Commodities & Energy Sector

Highlights The May-June WTI spread settled earlier in the week at a $7.29/bbl contango, the widest level since February 2009 during the GFC. This reflects an extraordinarily tight storage market in the US Gulf and Midcontinent. WTI for May delivery breached $20/bbl Wednesday, touching a 18-year low (Chart of the Week). Output cuts starting in May agreed by OPEC 2.0 over the weekend will remove 6.1mm b/d on average for May-December vs. 1Q20 levels. Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y. We raised our estimate of COVID-19-induced demand destruction in 2Q20 to 14.6mm b/d from 12.1mm b/d. We expect demand to fall ~ 8mm b/d in 2020 vs. our previous estimate of 4mm b/d, as global fiscal and monetary stimulus revives growth in 2H20. We expect 2021 demand to rise 7.7mm b/d, averaging 100.6mm b/d. In our updated forecast, Brent is expected to average $39/bbl – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Our Brent forecast for 2021 remains ~ $65/bbl. WTI will trade $2-$4/bbl lower. Feature   April is the cruellest month … - T.S. Eliot, The Waste Land1 Global oil logistical capacity will be tested in extremis this month, as cargoes laden with oil arrive in ports that have no need for ready supply and few storage options to hold the crude until its needed. This is filling traditional global storage, inland pipelines and ships, which, as typically occurs in extremis, are used as floating storage (Chart 2). Chart of the WeekCrude Oil In Extremis Crude Oil In Extremis Crude Oil In Extremis Chart 2Floating Storage Volumes Soar As Terminals and Pipelines Fill Floating Storage Volumes Soar As Terminals and Pipelines Fill Floating Storage Volumes Soar As Terminals and Pipelines Fill The most extreme testing of global logistics likely will occur in this cruel month, to borrow once again from the laureate, as markets are forced to absorb the production surge from OPEC 2.0 – mostly from KSA and its allies. Repeated excursions to and through $10/bbl in physical markets, as already have been registered in Canada and US shale basins, can be expected this month (Chart 3). Indeed, we expect price pressures to reduce US oil ouput – mostly in the shales – by 1.5mm b/d or more.2 Beginning in May, OPEC 2.0 will begin cutting production, with its putative leaders – KSA and Russia – accounting for 1.3mm b/d and 2.1mm b/d, respectively, of the coalition’s total pledged cuts of 7.6mm b/d vs. 1Q20 production levels. (Based on OPEC 2.0’s October 1, 2018, reference level – except for KSA and Russia, both of which are cutting from a nominal 11mm b/d level – the cuts amount to 9.7mm b/d for May-June, and 7.7mm b/d for 2H20).3 Chart 3Cash Markets Pressing /bbl Cash Markets Pressing $10/bbl Cash Markets Pressing $10/bbl While the official OPEC communique notes the coalition also will implement a 6mm b/d cut from January 2021 to April 2022, we doubt this will be necessary. The coalition meets again in June, and KSA’s Energy Minister, Prince Abdulaziz bin Salman, said the Kingdom is prepared to increase its cuts if needed.4 Based on historical experience, we expect KSA to over-deliver on cuts, and for Russia to gradually meet its pledged volumes. We are haircutting other states’ production cuts based on historical observation, and are projecting cuts of ~ 75% for 2020 and 70% for 2021 compliance (Table 1). Additional losses outside OPEC 2.0 will reduce global supply 4.5mm b/d y/y on average. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) US Storage Tightens, Pushing WTI Lower US Storage Tightens, Pushing WTI Lower Lowering Our Demand Forecast The COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008. Our estimate of COVID-19-induced demand destruction in 2Q20 is now 14.6mm b/d, up from 12.1mm b/d. For all of 2020, we expect demand to fall 7.9mm b/d in our base case vs. our previous estimate of 4mm b/d. These estimates are highly conditional on the trajectory of the containment of the COVID-19 pandemic, which, owing to the global lockdowns, has literally shut the majority of the world’s economies down, and produced a global real GDP contraction far greater than the recession the Global Financial Crisis (GFC) produced in 2008 (Chart 4). Nonetheless, we believe the massive global fiscal and monetary stimulus now being deployed will restore growth beginning in 2H20 and carrying through to expect 2021 demand to rise 7.7mm b/d, and to average 100.6mm b/d (Chart 5). Chart 4COVID-19 Real GDP Hits Dwarf 2009 GFC Recession US Storage Tightens, Pushing WTI Lower US Storage Tightens, Pushing WTI Lower Chart 5Massive Stimulus Will Revive Demand US Storage Tightens, Pushing WTI Lower US Storage Tightens, Pushing WTI Lower We assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. While our demand expectations are slightly weaker, in our modeling we see supply being curtailed sufficiently to produce a physical deficit beginning in 3Q20 (Chart 6). Our supply-demand trajectory projects a peak in OECD storage of 3.7 billion barrels in May, after which inventories fall sharply (Chart 7). Indeed, we assume OPEC 2.0 will be required to raise production in 2021 to keep prices from accelerating too fast. Chart 6Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Oil Supply-Demand Balances Point To Physical Deficit By 4Q20 Chart 7Inventories Spike, Then Draw Sharply Inventories Spike, Then Draw Sharply Inventories Spike, Then Draw Sharply Two-Way Price Risk Our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. In our updated forecast, we see Brent averaging $39/bbl this year – slightly above our earlier $35/bbl estimate – as incremental supply losses offset lower demand. Next year, our expectation remains ~ $65/bbl. WTI will trade $2-$4/bbl lower (Chart 8). As noted above, our forecast assumes the COVID-19 pandemic is contained and that fiscal and monetary stimulus re-energizes global growth. However, as the pandemic spreads deeper into less-developed EM economies without robust public-health infrastructures, or social security systems providing a basic income in the event of job loss due to recessions the risk of widespread infection rises significantly.5 Chart 8Stronger Price Recovery Expected Stronger Price Recovery Expected Stronger Price Recovery Expected No amount of fiscal or monetary stimulus will allow an economy to weather such a storm. This is a clear and present danger to the global recovery and to a recovery in commodities generally, oil in particular. Investment Implications Our expectation for prices is reflected in Chart 8, premised, again, on COVID-19 being contained and fiscal and monetary stimulus reviving global growth. We are retaining our long exposure to the market, expecting the supply and demand policies set in motion will be effective. However, there is no way of accurately assessing the likelihood of an uncontained pandemic hitting EM markets, and, from there, re-entering other markets that presumably have dealt with the coronavirus.   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 Global oil inventories will be filled rapidly in 2Q20 as major economies remain in lockdowns. High-cost Canadian oil sand producers will be severely hit as their output is landlocked, distant from key demand centers, and facing storage and pipeline infrastructure constraints. More than 500k b/d of production will be shut-in in April and May as crude-by-rail collapses, local and US refinery runs are reduced, and Alberta’s limited inventory moves closer to its maximum capacity – estimated at ~ 90mm bbls (Chart 9). Separately, a €20/MT stop to our EUA futures recommendation was triggered on April 14, 2020, leaving us with a 14.2% gain. Base Metals: Neutral China’s iron ore imports fell to 85.9mm MT in March, a decline 0.6% y/y, after growing 1.5% in January and February. This came as steel mills arranged maintenance or slowed production to deal with record-high inventories after the COVID-19 pandemic curtailed construction and industrial activities. However, in the long run the outlook for iron ore and steel appears to be improving. Mysteel data for China indicates utilization rates at blast furnaces have been rising for four weeks and are now at ~ 79%. Chinese Steel exports also picked up in March, up 2.4% from a year earlier, but are now facing new anti-dumping duties on stainless steel in the EU. Precious Metals: Neutral Gold continues to trade above $1700/oz – reaching its highest level since October 2012 – supported by easing fiscal and monetary policy in the US and fear of a prolonged economic slowdown. A lower US dollar – the DXY index fell back below 100 last week – and depressed real rates supported gold’s move higher (Chart 10). Dollar debasement risks and negative real rates increase gold’s attractiveness as a safe asset. Ags/Softs:  Underweight China’s March soybean imports came in at 4.28mm MT y/y, the lowest level since February 2015. Rains in Brazil delayed that country’s exports to China. The fall also reflects a 6% contraction in soymeal (i.e., the “crush”) consumed by livestock – as the African Swine Fever slashed China’s pig herd by more than 40% and shortages forced operations to grind to a halt. Similarly, meat suppliers in the US and Canada are closing plants temporarily due to COVID-19 cases among employees. As a result, Chicago soybean futures traded 0.8% lower on Tuesday. Chart 9Limited Storage Capacity In Alberta Limited Storage Capacity In Alberta Limited Storage Capacity In Alberta Chart 10Lower US Rates And Dollar Support Gold Lower US Rates And Dollar Support Gold Lower US Rates And Dollar Support Gold   Footnotes 1     The Waste Land, by T.S. Eliot, originally was published in 1922 in The Criterion, which was founded and edited by Eliot. 2     The Texas Railroad Commission held day-long hearings April 14 to consider returning to its historic roll as an oil-production regulator on Tuesday.  As we went to press no ruling on the petition to revive pro-rationing was delivered.  The Oklahoma Corporation Commission will hold similar hearings next month.  Please see Texas and Oklahoma weigh production quotas for oil published by washingtonpost.com April 13, 2020. 3    Please see The 10th (Extraordinary) OPEC and non-OPEC Ministerial Meeting concludes, posted by OPEC April 12, 2020. 4    Please see Saudi energy minister leaves door open for more cuts in June, published by worldoil.com April 13, 2020. 5    Please see National governments have gone big. The IMF and World Bank need to do the same. This op-ed by Gordon Brown and Larry Summers, published by washingtonpost.com April 14, 2020, lays out some of the issues that elevate downside risk to a COVID-19 recovery.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 US Storage Tightens, Pushing WTI Lower US Storage Tightens, Pushing WTI Lower Commodity Prices and Plays Reference Table   Trades Closed in 2020 Summary of Closed Trades US Storage Tightens, Pushing WTI Lower US Storage Tightens, Pushing WTI Lower

Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 Sales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters 2008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement 2009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-7European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper Nickel Vs. Copper Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... A Mixed Performance For Euro Area Investment Grade Spreads By Industry ... Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks ... With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis ... Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Buy What The Central Banks Are Buying Buy What The Central Banks Are Buying Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Oil prices are up strongly from their lows, but conditions for a durable bottom may not yet be in place. The main hiccup is that an air pocket will likely remain under global oil demand until most social-distancing measures are lifted. That said, most petrocurrencies offer a significant valuation cushion, making them attractive for longer-term investors. We will look to buy a basket of petrocurrencies on further weakness. The Asian economies that were closer to the epicenter of the epidemic are likely to recover faster than the West. Transport and electricity energy demand should pick up in these economies faster. AUD/CAD and AUD/EUR should benefit from this dynamic. CAD/USD is likely to weaken in the short term as Canadian crude remains trapped in Alberta, but then strengthen as the global economy recovers. Feature Chart I-1Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Massive Liquidation In Crude Oil Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $20 (Chart I-1). The extraordinary drop has sent many petrocurrencies, including the Norwegian krone, Mexican peso, and Canadian dollar, into freefall. The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Meanwhile, the trading of petrocurrencies is also complicated by a shifting production landscape among many oil producers. For investors, three key questions will determine whether petrocurrencies are a buy: Have we approached capitulation lows in oil prices? If so, what will be the velocity and magnitude of the demand recovery? Will the correlation between oil and petrocurrencies still hold once the dust settles? Have We Approached Capitulation Lows? In terms of magnitude and duration, yes. Over the last two decades, oil price drawdowns have tended to last between 8 and 20 months before a durable rally ensues. The oil price collapse from July 2008 to February 2009 lasted around 8 months. The decline from June 2014 to February 2016 was much longer, around 20 months. Given the October 2018 peak in oil prices, we should be very close to the bottom in terms of duration. Remarkably, in all episodes, the peak-to-trough decline in the West Texas Intermediate (WTI) blend has been around 75% (Chart I-2).   However, since the 1970s, oil has moved in a well-defined pattern of a 10-year bull market, followed by a 20-year bear market (Chart I-3). Assuming the bear market in oil began just after the global financial crisis, it does suggest that even if prices do recover, it will most likely be a bear-market rally. That said, history also suggests that these bear market rallies in oil can be quite powerful, with prices often doubling or trebling. As we go to press, oil prices are up a remarkable 18% from their lows Chart I-2Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Similar In Magnitude To Prior Oil Crashes Chart I-3Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows Oil Prices Are Close To Capitulation Lows What is different this time? Aside from a breakdown in OPEC+, a few other factors are in play. This alters the timing and duration of an intermediate-term bottom: Any coordinated supply response will need to involve the US to be viable.1 The OPEC+ cartel, specifically the alliance between Russia and Saudi Arabia, is broken. Chart I-4 illustrates why. While being the stewards of global oil production discipline, there has been one sole benefactor – the US. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces around 15% of global crude, having grabbed market share from many other countries. Chart I-4US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts US Is The Big Winner From OPEC Cuts As we go to press, there are reports that Saudi Arabia and Russia have come to an agreement. However, the history of OPEC alliances suggests that it is fraught with broken promises.  Oil still trades above cash costs for many producing countries, meaning the incentive to boost production in times of a demand shock is quite strong (Chart I-5). Ditto if oil prices are recovering. Oil futures are in a massive contango, with WTI trading close to $40 per barrel two years out. This incentivizes players with strong balance sheets to keep the taps open. The oil curve needs to shift significantly lower, probably pushing some blends into negative spot territory, in order to force production discipline on some players.   Chart I-5Oil Still Trading Above Cost Of Production A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies The dollar has been strong, meaning the local-currency revenues of oil producers have been cushioning part of the downdraft in oil prices. This could sustain production longer than would otherwise be the case, especially in a liquidation phase. The New York Fed’s model suggests that most of the downdraft in oil prices since 2010 has been due to rising supply (Chart I-6). Chart I-6Oil Downdraft Driven By Supply A New Paradigm For Petrocurrencies A New Paradigm For Petrocurrencies Both Saudi Arabia and Russia have low public debt and ample foreign exchange reserves. This buys them time in terms of dealing with a prolonged period of low prices. We know there will be massive economic pain from the oil price collapse (Chart I-7). The good news is that with the economic slowdown already in place, it may well be the catalyst needed to enforce any agreement put into effect. Chart I-7The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers The Coming Economic Pain For Oil Producers While the positive correlation between oil prices and petrocurrencies has weakened in recent years, it has been re-established during the current downturn. More importantly, should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit. Should production cuts be led by US shale producers, this will redistribute market share to OPEC and other non-OPEC members, allowing their currencies to benefit.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-8). Since then, that correlation has fallen from around 0.9 to about 0.3. Chart I-8Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Falling Correlation Between Petrocurrencies And The US Dollar Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter (Chart I-9). This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Chart I-9A Shifting Export Landscape A Shifting Export Landscape A Shifting Export Landscape That said, in the case of Canada and Norway, petroleum still represents over 20% and 50% of total exports. For Russia, Saudi Arabia, Iran or Venezuela, the number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast. Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. This correlation should remain in place if oil prices put in a definitive bottom, and it should strengthen if production cuts are led by the US. When Will Oil Demand Recover? Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a sudden stop in economic activity. Transport constitutes the largest share of global petroleum demand. Ergo the economic lockdowns have brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt. Encouragingly, passenger traffic in China has started to pick up as the number of new Covid-19 cases flattens, and the country is gradually reopening for business. There has also been an improvement in the manufacturing data. All eyes will be watching if the relaxation of measures in China lead to a second wave of infections. Otherwise, should the Western economies follow the Chinese recovery path, then the world will be open for business by the end of the summer (Chart I-10). One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro.  Part of the slowdown in global demand is being reflected through elevated oil inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-11). Chinese oil imports continue to hold up well, and should easier financial conditions continue to put a floor under the manufacturing cycle, overall consumption will follow suit. Chart I-10Some Optimism For The West Some Optimism For The West Some Optimism For The West Chart I-11Watch For A Peak In Inventories Watch For A Peak In Inventories Watch For A Peak In Inventories One way to play an early restart in Asia relative to the West is to go long the Australian dollar, relative to a basket of the Canadian dollar and the euro. There are three key reasons which support this trade: Liquefied natural gas will become the most important component of Australia’s export mix in the next few years (Chart I-12). As Beijing restarts its economy and electricity production picks up, Aussie exports will benefit. Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. The massive drop in pollution resulting from the shutdown will all but assure that this push occurs sooner rather than later. Chart I-12LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia There was already pent-up demand in the Australian economy going into the crisis, given the destruction of the capital stock from the fires. With an economy that was already running well below capacity, construction activity should see a V-shaped rebound once social distancing measures are relaxed. As the currency of the now largest oil producer in the world, the US dollar is becoming a petrocurrency itself. In this new paradigm, a better strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. AUD/EUR benefits from this. Chart I-13 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. Chart I-13Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Eventually, a pickup in manufacturing activity will be a global phenomenon rather than localized within Asia. When this happens, other petrocurrencies will begin to benefit. This will especially be the case for producers where production is more landlocked. Bottom Line: A recovery in global transport will help revive oil demand. This should be positive for oil prices in general and petrocurrencies in particular. One way to play the recovery in Asia relative to the West for now is to go long AUD/CAD and AUD/EUR. On CAD, NOK, MXN, RUB And COP Chart I-14NOK Will Outperform CAD NOK Will Outperform CAD NOK Will Outperform CAD While Canadian crude is likely to remain trapped in the oil sands, North Sea crude will face less transportation bottlenecks in the near term. This suggests the path of least resistance for CAD/NOK is down (Chart I-14). We were stopped out of our short CAD/NOK trade, but still recommend this position as a play on this dynamic. We are already long the Norwegian krone versus a basket of the euro and dollar. CAD/USD has been displaying a series of higher lows since the March 18 bottom, but the double-top formation in place since then suggests we could see some weakness in the near term. Should CAD/USD retest its recent lows, driven by a relapse in oil prices, we will be buyers.  Many petrocurrencies, including the Mexican and Colombian pesos, have become quite cheap and are attractive on a longer-term basis (Chart I-15). Given the uncertainty surrounding the nearer-term outlook, we a placing a limit buy on a broad basket of these currencies at -5%. Should oil prices retest the lows in the coming weeks/months, it will imply an 18% drop. Given the correlation between petrocurrencies and oil of 0.3, this suggests a 5.3% move lower.  Chart I-15ASome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Chart I-15BSome Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Some Petrocurrencies Are Very Cheap Bottom Line: Place a limit buy on a petrocurrency basket at -5%.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Commodity & Energy Strategy Weekly Report, “The Birth Of WOPEC,” dated April 9, 2020, available at ces.bcaresearch.com Currencies U.S. 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 negative: The unemployment rate soared from 3.5% to 4.4% in March. Nonfarm payrolls recorded a total loss of 701K jobs, the first decline in payrolls since September 2010. The NFIB business optimism index plunged from 104.5 to 96.4 in March. Initial jobless claims surged by 6.6 million last week, higher than the expected 5.3 million. Michigan consumer sentiment declined to 71 from 89.1 in April. The DXY index fell by 0.7% this week. Risk assets have recovered, fueled by an extra USD $2.3 trillion stimulus from the Federal Reserve. The lesson we are learning is that the deeper the perceived slowdown, the more the Fed will do to assuage any economic damage. As for currencies, what matters is relative monetary policies. The key variable to stem the rise in the USD is that the liquidity crisis does not morph into a solvency one. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 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 mostly negative: Markit services PMI fell further to 26.4 in March from 28.4 the previous month. The Sentix investor confidence dived to -42.9 from -17.1 in April. Moreover, the Sentix current situation index fell from -15 to -66 in April, while the outlook index moved up slightly from -20 to -15. EUR/USD appreciated by 0.5% this week. The euro zone members failed to reach an agreement on the joint EU debt issuance. On the other hand, the ECB adopted an unprecedented set of collateral measures to mitigate the negative impacts from COVID-19 across the euro area, including easing collateral conditions for credit claims, reduction of collateral valuation haircut, and waiver to accept Greek sovereign debt instruments as collateral.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Consumer confidence fell to 30.9 from 38.4 in March. Labor cash earnings grew by 1% year-on-year in February, but slowed from 1.2% in January. The Eco Watchers Survey current index fell from 27.4 to 14.2 in March. The outlook index also declined from 24.6 to 18.8. The Japanese yen fell by 1% against the US dollar this week. On Wednesday, the BoJ announced that it would scale back some non-urgent operations such as long-term research and studies for academic papers, following the government’s decision to declare a state of emergency. The Reuters poll forecasted the Q1 GDP to shrink by 3.7% quarter-on-quarter and Q2 by 6.1%. 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 dismal: Markit construction PMI plunged to 39.3 from 52.6 in March. GfK consumer confidence crashed to -34 from -9 in March. Total trade balance (including EU) shifted to a deficit of £2.8 billion from a surplus of £2.4 billion in February. The goods trade deficit widened from £5.8 billion to £11.5 billion. GBP/USD rose by 0.6% this week. After being told to cut dividends last week, the UK banks are now pressuring the BoE on fresh capital relief to help fight the COVID-19. The BoE has also agreed to temporarily lend the government money, funded through money printing. The details suggest the operations are temporary, but the BoE might be the first central bank to formally step closer to MMT. 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 negative: The AiG services performance index fell from 47 to 38.7 in March. Imports and exports both slumped 4% and 5% month-on-month respectively in February. The trade surplus narrowed from A$5.2 billion to A$4.4 billion.  The Australian dollar surged by 3.8% against the US dollar, making it the best performing G10 currency this week. The RBA held interest rate steady at 0.25% on Tuesday, while warning the country is in for a “very large” economic contraction. Lowe also suggested that the economy will “much depend on the success of the efforts to contain the virus and how long the social distancing measures need to remain in place”. 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 Recent data in New Zealand have been dismal: NZIER business confidence survey reported that a net 70% of firms expect general business conditions to deteriorate in Q1, compared to 21% in the previous quarter. Electronic card retail sales contracted by 1.8% year-on-year in March, down from 8.6% growth the previous month. The New Zealand dollar recovered by 1.7% against the US dollar this week. In addition to the NZ$30 billion purchases of central government bonds, the RBNZ is stepping up the QE program by offering to buy up to NZ$3 billion of local government bonds to support liquidity. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been dismal: Bloomberg Nanos confidence fell further from 46.9 to 42.7 the week ended April 3. Housing starts increased by 195K year-on-year in March, down from 211K in February. Building permits contracted by 7.3% month-on-month in February. On the labor market front, the pandemic has caused the unemployment rate to rise sharply from 5.6% to 7.8% in March, higher than the expected 7.2%. Employment fell by more than one million (-1,011,000 or -5.3%). The Canadian dollar rose by 1.2% against the US dollar this week, supported by the tentative rebound in oil prices. The BoC spring Business Outlook Survey shows that business sentiment had softened even before COVID-19 concerns intensified in Canada. The overall survey indicator fell below 0 to -0.68 in Q1. Businesses tied to the energy sector were hit the most due to falling oil prices. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Total sight deposits were little changed at CHF 627 billion for the week ended April 3. The unemployment rate jumped from 2.5% to 2.9% in March, above expectations of 2.8%. The number of total unemployed increased by 15%, now reaching 136K. The Swiss franc appreciated by 0.6% against the US dollar this week. The Swiss government forecasted the output to slump 10% this year under the worst-case scenario, given the incoming data proved worse than expected. On the positive side, the government said it would gradually relax restriction measures later this month should the current situation improve. 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 negative: The unemployment rate surged to 10.7% in March from 2.3%. Manufacturing output fell by 0.5% month-on-month in February. Headline inflation fell from 0.9% to 0.7% year-on-year in March, while core inflation remained unchanged at 2.1%.  The Norwegian krone rose by 2.8% against the US dollar this week, up 18% from its recent low three weeks ago. Norway will likely relax some restrictions later this month while the ban on public gatherings will still remain in place. The loosening of COVID-19 measures, together with oil prices recovering and cheap valuations all underpin the Norwegian krone in the long run. Please refer to our front section this week for more detailed analysis. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 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 mixed: Industrial production fell by 0.2% year-on-year in February. Manufacturing new orders increased by 6% year-on-year in February. Household consumption increased by 2.3% year-on-year in February, up from 1.6% the previous month. The Swedish krona increased by 1% against the US dollar this week. The recent efforts in buying up bonds by the Riksbank to increase liquidity amid COVID-19 is likely to increase the debt burden in Sweden. The stock of Swedish Treasury bills held by the Riksbank is estimated to be SEK 300 billion by the end of this year, compared to only 55 billion in February. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights A World Organization of the Petroleum Exporting Countries (WOPEC) looks set to emerge after today’s OPEC 2.0 video conference to discuss production cuts in the wake of the COVID-19 pandemic, and the market-share war between the leaders of the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. WOPEC will not be memorialized by a Declaration of Cooperation as OPEC 2.0 was.  Oil exporters globally will cooperate on harmonizing policy to meet demand. In our latest scenario concentrating on likely supply responses, we show cuts of ~ 8mm b/d will be sufficient to clear the storage overhang caused by COVID-19-induced demand destruction of close to 4mm b/d this year. Based on this modeling, we see Brent prices averaging $36/bbl and $64/bbl this year and next, with WTI trading $2-$6/bbl lower, depending on US Gulf storage availability. This is roughly in line with our previous scenario (Chart of the Week).1 Demand destruction over 4mm b/d would require additional production cuts. Feature The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action. Chart of the WeekExpect A Sharp Oil Price Recovery Expect A Sharp Oil Price Recovery Expect A Sharp Oil Price Recovery Chart 2The Oil-Price Collapse Of 2020 The Oil-Price Collapse Of 2020 The Oil-Price Collapse Of 2020 WOPEC is bigger than OPEC 3.0 – an unofficial grouping we hypothesized at the end of March to encompass the expected future cooperation of KSA, Russia and the Texas Railroad Commission (RRC) – our shorthand for US oil-producing interests – succeeding OPEC 2.0. Today’s OPEC 2.0 video conference originally was called by KSA for Monday, but was moved to today – presumably – to give member states time to agree production cuts. The conference most likely was delayed by the acrimonious public exchange between its leaders this past weekend.2 On the heels of the OPEC 2.0 video conference comes a hastily called video conference on Friday of G20 energy ministers to discuss energy security. The G20 is led by KSA this year.3 The 2020 oil price collapse brought on by COVID-19 – and super-charged by the market-share war declared by Russia following the breakdown of OPEC 2.0’s March 6 meeting – has spurred oil-producing states globally to action (Chart 2). KSA, Russia and their respective OPEC 2.0 allies all are fully invested in this meeting, as are producers in the US, Canada, Norway and Brazil.4 Supply Destruction Vs.Production Cuts Oil producers face a stark choice: Either cut production voluntarily to counter the global demand destruction of a pandemic, or have the market do it for them by driving prices through cash costs toward zero (i.e., $0.00/bbl), as global crude oil and product storage fills. Prices in some basins have fallen close to zero after accounting for the basis differentials to benchmark prices and transport costs (e.g., WTI-Midland), which, in the US has begun to force shut-ins (Chart 3).5 Continued weak pricing close to zero risks shutting older, high-cost landlocked production in permanently, and many states simply cannot afford to lose the critical revenue provided by oil exports. Chief among these states are the non-Gulf members of OPEC, excluding Russia, US onshore, and Canada, which we identify as “The Other Guys” (Chart 4).6 Chart 3Some Crude Grades Priced Close To $0.00/bbl Some Crude Grades Priced Close to $0.00/bbl Some Crude Grades Priced Close to $0.00/bbl Chart 4"The Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal The "Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal The "Other Guys" Production Declines Would Moderate With OPEC 2.0 Deal We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. The chief contribution of The Other Guys to the OPEC 2.0 coalition’s production-management scheme is their managed production decline. These states were only starting to recover from the Global Financial Crisis (GFC) beginning in 2010 when the OPEC market-share war of 2014-16 was declared. The COVID-19 price collapse, coupled with the knock-on effects of the 2020 KSA-Russia market-share war likely accelerates the rate of production decline for the Other Guys, as capital continues to avoid developing their resources. We expect The Other Guys in OPEC 2.0 will lose 700k b/d, with 400k b/d of that realized over the course of 2021. Core OPEC and Russia can increase (and decrease) production, and we expect they will deliver the largest part of the OPEC 2.0 production cuts. In this week’s simulation, we project KSA will cut 2mm b/d, from their April level of from 12mm b/d; and Russia will cut 1.1mm b/d, down from 11.6mm b/d. We then project Iraq will cut 460k b/d; Kuwait 280k b/d; and the UAE 315k b/d. Outside OPEC 2.0, a lot of the production we expect will be cut is out of necessity. Canada, for example, will be forced to either shut in high-cost tar-sands production or go back to pro-rating production as it did last year, owing to a lack of storage in Alberta and pipeline takeaway capacity to move their crude south to US refiners. We expect Canada to cut 350k b/d this year, as a result. Brazil’s Petrobras already has shut in 100k b/d, and US producers have begun shutting in shale-oil production.7 US Production Cuts Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Production cuts most likely will be focused on the US, as this is the most easy-to-adjust output in the world. It also still is higher up the global cost curve, although, as we have noted earlier, this will change in the event bankruptcies pick up.8 In the US, production cuts already have begun. They are and will continue to be focused on the shales. We continue to project cuts in the US shales of ~ 1.5 mm b/d this year. However, this number could be higher: If producers respond to the collapse in prices by not sending any new rigs to the field in the next 12 months, production will fall by 2.9mm b/d from production declines alone. Just to keep production flat, the US shales will need an average of ~ 520 rigs per month (assuming no drilled-uncompleted wells are finished). The risk on our rig-count estimates are straightforward: If rig counts go much lower, we could see a large decline in shale production in the coming months (Chart 5). Chart 5US Shale Output Falls This Year And Next The Birth Of WOPEC The Birth Of WOPEC Some of the more efficient producers in The Great State of Texas have been calling for pro-rationing of up to 20%, which would push the cuts in Texas’s Permian and Eagle Ford shale basins alone to 1.23mm b/d. Including the Anadarko Basin, most of which is in Oklahoma, which also permits pro-rationing, 20% pro-rationing would push TX-OK cuts to ~ 1.33mm b/d. As we have been writing over the past month, we could see a return of pro-rationing in the states of Texas and Oklahoma. In the Great State, producers have filed a petition before the Texas RRC asking the Commission to reprise its 1928-73 production-management role.9 The Texas RRC will hold a video conference Tuesday, April 14, to consider this petition. We’re expecting this petition to be granted, and for pro-rationing to begin in the near future. On the demand side, we are staying with the scenario we presented March 30, with 2Q20 demand falling ~ 12mm b/d (y/y vs. 2Q19). In 2H20, we project demand to grow at a rate of 800k b/d by 4Q20. For all of 2020, we model average demand losses equal to 3.8mm b/d. For 2021, massive fiscal and monetary stimulus globally will lift demand 5.3mm b/d. With the supply cuts projected above and our demand view, we see balances tightening over the course of the year and moving into a physical deficit in 4Q20 (Chart 6). While near-term oversupply will force inventories to grow sharply, we expect them to draw as sharply beginning by September and continuing into next year (Chart 7). Chart 6Supply-Demand Imbalance Will Tighten Into 2021 Supply-Demand Imbalance Will Tighten Into 2021 Supply-Demand Imbalance Will Tighten Into 2021 Chart 7Inventories Will Build Sharply, Then Draw Sharply in 2021 Inventories Will Build Sharply, Then Draw Sharply in 2021 Inventories Will Build Sharply, Then Draw Sharply in 2021 Investment Implications Our projections for supply presented this week and our demand scenario presented at the end of March are evolving into our base case for oil and gas. We still do not know with certainty the OPEC 2.0 coalition will agree to production cuts today, or whether the Texas RRC will return to the business of pro-rationing. If either or both of these outcomes does not materialize, markets will take over and savagely destroy supply. This will be extremely volatile. For our part, we expect OPEC 2.0, the Other Guys outside the coalition, and the US shales to deliver something that looks like voluntary cuts. This will occur via voluntary cuts, “managed” declines, and pro-rationing and shut-ins. Unlike many of our economist colleagues who argue against such jointly coordinated policies – invoking a free-market, pure-competition paradigm that has not existed for any meaningful period in the modern history of the oil market – we believe producers are intelligently pursuing their interests by jointly coordinating the boom-bust mayhem of unfettered oil markets. Similarly, we believe consumers are better served by diversified sources of energy vs. an over-reliance on large concentrated supplies who can use their low-cost endowment to monopolize supply and set up barrier to entry to competition. Given our view, we remain constructive to the oil market, expecting a rally that will look a lot like the Chart of the Week and the balances we show in Chart 7. As a result, we are getting long 2H21 Brent vs. short 2H22 Brent futures.   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 Defying the global rush to cut oil production, Mexico apparently is moving toward increasing production. Petroleos Mexicanos (PEMEX) is looking to drill 423 wells this year, according to Bloomberg. A March 26 Journal of Petroleum Technology survey suggests capex by E&P companies will fall by up to 35% this year. Base Metals: Neutral This week Japan’s Nippon Steel became the latest producer to idle blast furnaces, halting about 15% of the company’s total capacity. More generally an iron ore surplus in other parts of Asia and in Europe is expected as steel mills idle furnaces amidst lower demand for their output. However, diminished activities in mines – severely impacted by lockdowns – will offset some of the demand loss. COVID-19 induced shutdown in South Africa, Iran, India and Canada have curtailed exports from those countries until late April. Additionally, bad weather in Brazil led iron ore exports to fall on a yoy basis for the third month in a row in March. A decline of ~ 2% vs. last year’s already depressed – following the Vale dam incident – levels. China’s anticipated infrastructure stimulus will support iron ore demand, drawing down inventories and pushing up prices, but it, too, will be tempered by the pace of the recovery in its export markets. Precious Metals: Neutral A strong US dollar remains an important risk for precious metals. The dollar rose 1.6% since March 28 despite the Fed’s actions to calm the global dollar liquidity squeeze. This signals the funding crisis has not been thoroughly controlled and that swap lines will have to be extended to additional EM central banks. However, a large share of outstanding foreign exchange swaps/forwards resides in non-bank financial corporations and institutions with limited access to dollar funding via central bank swap lines. Over the short-term, our gold price recommendation remains vulnerable to deterioration, due to uncertain liquidity conditions (Chart 8). Ags/Softs:  Underweight This week we begin tracking the lumber market. Lumber consumption fell sharply as the coronavirus spread in the United States, pushing front-month futures down 44% from February highs. With housing starts already weak in February – down 1.5% month on month – and expected to be even weaker in March (Chart 9), continued lumber supply curtailments will stabilize prices in the short term and eventually push prices up once lower interest rates kick in and demand resumes. Chart 8 Global USD Squeeze Could Threaten Gold Again Global USD Squeeze Could Threaten Gold Again Chart 9 Lumber Hammered As COVID-19 Pounds Housing Starts Lumber Hammered As COVID-19 Pounds Housing Starts       1     Please see OPEC 3.0 In the Offing?, published March 30, 2020, which focused on demand destruction. 2     Please see OPEC+ meeting delayed as Saudi Arabia and Russia row over oil price collapse: sources, and G20 energy ministers to hold video conference on Friday: document published by reuters.com April 4 and April 7, 2020. 3    The G20 consists of Argentina, Australia, Brazil, Canada, China, Germany, France, India, Indonesia, Italy, Japan, Mexico, the Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, the UK, the US and the EU. 4    Please see A look at the major players in this week’s “OPEC++” meeting, a Bloomberg analysis published by worldoil.com April 7, 2020. 5    Please see Can the world agree a deal to boost oil prices? Published by Wood MacKenzie April 3, 2020.  6    The Other Guys is our moniker for all producers excluding core-OPEC, US shale, Russia and Canada. Production from this group of producers has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. 7     In its latest Short-Term Energy Forecast, the EIA estimates US crude oil production will fall 500k b/d this year and 700k b/d next year, driven by market forces. 8    For a discussion, please see How Long Will The Oil-Price Rout Last?, a Special Report we published with BCA Research’s Geopolitical Strategy March 9, 2020. It is available at ces.bcaresearch.com. 9    Please see Oil Prorationing in the Spotlight at Texas Railroad Commission, published by Baker Botts, a Texas law firm, on March 30, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 The Birth Of WOPEC The Birth Of WOPEC Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades The Birth Of WOPEC The Birth Of WOPEC

Highlights Global shortages of medical equipment – including medicines – are frontloaded until emergency production kicks in. As the crisis abates, political recriminations between the US and China will surge. The US will seek to minimize medical supply exposure to China going forward, a boon for India and Mexico. China has escaped the COVID-19 crisis with minimal impact on food supply. Pork prices are surging due to African Swine Flu, but meat is a luxury. Still, the “Misery Index” is spiking and this will increase social instability. Food insecurity, inflation, and large current account deficits suggest that emerging market currencies will remain under pressure. Turkey and South Africa stand to suffer while we remain overweight Malaysia. Feature Chart 1Collapse In Economic Activity Collapse In Economic Activity Collapse In Economic Activity With a third of the world population under some form of lockdown, general activity in the world’s manufacturing powerhouses has collapsed (Chart 1). The breakdown is a double whammy on market fundamentals. On the supply side, government-mandated containment efforts force workers in non-essential services to stay home while, on the demand side, households confined to their homes are unable to spend. Acute demand for medical supplies is causing shortages, while supply disruptions threaten states that lack food security. While global monetary and fiscal stimulus will soften the blow (Chart 2), the economic shock is estimated to be a 2% contraction in real GDP for every month of strict isolation. If measures are extended beyond April, markets will sell and new stimulus will be applied. Already the US Congress is negotiating the $1-$2 trillion infrastructure package that we discussed in our March 4 report, and cash handouts will be ongoing. When the dust settles the political fallout will be massive. Authoritarian states like China and especially Iran will face greater challenges maintaining domestic stability. Democracies like Italy and the US, which lead the COVID-19 case count, are the most likely to experience a change in leadership (Chart 3). Initially the ruling parties of the democracies are receiving a bump in opinion polling, but this will fade as households will be worse off and will likely vent their grievances at the ballot box. Chart 2 Chart 3 Until a vaccine or treatment is discovered, medical equipment and social distancing are the only weapons against the pandemic. National production is (rightly) being redirected from clothing and cars to masks and ventilators to meet the spike in demand. Will the supply shock cause shortages in food and medicine – essential goods for humankind? In this report we address the impact of COVID-19 on global supply security and assess the market implications. Medical Equipment Shortages Will Spur Protectionism Chart Policymakers are fighting today’s crisis with the tools of the 2008 crisis, but a lasting rebound in financial markets will depend on surmounting the pandemic, which is prerequisite to economic recovery (Table 1). As the US faces the peak of its COVID-19 outbreak, public health officials and doctors are raising the alarm on the shortage of medical supplies. A recent US Conference of Mayors survey reveals that out of the 38% of mayors who say they have received supplies from their state, 84.6% say they are inadequate (Chart 4). Italy serves as a warning: A reported 8% of the COVID-19 cases there are doctors and health professionals, often treating patients without gloves or with compromised protective gear. These workers are irreplaceable and when they succumb the virus cannot be contained. In the US, doctors and nurses are re-using masks and sometimes treating patients behind a mere curtain, highlighting the supply shortage. While the shortages are mainly driven by a surge in demand from both medical institutions and households, they also come from the supply side, particularly China. Factory closures and transportation disruptions in China earlier this year, coupled with Beijing’s government-mandated export curbs, reduced Chinese exports, a major source of US and global supplies (Chart 5). Chart 4 Chart 5 Other countries have imposed restrictions on exports of products used in combating the spread of COVID-19. Following export restrictions by the French, German, and Czech governments in early March, the European Commission intervened on March 15 to ensure intra-EU trade. It also restricted exports of protective medical gear outside of the EU. At least 54 nations have imposed new export restrictions on medical supplies since the beginning of the year.1 Both European and Chinese measures will reduce supplies in the US, the top destination for most of these halted exports (Chart 6). Chart 6 Thus it is no wonder that the Trump administration has rushed to cut import duties and boost domestic production. The administration has released strategic stockpiles and cut tariffs on Chinese medical equipment used to treat COVID-19. With the whole nation mobilized, supply kinks should improve greatly in April. After a debacle in rolling out test kits (Chart 7), the US is rapidly increasing its testing capabilities to manage the crisis, with over a million tests completed as of the end of March (Chart 8). Meanwhile a coalition of companies is taking shape to make face masks. The president has invoked the defense production act to force companies to make ventilators. Chart 7 Chart 8 However, with the pandemic peaking in the US, the hardest-hit regions will continue experiencing shortages in the near term. Shortages are prompting public outcry against the US government for its failure to anticipate and redress supply chain vulnerabilities that were well known and warned against. A report in The New York Times tells how Mike Bowen, owner of Texas-based mask-maker Prestige Ameritech, has advised the past three presidents about the danger in the fact that the US imports 95% of its surgical masks. “Aside from sitting in front of the White House and lighting myself on fire, I feel like I’ve done everything I can,” he said. He is currently inundated with emergency orders from US hospitals. The same report tells of a company called Strong Manufacturers in North Carolina that had to cut production of masks because it depends on raw materials from Wuhan, China, where the virus originated.2 The Trump administration will suffer the initial public uproar, but the US government will also seek to reduce import dependency going forward, and it will likely deflect some of the blame by focusing on the supply risks posed by China. Beijing, for its part, is launching a propaganda campaign against the US to distract from its own failures at home (some officials have even blamed the US for the virus). Meanwhile it is cranking up production and shipping medical supplies to crisis hit areas like Italy to try to repair its global image after having given rise to the virus. In addition, the city of Shenzhen is sending 1.2 million N95 masks to the US on the New England Patriots’ team plane. Even Russia is sending small donations. But these moves work to propagandistic efforts in these countries and will ultimately shame the Americans into taking measures to improve self-sufficiency. Bottom Line: The most important supply shortage amid the global pandemic is that of medical equipment. While these shortages will abate sooner rather than later, the supply chain vulnerabilities they have exposed will trigger new policies of supply redundancy and import substitution. The US in particular will seek to reduce dependency on China. That COVID-19 is aggravating rather than reducing tensions between these states, despite China’s role as a key supplier in a time of need, highlights the secular nature of their rising tensions. The US-China Drug War Shortages of pharmaceuticals are also occurring, despite the fact that the primary pandemic response is necessarily “non-pharmaceutical” (e.g. social distancing). The US Food and Drug Administration (FDA) announced the first COVID-19 related drug shortage in the US on February 27. While the specific drug was not disclosed, the announcement notes that “the shortage is due to an issue with manufacturing of an active pharmaceutical ingredient used in the drug.”3 The FDA is monitoring 20 other (non-critical) drugs potentially at risk of shortages because the sole source is China. The global spread of the pandemic will increase these shortages. On March 3 India announced export restrictions on 26 drugs, including paracetamol and several antibiotics, due to supply disruptions caused by the Chinese shutdown. While Chinese economic activity has since picked up, India is now among the string of countries under a nationwide lockdown. Similar measures enforced across Europe will also hamper the production and transportation of these goods. The implication is that even if Chinese drugs return to market, supplies further down the chain and from alternative suppliers will take a hit. The risk that this will evolve into a drug shortage depends on the intensity of the outbreak. Drug companies generally hold 3-6 months’ worth of inventories. Consequently, while inventories are likely to draw as supplies are disrupted, consumers may not experience an outright shortage immediately. In the US, as with equipment and protective gear, the government’s strategic stockpile will buffer against shortfalls in supplies of critical drugs. COVID-19 is aggravating rather than reducing US-China tensions. Nevertheless the supply chain is getting caught up in the larger US-China strategic conflict. Even before the pandemic, the US-China trade war brought attention to the US’s vulnerabilities to China’s drug exports. This dispute is not limited to illicit drugs, as with China’s production of the opioid fentanyl, but also extends to mainstream medicines, as highlighted in the selection of public statements shown in Table 2. Chart Chart 9 How much does the US rely on China for medicine? According to FDA data, just over half of manufacturing facilities producing regulated drugs in finished dosage form for the US market are located abroad, with China’s share at 7% (Chart 9).4 The figures are higher for manufacturing facilities producing active pharmaceutical ingredients, though still not alarming – 72% of the facilities are located abroad, with 13% in China. Of course, high-level data understate China’s influence. The complex nature of global drug supply chains means that the source of finished dosage forms masks dependencies and dominance higher up the supply chain (Figure 1). Chart For instance, active pharmaceutical ingredients produced in Chinese facilities are used as intermediate goods by finished dosage facilities in India as well as China. The FDA reports that Indian finished dosage facilities rely on China for three-quarters of the active ingredients in their generic drug formulations, which are then exported to the US and the rest of the world. Any supply disruption in China – or any other major drug producer – will lead to shortages further down the supply chain. Chart 10 Chinese influence becomes more apparent when the sample is restricted to generic prescription drugs. These are especially relevant because nearly 70% of Americans are on at least one prescription drug, of which more than 90% are dispensed in the generic form. In this case, 87% of ingredient manufacturers and 60% of finished dosage manufacturers are located outside the US, with 17% of ingredient facilities and 8% of dosage facilities in China (Chart 10). Of all the facilities that manufacture active ingredients that are listed on the World Health Organization’s Essential Medicines List – a compilation of drugs that are considered critical to the health system – 71% are located aboard with 15% located in China (Chart 11). Moreover, manufacturers are relatively inflexible when adapting to market conditions and shortages. Drug manufacturing facilities generally operate at above 80% of their capacity and are thus left with little immediate capacity to ramp up production in reaction to shortages elsewhere. In addition, manufacturers face challenges in changing ingredient suppliers – there is no centralized source of information on them, and additional FDA approvals are required. The US will look to reduce its dependency on China for its drug supplies regardless of 2020 election outcome. China also has overwhelming dominance in specific categories. The Council on Foreign Relations reports that China makes up 97% of the US antibiotics market.5 Other common drugs that are highly dependent on China for supplies include ibuprofen, acetaminophen, hydrocortisone, penicillin, and heparin (Chart 12). Chart 11 Chart 12 Taking it all together, US vulnerability can be overstated. Consider the following: Of the 370 drugs on the Essential Medicines List that are marketed in the US, only three are produced solely in China. None of these three are used to treat top ten causes of death in the United States. Import substitution is uneconomical. Foreign companies, especially Chinese companies, are attractive due to their lower costs and lax regulations. While China’s influence extends higher up the supply chain, this is true for US markets as well as other consumer markets. While China can cut off the US from the finished dosages it supplies, it cannot do the same for the ingredients that are used by facilities in other countries and eventually make their way to the US in finished dosage form. Americans are demanding that drug prices be reduced and an obvious solution is looser controls on imports. The recent activation of the Defense Production Act shows that the US can take action to boost domestic production in emergencies. Nevertheless, China is growing conspicuous to the American public due to general trade tensions and COVID-19. As it moves up the value chain, it also threatens increasing competition for the US and its allies. Hence the US government will have a strategic reason to cap China’s influence that is also supported by corporate interests and popular opinion. This will lead to tense trade negotiations with China and meanwhile the US will seek alternative suppliers. China will not want to lose market share or leverage over the United States, so it may offer trade concessions at some point to keep the US engaged. Ultimately, however, strategic tensions will catalyze US policy moves to reduce the cost differential with China and promote its rivals. Pressure on China over its currency, regulatory standards, and scientific-technological acquisition will continue regardless of which party wins the White House in 2020. The Democrats would increase focus on China’s transparency and adherence to international standards, including labor and environmental standards. Both Republicans and Democrats will try to boost trade with allies. The key beneficiaries will be India, Southeast Asia, and the Americas. Taiwan’s importance will grow as a middle-man, but so will its vulnerability to strategic tensions. Bottom Line: The US and the rest of the world are suffering shortfalls of equipment necessary to combat COVID-19. There is also a risk of drug shortages stemming from supply disruptions and emergency protectionist policies. These shortages look to be manageable, but they have exposed national vulnerabilities that will be reduced in future via interventionist trade policies. While the US and Europe will ultimately manage the outbreak, the political fallout will be immense. The US will look to reduce its dependency on China. This will increase investment in non-China producers of active pharmaceutical ingredients, such as India and Mexico. The US tactics against China will vary according to the election result, but the strategic direction of diversifying away from China is clear and will have popular impetus in the wake of COVID-19. Food Security In addition to the challenges posed by COVID-19 on medical supplies, food – another essential good – also faces risk of shortages. China is a case in point. Food prices there were on the rise well before the COVID-19 outbreak, averaging 17.3% in the final quarter of 2019. However inflation was limited to pork and its substitutes – beef, lamb and poultry – and reflected a reduction in pork supplies on the back of the African Swine Flu outbreak. While year-on-year increases in the prices of pork and beef averaged 102.8% and 21.0%, respectively, grain, fresh vegetable, and fresh fruit prices averaged 0.6%, 1.5%, and -5.0% in Q42019 (Chart 13). Chart 13Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chart 14China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability However China’s COVID-19 containment measures had a more broad-based impact on food supplies, threatening to push up China’s Misery Index (Chart 14). Travel restrictions, roadblocks, quarantined farm laborers, and risk-averse truck drivers introduced challenges not only in ensuring supplies were delivered to consumers, but also to daily farm activity and planting. The absence of farm inputs needed for planting such as seeds and fertilizer, and animal feed for livestock, was especially damaging in regions hardest hit by the pandemic. Livestock farmers already struggling with swine flu-related reductions in herd sizes were forced to prematurely cull starving animals, cutting the stock of chicken and hogs. Now as the country transitions out of its COVID-19 containment phase and moves toward normalizing activity (Chart 15), food security is top of the mind. Authorities are emphasizing the need to ensure sufficient food supplies and adopt policies to encourage production.6 This is especially important for crops due to be planted in the spring. Delayed or reduced plantings would weight on the quality and quantity of the crops, pushing prices up. Chart 15 With food estimated to account for 19.9% of China’s CPI basket – 12.8% of which goes towards pork (Chart 16) – a prolonged food shortage, or a full-blown food crisis, would be extremely damaging to Chinese families and their pocketbooks. Chart 16 However, apart from soybeans and to a lesser extent livestock, China’s inventories are well stocked (Chart 17) and are significantly higher than levels amid the 2006-2008 and 2010-2012 food crises. Inventories have been built up specifically to provide ammunition precisely in times of crisis. Corn and rice stocks are capable of covering consumption for nearly three quarters of a year, and wheat stocks exceeding a year’s worth of consumption. Thus, while not completely immune, China today is better able to weather a supply shock. Moreover, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 18). Chart 17   Chart 18 As the COVID-19 epicenter shifts to the US and Europe, farmers there are beginning to face the same challenges. Reports of delays in the arrival of shipments of inputs such as fertilizer and seeds have prompted American farmers to prepare for the worst and order these goods ahead of time. Chart 19 While these proactive measures will help reduce risks to supply, farmers in Europe and parts of the US who typically rely on migrant laborers will need to search for alternative laborers as the planting season nears. Just last week France’s agriculture minister asked hairdressers, waiters, florists, and others that find themselves unemployed to take up work in farms to ensure food security. As countries become increasingly aware of the risks to food supplies, some have already introduced protectionist measures, especially in the former Soviet Union: The Russian agriculture ministry proposed setting up a quota for Russian grain exports and has already announced that it is suspending exports of processed grains from March 20 for 10 days. Kazakhstan suspended exports of several agricultural goods including wheat flour and sugar until at least April 15. On March 27, Ukraine’s economy ministry announced that it was monitoring wheat export and would take measures necessary to ensure domestic supplies are adequate. Vietnam temporarily suspended rice contracts until March 28 as it checked if it had sufficient domestic supplies. The challenge is that, unlike China, inventories in the rest of the world are not any higher than during the previous food crisis and do not provide much of a buffer against supply shortfalls (Chart 19). Higher food prices would be especially painful to lower income countries where food makes up a larger share of household spending (Chart 20). In addition to using their strategic food stockpiles, governments will attempt to mitigate the impact of higher food prices by implementing a slew of policies: Chart 20 Trade policies: Producing countries will want to protect domestic supplies by restricting exports – either through complete bans or export quotas. Importing countries will attempt to reduce the burden of higher prices on consumers by cutting tariffs on the affected goods. Consumer-oriented policies: Importing countries will provide direct support to consumers in the form of food subsidies, social safety nets, tax reductions, and price controls. Producer-oriented policies: Governments will provide support to farmers to encourage greater production using measures such as input subsidies, producer price support, or tax exemptions on goods used in production. While these policies will help alleviate the pressure on consumers, they also result in greater government expenditures and lower revenues. Thus, subsidizing the import bill of a food price shock can weigh on public finances, debt levels, and FX reserves. Currencies already facing pressure due to the recessionary environment, such as Turkey, South Africa and Chile will come under even greater downward pressure. Food inventories ex-China are insufficient to protect against supply shortages. Bottom Line: COVID-19’s logistical disruptions are challenging farm output. This is especially true when transporting goods and individuals across borders rather than within countries. This will be especially challenging for food importing countries, as some producers have already started erecting protectionist measures and this will result in an added burden on government budgets that are already extended in efforts to contain the economic repercussions of the pandemic. Investment Implications Chart 21Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD China will continue trying to maximize its market share and move up the value chain in drug production. At the same time, the US is likely to diversify away from China and try to cap China’s market share. This will result in tense trade negotiations regardless of the outcome of the US election. The COVID-19 experience with medical shortages and newfound public awareness of potential medical supply chain vulnerabilities means that another round of the trade war is likely. Stay long USD-CNY. Regarding agriculture, demand for agricultural commodities is relatively inelastic. This inelasticity should prevent a complete collapse in prices even amid a weak demand environment. Thus given the risk on supplies, prices face upward pressure. However, not all crops are facing these same market dynamics. While wheat and rice prices have started to move in line with the dynamics described above, soybeans and to a greater extent corn prices have not reacted as such (Chart 21). In the case of soybeans, we expect demand to be relatively muted. China accounts for a third of the world’s soybean consumption. 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry. However, the 21% y/y decline in pork output in 2019 on the back of the African Swine Flu outbreak will weigh on demand and mute upward pressures on supplies. Demand for corn will also likely come in weak. The COVID-19 containment measures and the resulting halt in economic activity reduce demand for gasoline and, as a consequence, reduce demand for corn-based ethanol, which is blended with gasoline. In addition to the above fundamentals, ag prices have been weighed down by a strong USD which makes ex-US exporters relatively better off, incentivizing them to raise exports and increase global supplies. A weaker USD – which we do not see in the near term – would help support ag prices. It is worth noting that if there is broad enforcement of protectionist measures, then producers will not be able to benefit from a stronger dollar. In that case we may witness a breakdown in the relationship between ag prices and the dollar. In light of these supply/demand dynamics, we expect rice and wheat prices to be well supported going forward and to outperform corn and soybeans.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 See "Tackling COVID-19 Together: The Trade Policy Dimension," Global Trade Alert, University of St. Gallen, Switzerland, March 23, 2020. 2 See Rachel Abrams et al, "Governments and Companies Race to Make Masks Vital to Virus Fight," The New York Times, March 21, 2020. 3 The announcement also notes that there are other alternatives that can be used by patients. See "Coronavirus (COVID-19) Supply Chain Update," US FDA, February 27, 2020. 4 All regulated drugs include prescription (brand and generic), over the counter, and compounded drugs. 5 Please see Huang, Yanzhong, "The Coronavirus Outbreak Could Disrupt The US Drug Supply," Council on Foreign Relations, March 5, 2020. 6 The central government ordered local authorities to allow animal feed to pass through checkpoints amid the lockdowns. In addition, Beijing has relaxed import restrictions by lifting a ban on US poultry products and announcing that importers could apply for waivers on goods tariffed during the trade war such as pork and soybeans. The lifting of these restrictions also serves to help China meet its phase one trade deal commitments. Please see "Coronavirus hits China’s farms and food supply chain, with further spike in meat prices ahead," South China Morning Post, dated February 21, 2020.