprecedented super-strong imports; (2) global investors buying commodities; and (3) output cuts. It is highly unlikely that commodity demand in China is this strong. In our opinion, this reflects restocking. Chart 11 shows that Chinse imports of copper and copper products surged by 100% in June from a year ago, while imports of steel products increased by 100% and oil import volumes rose by 34%. It is highly unlikely that commodity demand in China is this strong. In our opinion, this reflects restocking. Provided cheap credit availability, wholesalers, intermediaries or users of commodities have rushed to buy before prices rise further. In the case of copper, it will take several months before the real economy absorbs that much of the red metal. Hence, China’s copper imports are poised to relapse in the coming months.   Chart 12 illustrates that investors’ net long positions in copper have risen to their highest level since early 2019. Consistently, the July Bank of America/Meryl Lynch Global Fund Manager Survey revealed that as of early July, portfolio managers had built up their largest net long positions in commodities since July 2011.   Not only oil but also copper and iron ore prices have benefitted from production declines. Due to surging COVID infections, Chile and Peru have sharply reduced copper output and Brazil has curtailed iron ore production. Chart 11Chinese Imports Of Commodities Have Surged Chinese Imports Of Commodities Have Surged Chinese Imports Of Commodities Have Surged Chart 12Investors Have Gone Long Copper Investors Have Gone Long Copper Investors Have Gone Long Copper Simultaneous buying of commodities by China and global investors as well as production cuts have considerably benefited resource prices as of late. Our suspicion is that commodities inventories in China have become elevated. This entails reduced purchases by China, and by extension an air pocket in commodities prices in the months ahead. Bottom Line: The rally in resources in general and copper in particular is at risk of a correction. We remain long gold/short copper.     Investment Strategy In absolute terms, the risk-reward of EM share prices is not attractive. However, as we have argued in the past two months, FOMO (fear-of-missing-out) mania forces could take share prices higher. The timing of a reversal is never easy especially when a FOMO-driven mania is alive. For now, for asset allocators we reiterate a below-benchmark allocation in EM stocks within a global equity portfolio. However, a breakdown in the trade-weighted US dollar will prompt us to upgrade EM within the global equity benchmark (Chart 13). The broad trade-weighted dollar is teetering on an edge but has not yet broken down (Chart 14). In sum, global equity portfolios should be ready to upgrade their EM allocation to neutral on signs that the broad trade-weighted US dollar is breaking down. Chart 13EM vs DM: Is The Downtrend Intact? EM vs DM: Is The Downtrend Intact? EM vs DM: Is The Downtrend Intact? Chart 14The Broad Trade-Weighted Dollar Is On An Edge The Broad Trade-Weighted Dollar Is On An Edge The Broad Trade-Weighted Dollar Is On An Edge   As we argued last week, the US dollar could weaken against DM currencies amid the next selloff in global share prices. This is why last week we switched our short positions in an EM currency basket from the US dollar to an equally-weighted basket of the euro, the Swiss franc and Japanese yen. This strategy remains valid. The US dollar is at risk versus DM currencies. However, EM exchange rates may not be out of the woods, given their poor fundamentals on the one hand and potential geopolitical risks in North Asia on the other. We are neutral on both EM local currency bonds and EM sovereign and corporate credit.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Please see Emerging Markets Strategy Special Report "How To Play EM In The Coming Decade," dated June 10, 2010. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories Watch For Falling Inventories Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com