Commodities & Energy Sector

Crude oil price volatility surged over the past week, and likely will remain elevated. Underlying prices continue to reflect heightened policy risk ranging from continuing Sino – U.S. trade-war tensions; new tariff threats against Mexico from the Trump administration; global growth concerns, which are fuelled by rising oil inventories in the U.S.; and the continued threat of war in the Persian Gulf (Chart of the Week). These factors are exacerbating recession fears in the U.S., where the yield curve is pricing in a greater than one-in-three chance of a recession one year forward (Chart 2). Given the above-trend performance of the American economy relative to other DM economies, this is disconcerting re global growth generally, and re EM GDP prospects in particular. EM GDP drives EM commodity demand. Given EM commodity demand is the principal driver of global commodity demand, it is especially important in our modeling. Chart of the WeekVolatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns   Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. Chart 2Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession To be conservative, our oil-demand assumptions for EM GDP have followed World Bank estimates, which means they’ve been below post-Global Financial Crisis (GFC) trend (Chart 3). Chart 3 Cutting right to the chase: Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. This brings our Brent forecast to $73/bbl and $77/bbl for this year and next.1 We continue to expect WTI to trade $7/bbl and $5/bbl below Brent this year and next. Highlights Energy: Overweight. We expect OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – to extend its production cuts to year end when it meets later this month or next month. This will still allow OPEC 2.0 to raise production in 2H19 over 1H19 if needed, due to the group's current over-compliance with the agreed cuts. KSA's production is currently close to ~500k b/d below its output target. We believe Wednesday’s inventory report released by the U.S. EIA showing a 22.4mm-barrel increase in commercial crude oil and refined products inventories all but assures OPEC 2.0’s production cuts will be extended when the producer coalition meets. Base Metals: Neutral. Union members who voted to strike a Codelco copper mine over the weekend remain on the job, after Chilean government officials joined to mediate negotiations, according to Fastmarkets MB. Precious Metals: Neutral. Gold rallied above $1,340/oz – up 4% over the past week – as global trade tensions and other factors riling equity, bond and commodity markets intensified. Ags/Softs: Underweight. The USDA reported corn plantings were running at 67% this week, vs. an average of 96% percent over the 2014 – 18 period. The department surveyed 18 states, which account for 92% of all 2018 corn acreage. Feature Global oil demand concerns are manifesting themselves in the almost-relentless selling of futures seen in the past two weeks. This coincided with an increasing risk premium noted in our price decomposition, and with rising concerns over the health of the global economy generally.2 Markets are becoming increasingly concerned U.S. and Chinese trade and foreign policy will spill into the larger global economy and result in a full-blown global trade war. Already, Mexico and Canada have been drawn into this vortex once again – the former is being threatened with U.S. tariffs once more, after presumably having agreed to a revised NAFTA treaty, the latter via increased inspection of meat imports into China.3 On Wednesday, the World Bank lowered its global growth forecast, taking 0.3 percentage points off its 2019 growth estimate – lowering it to 2.6% in 2019 – and reducing its 2020 forecast to 2.7% from 2.8% earlier.4 The Bank noted, “Emerging and developing economy growth is constrained by sluggish investment, and risks are tilted to the downside. These risks include rising trade barriers, renewed financial stress, and sharper-than-expected slowdowns in several major economies.” Assessing Lower EM Growth Prospects We follow the World Bank’s GDP growth estimates closely, largely because the Bank’s forecasts tend to be lower than those of the IMF, which induces a measure of conservatism to our forecasts. We use the Bank’s EM GDP estimates (levels and growth rates) to estimate oil demand in our modelling. Prior to the Bank’s updated forecast released on June 4, we re-estimated EM oil consumption, by shaving 0.4 percentage points from our earlier EM GDP forecast. This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate. Using the World Bank's revised forecasts as inputs to our fundamental model – and leaving all other assumptions unchanged – the lower EM GDP estimate for 2019 would take our average Brent expectation to $71/bbl. Averaging this with our existing expectation of $75/bbl leads us to change our 2019 forecast to $73/bbl. To hit this new estimate of $73/bbl would require 2H19 Brent prices to average ~ $79/bbl, which we believe is not unreasonable. For 2020, the slowdown in EM GDP we used gives an expectation of $73/bbl for Brent, versus our previous estimate of $80/bbl. We average these as well, and change our estimate for 2020 Brent to $77/bbl. OPEC 2.0 Remains Focused On Lower Inventories Our lower EM GDP estimates take growth rates to those roughly prevailing during the 2015 – 16 oil-price collapse. This episode was a true global shock, particularly for commodity exporters, which was not offset by higher growth in the GDPs of commodity importers (Chart 4). This go-round is different, however: The 2015 – 16 oil price collapse was a self-inflicted shock, occasioned by OPEC’s decision to launch an all-out market-share war in 2014. This had a devastating effect on EM commodity-exporting countries, particularly the oil exporting countries. We expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition. This time, the global backdrop is considerably different. For one thing, the oil-price collapse laid the foundation for the formation of OPEC 2.0, which has shown remarkable production discipline since it was founded in November 2016, and took on the mission of reducing the massive unintended inventory accumulation brought on by the combination of the OPEC market-share war and surging U.S. shale production (Chart 5). The nominal target for this mission is OECD inventories. Chart 4EM Oil Demand vs. GDP EM Oil Demand vs. GDP EM Oil Demand vs. GDP Chart 5Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing We continue to stress this founding principal of OPEC 2.0, because its leadership continues to make it a focal point when engaging with the press and guiding the market. It is for this reason we expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition to keep prices below $85/bbl. KSA’s Energy Minister, Khalid al-Falih, this week said, “We will do what is needed to sustain market stability beyond June. To me, that means drawing down inventories from their currently elevated levels.”5 Fiscal, Monetary Policy Support EM Demand The other noteworthy aspect of the current market is central banks globally are more accommodative than they were during the 2015 – 16 oil-price collapse. In addition, fiscal stimulus is being deployed globally, and likely will be increased. Against this backdrop, it is difficult to see monetary or fiscal policy being the sort of headwind it has shown it can be post-GFC. As our colleague Peter Berezin noted in last week’s Global Investment Strategy, “politicians will pursue large-scale fiscal stimulus” to avoid a slide into deflation.6 U.S. – Iran Tensions High, But Ebbing Lastly, oil markets seem to have reduced their concern over U.S. – Iran tensions in the Persian Gulf. This may be due to the fact that U.S. Secretary of State Mike Pompeo said the U.S. was “prepared to engage in a conversation (with Iran) with no pre-conditions. We are ready to sit down.”7 All the same, the U.S. recently deployed an aircraft carrier strike group to the Persian Gulf, where it now is on station, and B52 bombers. From the oil market’s perspective, any thawing in the potential military standoff in the Gulf would require the U.S. to abandon its stated goal of reducing Iran’s oil exports to zero. In and of itself, a resumption of official Iranian oil exports would simply re-distribute production cuts and the make-up production OPEC 2.0 is providing markets in the wake of Venezuela’s collapse, where oil production has fallen to ~ 850k b/d from ~ 2mm b/d when OPEC 2.0 was formed. Bottom Line: Wednesday’s massive 22.4mm-barrel build in U.S. crude and refined product inventories shocked the global oil market, and pushed Brent prices toward $60/bbl as we went to press. Almost surely, this will harden KSA’s and OPEC 2.0’s resolve to maintain production cuts into 2H19 to drain oil inventories globally. The lower prices also will act as a headwind to U.S. shale producers, a topic we will take up in a two-part Special Report next week and the following week. We’ve established rig counts in the U.S. shales are closely tied to WTI price levels and curve shape: Lower prices and a flattening forward curve will restrain drilling in the shales, and the rate of growth in U.S. output. Lastly, fiscal and monetary policy globally will be supportive of commodity demand, and EM oil demand in particular, as this stimulus is deployed. We continue to expect prices to rally from here, but have lowered our forecasts slightly to $73 and $77/bbl for Brent this year and next. We continue to expect WTI to trade $7 and $5/bbl below these levels in 2019 and 2020.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please note, we ran our simulations earlier this week, prior to the World Bank’s most recent forecast released June 4.  This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate.  2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 3      The amounts involved in the stepped up meat inspections in China are small. However, they can be read as an extension of the foreign-policy imbroglio involving the possible extradition of Huawei Technologies’ CFO from Canada to the U.S. to face trial on charges she and the company allegedly conspired to commit bank and wire fraud to avoid U.S. sanctions on Iran.  Chinese officials deny there is any connection.  Please see “Canada says China plans more meat import inspections, industry fears disaster,” published by reuters.com June 4, 2019. 4      Please see Global growth to Weaken to 2.6% in 2019, Substantial Risks Seen , published by the World Bank June 4, 2019. 5      This quote came from a reuters.com report that relayed what al-Falih told Arab News. Please see “Saudi’s Falih says OPEC+ consensus emerging on output deal in second half,” published June 3, 2019. 6      Please see Global Investment Strategy Weekly Report titled “MMT And Me,” dated May 31, 2019, which discusses the prospects for large-scale fiscal stimulus and accommodative monetary policy globally.  It is available at gis.bcaresearch.com.  Peter also expects a détente in the Sino – U.S. trade war, arguing both sides would benefit from reducing trade tensions and tariffs. 7      Please see U.S. prepared to talk to Iran with 'no preconditions', Iran sees 'word-play' published by reuters.com June 2, 2019.  This followed news that Iran’s President Hassan Rouhani said his country is willing to speak with the U.S. if it shows respect. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? Chart 1Worrying Signs? Worrying Signs? Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Term Premium Near Record Low Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Investors Very Long Duration Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 16 Chart 17Industrial Metals Driven By China Too Industrial Metals Driven By China Too Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Oil Supply Remains Tight Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Underweight High-Conviction The latest GDP release as it pertains to housing made for grim reading: residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel). Residential investment is also on the verge of contracting in absolute terms (second panel) and will likely weigh on home improvement retailers (HIR). The direct link to HIR comes via existing home sales: when a home changes ownership usually some renovation activity takes place. Finally, lumber prices continue to crumble and given that HIR make a set margin on lumber sales, HIR profits will likely underwhelm (bottom panel). Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Home Improvement Retailers: Timber Alert Home Improvement Retailers: Timber Alert Home Improvement Retailers: Timber Alert    

Highlights So What? U.S.-China relations are still in free fall as we go to press. Why? The trade war will elicit Chinese stimulus but downside risks to markets are front-loaded. The oil risk premium will remain elevated as Iran tensions will not abate any time soon. The odds of a no-deal Brexit are rising. Our GeoRisk Indicators show that Turkish and Brazilian risks have subsided, albeit only temporarily. Maintain safe-haven trades. Short the CNY-USD and go long non-Chinese rare earth providers. Feature The single-greatest reason for the increase in geopolitical risk remains the United States. The Democratic Primary race will heat up in June and President Trump, while favored in 2020 barring a recession, is currently lagging both Joe Biden and Bernie Sanders in the head-to-head polling. Trump’s legislative initiatives are bogged down in gridlock and scandal. The remaining avenue for him to achieve policy victories is foreign policy – hence his increasing aggressiveness on both China and Iran. The result is negative for global risk assets on a tactical horizon and possibly also on a cyclical horizon. A positive catalyst is badly needed in the form of greater Chinese stimulus, which we expect, and progress toward a trade agreement. Brexit, Italy, and European risks pale by comparison to what we have called “Cold War 2.0” since 2012. Nevertheless, the odds of Brexit actually happening are increasing. The uncertainty will weigh on sentiment in Europe through October even if it does not ultimately conclude in a no-deal shock that prevents the European economy from bouncing back. Yet the risk of a no-deal shock is higher than it was just weeks ago. We discuss these three headline geopolitical risks below: China, Iran, and the U.K. No End In Sight For U.S.-China Trade Tensions U.S.-China negotiations are in free fall, with no date set for another round of talks. On March 6 we argued that a deal had a 50% chance of getting settled by the June 28-29 G20 summit in Japan, with a 30% chance talks would totally collapse. Since then, we have reduced the odds of a deal to 40%, with a collapse at 50%, and a further downgrade on the horizon if a positive intervention is not forthcoming producing trade talks in early or mid-June (Table 1). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 We illustrate the difficulties of agreeing to a deal through the concept of a “two-level game.” In a theoretical two-level game, each country strives to find overlap between its international interests and its rival’s interests and must also seek overlap in such a way that the agreement can be sold to a domestic audience at home. The reason why the “win-win scenario” is so remote in the U.S.-China trade conflict is because although China has a relatively large win set – it can easily sell a deal at home due to its authoritarian control – the U.S. win set is small (Diagram 1). Diagram 1Tiny Win-Win Scenario In U.S.-China Trade Conflict GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 The Democrats will attack any deal that Trump negotiates, making him look weak on his own pet issue of trade with China. This is especially the case if a stock market selloff forces Trump to accept small concessions. His international interest might overlap with China’s interest in minimizing concessions on foreign trade and investment access while maximizing technological acquisition from foreign companies. He would not be able to sell such a deal – focused on large-scale commodity purchases as a sop to farm states – on the campaign trail. Democrats will attack any deal that Trump negotiates. While it is still possible for both sides to reach an agreement, this Diagram highlights the limitations faced by both players. Meanwhile China is threatening to restrict exports of rare earths – minerals which are critical to the economy and national defense. China dominates global production and export markets (Chart 1), so this would be a serious disruption in the near term. Global sentiment would worsen, weighing on all risk assets, and tech companies and manufacturers that rely on rare earth inputs from China would face a hit to their bottom lines. Chart 1China Dominates Rare Earths Supply France: GeoRisk Indicator France: GeoRisk Indicator Over the long haul, this form of retaliation is self-defeating. First, China would presumably have to embargo all exports of rare earths to the world to prevent countries and companies from re-exporting to the United States. Second, rare earths are not actually rare in terms of quantity: they simply occur in low concentrations. As the world learned when China cut off rare earths to Japan for two months in 2010 over their conflict in the East China Sea, a rare earths ban will push up prices and incentivize production and processing in other regions. It will also create rapid substitution effects, recycling, and the use of stockpiles. Ultimately demand for Chinese rare earths exports would fall. Over the nine years since the Japan conflict, China’s share of global production has fallen by 19%, mostly at the expense of rising output from Australia. A survey of American companies suggests that they have diversified their sources more than import statistics suggest (Chart 2). Chart 2Import Stats May Be Overstating China’s Dominance U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator The risk of a rare earths embargo is high – it fits with our 30% scenario of a major escalation in the conflict. It would clearly be a negative catalyst for companies and share prices. But as with China’s implicit threat of selling U.S. Treasuries, it is not a threat that will cause Trump to halt the trade war. The costs of conflict are not prohibitive and there are some political gains. Bottome Line: The S&P 500 is down 3.4% since our Global Investment Strategists initiated their tactical short on May 10. This is nearly equal to the weighted average impact on the S&P 500 that they have estimated using our probabilities. Obviously the selloff can overshoot this target. As it does, the chances of the two sides attempting to contain the tensions will rise. If we do not witness a positive intervention in the coming weeks, it will be too late to salvage the G20 and the risk of a major escalation will go way up. We recommend going short CNY-USD as a strategic play despite China’s recent assurances that the currency can be adequately defended. Our negative structural view of China’s economy now coincides with our tactical view that escalation is more likely than de-escalation. We also recommend going long a basket of companies in the MVIS global rare earth and strategic metals index – specifically those companies not based in China that have seen share prices appreciate this year but have a P/E ratio under 35. U.S.-Iran: An Unintentional War With Unintentional Consequences? “I really believe that Iran would like to make a deal, and I think that’s very smart of them, and I think that’s a possibility to happen.” -President Donald Trump, May 27, 2019 … We currently see no prospect of negotiations with America ... Iran pays no attention to words; what matters to us is a change of approach and behavior.” -Iranian Foreign Ministry spokesman Abbas Mousavi, May 28, 2019 The U.S. decision not to extend sanction waivers on Iran multiplied geopolitical risks at a time of already heightened uncertainty. Elevated tensions surrounding major producers in the Middle East could impact oil production and flows. In energy markets, this is reflected in the elevated risk premium – represented by the residuals in the price decompositions that include both supply and demand factors (Chart 3). Chart 3The Risk Premium Is Rising In Brent Crude Oil Prices Germany: GeoRisk Indicator Germany: GeoRisk Indicator Tensions surrounding major oil producers ... are reflected in the elevated risk premium – represented by the residuals in the Brent price decomposition. Already Iranian exports are down 500k b/d in April relative to March – the U.S. is acting on its threat to bring Iran’s exports to zero and corporations are complying (Chart 4). Chart 4Iran Oil Exports Collapsing Italy: GeoRisk Indicator Italy: GeoRisk Indicator What is more, the U.S. is taking a more hawkish military stance towards Iran – recently deploying a carrier strike group and bombers, partially evacuating American personnel from Iraq, and announcing plans to send 1,500 troops to the Middle East. The result of all these actions is not only to reduce Iranian oil exports, but also to imperil supplies of neighboring oil producers such as Iraq and Saudi Arabia which may become the victims of retaliation by an incandescent Iran. Our expectation of Iranian retaliation is already taking shape. The missile strike on Saudi facilities and the drone attack on four tankers near the UAE are just a preview of what is to come. Although Iran has not claimed responsibility for the acts, its location and extensive network of militant proxies affords it the ability to threaten oil supplies coming out of the region. Iran has also revived its doomsday threat of closing down the Strait of Hormuz through which 20% of global oil supplies transit – which becomes a much fatter tail-risk if Iran comes to believe that the U.S. is genuinely pursuing immediate regime change, since the first-mover advantage in the strait is critical. This will keep markets jittery. Current OPEC spare capacity would allow the coalition to raise production to offset losses from Venezuela and Iran. Yet any additional losses – potentially from already unstable regions such as Libya, Algeria, or Nigeria – will raise the probability that global supplies are unable to cover demand. Going into the OPEC meeting in Vienna in late June, our Commodity & Energy Strategy expects OPEC 2.0 to relax supply cuts implemented since the beginning of the year. They expect production to be raised by 0.9mm b/d in 2H2019 vs. 1H2019.1 Nevertheless, oil producers will likely adopt a cautious approach when bringing supplies back online, wary of letting prices fall too far. This was expressed at the May Joint Ministerial Monitoring Committee meeting in Jeddah, which also highlighted the growing divergence of interests within the group. Russia is in support of raising production at a faster pace than Saudi Arabia, which favors a gradual increase (conditional on U.S. sanctions enforcement). Both the Iranians and Americans claim that they do not want the current standoff to escalate to war. On the American side, Trump is encouraging Prime Minister Shinzo Abe to try his hand as a mediator in a possible visit to Tehran in June. We would not dismiss this possibility since it could produce a badly needed “off ramp” for tensions to de-escalate when all other trends point toward a summer and fall of “fire and fury” between the U.S. and Iran. If forced to make a call, we think President Trump’s foreign policy priority will center on China, not Iran. But this does not mean that downside risks to oil prices will prevail. China will stimulate more aggressively in June and subsequent months. And regardless of Washington’s and Tehran’s intentions, a wrong move in an already heated part of the world can turn ugly very quickly. Bottom Line: President Trump’s foreign policy priority is China, not Iran. Nevertheless, a wrong move can trigger a nasty escalation in the current standoff, jeopardizing oil supplies coming out of the Gulf region. In response to this risk, OPEC 2.0 will likely move to cautiously raise production at the next meeting in late June. Meanwhile China’s stimulus overshoot in the midst of trade war will most likely shore up demand over the course of the year. Can A New Prime Minister Break The Deadlock In Westminster? “There is a limited appetite for change in the EU, and negotiating it won’t be easy.” - Outgoing U.K. Prime Minister Theresa May Prime Minister Theresa May’s resignation has hurled the Conservative Party into a scramble to select her successor. While the timeline for this process is straightforward,2 the impact on the Brexit process is not. The odds of a “no-deal Brexit” have increased but so has the prospect of parliament passing a soft Brexit prior to any new election or second referendum. The odds of a “no-deal Brexit” have increased. Eleven candidates have declared their entry to the race and the vast majority are “hard Brexiters” willing to sacrifice market access on the continent (Table 2). Prominent contenders such as Boris Johnson and Dominic Raab have stated that they are willing to exit the EU without a deal. Table 2“Hard Brexiters” Dominate The Tory Race GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 Given that the average Tory MP is more Euroskeptic than the average non-conservative voter or Brit, the final two contenders left standing at the end of June are likely to shift to a more aggressive Brexit stance. They will say they are willing to deliver Brexit at all costs and will avoid repeating Theresa May’s mistakes. This means at the very least the rhetoric will be negative for the pound in the coming months. A clear constraint on the U.K. in trying to negotiate a new withdrawal agreement is that the EU has the upper hand. It is the larger economy and less exposed to the ramifications of a no-deal exit (though still exposed). This puts it in a position of relative strength – exemplified by the European Commission’s insistence on keeping the current Withdrawal Agreement. Whoever the new prime minister is, it is unlikely that he or she will be able to negotiate a more palatable deal with the EU. Rather, the new leader will lead a fractured Conservative Party that still lacks a strong majority in parliament. The no-deal option is the default scenario if an agreement is not finalized by the Halloween deadline and no further extension is granted. However, Speaker of the House of Commons John Bercow recently stated that the prime minister will be unable to deliver a no-deal Brexit without parliamentary support. This will likely manifest in the form of a bill to block a no-deal Brexit. Alternatively, an attempt to force a no-deal exit could prompt a vote of no confidence in the government, most likely resulting in a general election.3 Chart 5British Euroskeptics Made Gains In EP Election Spain: GeoRisk Indicator Spain: GeoRisk Indicator While the Brexit Party amassed the largest number of seats in the European Parliament elections at the expense of the Labour, Conservative, and UKIP parties (Chart 5), the results do not suggest that British voters have generally shifted back toward Brexit. In fact, if we group parties according to their stance, the Bremain camp has a slight lead over the Brexit camp (Chart 6). Thus, it is not remotely apparent that a hard Brexiter can succeed in parliament; that a new election can be forestalled if a no-deal exit is attempted; or that a second referendum will repeat the earlier referendum’s outcome. Chart 6Bremain Camp Still Dominates Russia: GeoRisk Indicator Russia: GeoRisk Indicator Bottom Line: While the new Tory leader is likely to be more on the hard Brexit end of the spectrum than Theresa May, this does not change the position of either the European Commission or the British MPs and voters on Brexit. The median voter both within parliament and the British electorate remains tilted towards a softer exit or remaining in the EU. This imposes constraints on the likes of Boris Johnson and Dominic Raab if they take the helm of the Tory Party. These leaders may ultimately be forced to try to push through something a lot like Theresa May’s plan, or risk a total collapse of their party and control of government. Still, the odds of a no-deal exit – the default option if no agreement is reached by the October 31 deadline – have gone up. In the meantime, the GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. GeoRisk Indicators Update – May 31, 2019 Last month BCA’s Geopolitical Strategy introduced ten indicators to measure geopolitical risk implied by the market. These indicators attempt to capture risk premiums priced into various currencies – except for Euro Area countries, where the risk is embedded in equity prices. A currency or bourse that falls faster than it should fall, as implied by key explanatory variables, indicates increasing geopolitical risk. All ten indicators can be found in the Appendix, with full annotation. We will continue to highlight key developments on a monthly basis. This month, our GeoRisk indicators are picking up the following developments: Trade war: Our Korean and Taiwanese risk indicators are currently the best proxies to measure geopolitical risk implications of the U.S.-China trade war, as they are both based on trade data. Both measures, as expected, have increased more than our other indicators over the past month on the back of a sharp spike in tensions between the U.S. and China. Currently, the moves are largely due to depreciation in currencies, as trade is only beginning to feel the impact. We believe that we will see trade decline in the upcoming months. Brexit: While it is still too early to see the full effect of Prime Minister May’s resignation captured in our U.K. indicator, it has increased in recent days. We expect risk to continue to increase as a leadership race is beginning among the Conservatives that will raise the odds of a “no-deal exit” relative to “no exit.” EU elections: The EU elections did not register as a risk on our indicators. In fact, risk decreased slightly in France and Germany during the past few weeks, while it has steadily fallen in Spain and Italy. Moreover, the results of the election were largely in line with expectations – there was not a surprising wave of Euroskepticism. The real risks will emerge as the election results feed back into political risks in certain European countries, namely the U.K., where the hardline Conservatives will be emboldened, and Italy, where the anti-establishment League will also be emboldened. In both countries a new election could drastically increase uncertainty, but even without new elections the respective clashes with Brussels over Brexit and Italian fiscal policy will increase geopolitical risk. Emerging Markets: The largest positive moves in geopolitical risk were in Brazil and Turkey, where our indicators plunged to their lowest levels since late 2017 and early 2018. Brazilian risk has been steadily declining since pension reform – the most important element of Bolsonaro’s reform agenda – cleared an initial hurdle in Congress. While we would expect Bolsonaro to face many more ups and downs in the process of getting his reform bill passed, we have a high conviction view that the decrease in our Turkish risk indicator is unwarranted. This decrease can be attributed to the fact that the lira’s depreciation in recent weeks is slowing, which our model picks up as a decrease in risk. Nonetheless, uncertainty will prevail as a result of deepening political divisions (e.g. the ruling party’s attempt to overturn the Istanbul election), poor governance, ongoing clashes with the West, and an inability to defend the lira while also pursuing populist monetary policy. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   France: GeoRisk Indicator Image U.K.: GeoRisk Indicator Image Germany: GeoRisk Indicator Image Italy: GeoRisk Indicator Image Spain: GeoRisk Indicator Image Russia: GeoRisk Indicator Image Korea: GeoRisk Indicator Image Taiwan: GeoRisk Indicator Image Turkey: GeoRisk Indicator Image Brazil: GeoRisk Indicator Image What's On The Geopolitical Radar? Image Footnotes 1 Please see BCA Research Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 2 The long list of candidates will be whittled down to two by the end of June through a series of votes by Tory MPs. Conservative Party members will then cast their votes via a postal ballot with the final result announced by the end of July, before the Parliament’s summer recess. 3 A vote of no confidence would trigger a 14-day period for someone else to form a government, otherwise it will result in a general election. Geopolitical Calendar

Highlights In the political economy of oil, an awareness of the speed at which policy in systematically important states can change can restrain risk taking and investment. This can keep markets in an agitated state of anticipation, awaiting the next policy shift – or the fallout from earlier decisions – and can separate prices from fundamentals. Crude oil markets are in such an agitated state. Fundamentally, oil markets are tight and likely will get tighter, as backwardations in benchmark forward curves indicate (Chart 1). Oil demand continues to grow, with EM growth offsetting DM declines (Chart 2). Production is being restrained by OPEC 2.0, and could remain so in 2H19. U.S. shale-oil producers appear to be taking capital discipline seriously, and prioritizing shareholder interests, which likely will keep production growth within the limits dictated by free cash flow. Chart of the WeekBackwardations In Brent & WTI: Evidence Of Tight Oil Markets Backwardations In Brent & WTI: Evidence Of Tight Oil Markets Backwardations In Brent & WTI: Evidence Of Tight Oil Markets Chart 2EM Continues To Lead Global Oil Demand Growth EM Continues To Lead Global Oil Demand Growth EM Continues To Lead Global Oil Demand Growth   The combination of these fundamentals will keep supply growth below demand growth this year, which means balances will remain tight (Table 1 below). This will drain inventories and keep forward curves backwardated (Chart 3). Globally, monetary policy will remain largely accommodative. However, policy risks – chiefly Sino – U.S. trade tensions and rising U.S. – Iran tensions – are taking their toll, increasing uncertainty re demand growth, and raising concerns over the security of oil supply from the Persian Gulf, which accounts for ~ 20% of global output. The combination of these policy-risk factors is putting a bid under the USD, which creates a demand headwind by raising the cost of oil ex-U.S.1 This is, in our view, keeping Brent prices below $70/bbl, vs. the $75/bbl we expect this year. Chart 3Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Highlights Energy: Overweight. U.S. National Security Adviser John Bolton declared Iran was responsible for naval mines attached to oil tankers off the coast of the UAE earlier this month, which damaged four ships, two of them belonging to Saudi Arabia. Bolton also said the Iranian naval operation was connected to a drone attack on the Saudi East – West pipeline two days later, and an unsuccessful attack on the Saudi Red Sea port of Yanbu.2 Base Metals: Neutral. Global copper markets continue to tighten: Fastmarkets MB’s Asian treatment and refining charges (TC/RC) weekly index dropped to its lowest level since it was launched June 2013 at the end of last week – to $58.30/MT, $0.0583/lb. Lower TC/RC charges reflect lower raw ore supplies available for refining. Global inventories remain low – down 22% y/y at the LME, COMEX, SHFE and Chinese bonded warehouses – and a threatened strike at on of Codelco's Chilean mines could tighten supplies further. We are re-establishing our tactical long July $3.00/lb Comex copper vs. short $3.30/lb Comex copper call spread at tonight’s close, expecting continued tightening in markets. Precious Metals: Neutral. Gold prices appear supported on either side of $1,280/oz, as trade, foreign and monetary policy risks remain elevated. Ags/Softs: Underweight. Heavier-than-expected rains are hampering plantings in the U.S. Midwest, which is driving grain prices higher. Corn, wheat, oats and beans surged Tuesday as markets re-opened from a long holiday weekend in the U.S. Feature Within the context of the political-economy framework we use to frame our analysis of oil markets, foreign policy and trade policy – particularly in the U.S. and China – are dominating fundamentals. Indeed, absent the threat of war in the Persian Gulf between Iran and the U.S., and their respective allies, and an uncertainty surrounding an expanded Sino – U.S. trade war, Brent crude oil would be trading above $75/bbl in 2H19, based on our modeling. As things stand now, we believe markets are under-pricing the risk of war in the Persian Gulf, and are over-estimating the short-term effects of the Sino – U.S. trade war. The longer-term consequences of a deeper and more protracted Sino – U.S. trade war, however, continue to be under-estimated. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Policy Risk Restrains Oil Prices Policy Risk Restrains Oil Prices U.S. – Iran War Risk Is Under-priced We have noted in the past the risk of an escalation in the military confrontation in the Persian Gulf remains acute for global oil markets, most recently in our latest balances report.3 In particular, we believe the risk of this scenario is not fully priced, given market participants’ mark-down of the probability of the price of Brent for December 2019 delivery exceeding $75/bbl and $80/bbl from 39% to 26% and 25% to 16% over the past month in options markets. The probability of Brent for March 2020 delivery exceeding $75/bbl and $80/bbl has similarly been marked down from 38% to 28% and 26% to 19% (Chart 4). Chart 4 An escalation of attacks on soft targets – specifically Saudi and UAE oil shipping and pipeline networks, as occurred earlier this month – likely would provoke a U.S. response against Iran or its proxies, given U.S. National Security Adviser John Bolton’s declaration this week re Iran, which we noted above. A direct attack on the U.S. military presence in the Gulf would be met with extreme force, according to U.S. President Donald Trump.4 A shooting war in the Gulf would, once again, raise the odds of a closing of the Strait of Hormuz, which has been threatened in the past by Iran. Some 20% of the world’s oil supply transits the Strait daily.5 A credible attack against shipping in the Strait would send oil prices sharply higher. If Iran were to succeed in blocking transit through the Gulf, an even sharper move in prices – above $150/bbl – could be expected. Markets Too Sanguine Re Sino – U.S. Trade War Commodity markets are not fully pricing the recent escalation of Sino – U.S. trade war, which were dialled up recently when Chinese President Xi Jinping declared China is embarking on a “New Long March” at a domestic political visit.6 The size of the tariffs thus far imposed by the U.S. against China and the EU are trivial in the context of global trade flows of ~ $19.5 trillion this year (Chart 5).7 According to the WTO, the USD value of merchandise trade rose 10% last year to $19.5 trillion, partly on the back of higher energy prices, while the value of services increased to $5.8 trillion, an 8% gain. Against this, U.S. tariffs of 25% on $250 billion worth of goods imported from China remain trivial. U.S. tariffs so far on EU imports by the U.S. are de minimis. Trade concerns do matter, however, in the longer run. Our geopolitical strategists make the odds of a no-deal outcome 50%, vs. a 40% chance of a deal being reached, and a 10% chance trade talks extend beyond the G20 talks scheduled for June. Chart 5 If markets become convinced the current Sino – U.S. trade war will evolve into a larger standoff between the U.S. and China – military or economic – capex and global supply chains will undergo profound changes. Globally, states likely will find themselves in the orbit of one of these powers, which will fundamentally alter investment flows and, ultimately, the profitability of global businesses. A full-blown trade war could become a Cold War, in other words, which would re-order global supply chains.8 Should this occur, an increase in demand for oil, bulks like iron ore, and base metals could ensue, as China ramps its fiscal and monetary stimulus, and the U.S. and others in its sphere of influence bid up commodity prices as they are forced to pay for other higher-cost alternatives for once-cheaper goods and services.9 USD Will Remain A Short-Term Headwind Globally, central banks remain accommodative, which will support aggregate demand domestically. However, the combination of rising U.S. – Iran tensions and the prospect of a widening Sino – U.S. trade war have put a bid under the USD in the short term. Our FX strategists expect the USD will appreciate another 2 – 3% before cresting and heading lower later in the year. In the short term, USD strengthening is a headwind for oil prices. A stronger dollar translates into higher prices in local currencies ex U.S., which reduces demand, all else equal. On the supply side, a stronger dollar lowers local production costs, which stimulates supply ex U.S. at the margin. Together, these militate against higher oil prices. Assuming the USD does weaken later in the year, as our FX strategists expect, oil prices could pick up a slight tailwind. However, policy risk and supply-demand fundamentals will continue to drive oil prices for the balance of the year. Bottom Line: Oil prices are being restrained by policy risk – particularly U.S. and Chinese trade policy and U.S. foreign policy in the Persian Gulf. We believe markets are under-estimating the odds of Brent prices being above $75/bbl for barrels delivering in December 2019, and in March 2020. A resolution of Sino – U.S. trade tensions is less likely than a no-deal outcome (40% vs. 50%), with the odds of trade talks continuing beyond next month’s G20 meeting being very slim (10%). A deepening of the Sino – U.S. trade war will have longer-term consequences for commodity demand – possibly positive in the wake of Chinese fiscal and monetary stimulus.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please see BCA’s Foreign Exchange Strategy Weekly Report titled“President Trump And The Dollar”, dated May 9, 2019, available at fes.bcaresearch.com. 2      Please see “Iranian naval mines likely used in UAE tankers attacks: Bolton,” published by reuters.com on May 29, 2019.  See also BCA’s Commodity & Energy Strategy Weekly Report titled “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity”, dated October 25, 2018, and BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report “U.S.-Iran: This Means War?”, dated May 3, 2019, both available at ces.bcaresearch.com. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled“Policy Risk Sustains Oil’s Unstable Equilibrium” , dated May 23, 2019, available at cesbcaresearch.com. 4      Please see Trump issues harsh warning to Iran, tweeting it would meet its "official end" if it fights U.S. posted by cbsnews.com on May 20, 2019. 5      Please see BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report titled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic”, dated July 19, 2018, available at ces.bcaresearch.com. 6      For an excellent discussion of these developments, please see BCA’s Geopolitical Strategy Weekly Report titled “Is Trump Ready For The New Long March?”, dated May 24, 2019, available at gps.bcaresearch.com. The “New Long March” is a reference to the 8,000-mile retreat of Chinese Communist Party fighters so they could regroup and ultimately prevail in their civil war in 1934-35. In recalling the Long March, “President Xi … told President Trump to ‘bring it on,’ as he apparently believes that a conflict with the U.S. will strengthen his rule,” according to Matt Gertken, BCA Research’s Chief Geopolitical Strategist. 7      Please see “Global trade growth loses momentum as trade tensions persist,” published by the WTO April 2, 2019. The World Trade Organization expects the growth in merchandise trade volume to drop from 3% last year to 2.6% in 2019, with a slight improvement next year back to 3% growth. Importantly, the WTO notes this is “dependent on an easing of trade tensions.” 8      The odds of a “hot war” between the U.S. and China also are rising, particularly in the South China Sea, according to Adm. James Stavridis (USN, Retired). Please see Collision course in the South China Sea published by the Nikkei Asian Review May 22, 2019. 9      Please see BCA’s Commodity & Energy Strategy Weekly Report titled“Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals” dated May 9, 2019, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

In our recent research, we have highlighted that our confidence in our constructive cyclical equity view has been shaken. There is budding evidence that the global growth recovery anticipated for the back half of the year could be pushed out to Q1/2020. In China, apparent diesel demand is adding insult to injury and warns that the ongoing Chinese easing has not translated into rising economic activity. Importantly, despite being collected prior to President Trump’s May 5th tweet, this data signals that global growth will likely remain downbeat in the coming months. Moreover, it underscores that more equity market pain lies ahead (see chart), as historically, Chinese diesel consumption growth and SPX momentum have been joined at the hip. Granted, there is a caveat as Beijing has been clamping down on highly polluting diesel fuel, suggesting that part of the recent plunge in apparent diesel consumption might have been exacerbated by the ongoing smog crackdown. Nonetheless, as it still powers trucking freight and infrastructure activity, Chinese diesel demand is telling us something about the weakness in domestic activity. Bottom Line: Stay cautious on the broad equity market. Chinese Diesel Demand And The SPX Chinese Diesel Demand And The SPX

Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Reflation Indicator And EM Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Asian Exports To China And To U.S Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities bca.ems_wr_2019_05_30_s1_c12 bca.ems_wr_2019_05_30_s1_c12 Chart I-13Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle bca.ems_wr_2019_05_30_s1_c16 bca.ems_wr_2019_05_30_s1_c16 Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). Chart I-18 This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Facing Resistance? Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Business Cycle Is Weak Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Domestic Demand Is Fragile Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Less Provisions = More Paper Profit Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth Very Weak Equity Breadth Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices India Versus EM & Oil Prices India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes   1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Feature Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart II-1 Chart II- Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart II- Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? Chart II-1 To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities Chart II-2 The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-2 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-2 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-2 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset Classes Global Equity Sectors Chart II-3 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart II-3 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart II-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Chart II-4 Chart II-4   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation Footnotes 1       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 2       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 3       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 4       Excess returns are defined as asset return relative to a 3-month Treasury bill. 5       Sector classification does not take into account GICS changes prior to December 2018.  6       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 7       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 8       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.

Highlights The Federal Reserve’s monetary policy stance is slightly accommodative for the U.S., but it is too tight for the rest of the world. Inflation is likely to slow further before making a durable bottom toward year-end. The Fed will remain on an extended pause, maybe all the way through to December 2020. The trade war is not going away, and investors should not be complacent. However, it also guarantees that Chinese policymakers will redouble on their reflationary efforts. As a result, global growth is still set to improve in the second half of 2019. The dollar rally is in its last innings; the greenback will depreciate in the second half of this year. Treasury yields have limited downside and their recent breakdown is likely to be a fake-out. Use any strength in bond prices to further curtail portfolio duration. The correction in stocks is not over. However, the cycle’s highs still lie ahead. Feature Ongoing Sino-U.S. tensions and weakness in global growth are taking their toll. The S&P 500 has broken below its crucial 2,800 level, EM equities are quickly approaching their fourth-quarter 2018 lows, U.S. bond yields have fallen to their lowest readings since 2017, copper has erased all of its 2019 gains and the dollar is attempting to break out. In response, futures markets are now pricing in interest rate cuts by the Fed of 54 bps and 64 bps, over the next 12 and 24 months, respectively. Will the Fed ratify these expectations? Last week’s release of the most recent Fed’s Federal Open Market Committee meeting minutes, as well as comments from FOMC members ranging from Jerome Powell to Richard Clarida, are all adamantly clear: U.S. monetary policy is appropriate, and a rate cut is not on the table for now. However, the avowed data-dependency of the Fed implies that if economic conditions warrant, the FOMC will capitulate and cut rates. Even as U.S. inflation slows, a recession is unlikely. Moreover, the Sino-U.S. trade war will catalyze additional reflationary policy from China, putting a floor under global growth. In this context, the Fed is likely to stay put for an extended period, but will not cut rates. While the S&P 500 is likely to fall toward 2,600, the high for the cycle is still ahead. We therefore maintain our positive cyclical equity view, especially relative to government bonds, but we are hedging tactical risk. Fed Policy Is Neutral For The U.S…. If the fed funds rate was above the neutral rate – the so-called R-star – we would be more inclined to agree with interest rate markets and bet on a lower fed funds rate this year. However, it is not clear that this is the case. Chart I-1Mixed Message From The R-Star Indicator Mixed Message From The R-Star Indicator Mixed Message From The R-Star Indicator Admittedly, the inversion of the 10-year/3-month yield curve is worrisome, but other key variables are not validating this message. Currently, our R-star indicator, based on M1, bank liquidity, consumer credit, and the BCA Fed monitor, is only in neutral territory (Chart I-1). Moreover, we built a model based on the behavior of the dollar, yield curve, S&P homebuilding relative to the broad market and initial UI claims that gauges the probability that the fed funds rate is above R-star. Currently, the model gives a roughly 40% chance that U.S. monetary policy is tight (Chart I-2). Historically, such a reading was consistent with a neutral policy stance.   Chart I-2Today, Fed Policy Is At Neutral Today, Fed Policy Is At Neutral Today, Fed Policy Is At Neutral Models can be deceiving, so it is important to ensure that facts on the ground match their insights. Historically, housing is the sector most sensitive to monetary policy.1 Key forward-looking activity measures are not showing signs of stress: mortgage applications for purchases have jumped to new cyclical highs, and the NAHB homebuilders confidence index has smartly rebounded after weakening last year (Chart I-3). Also, homebuilder stocks have been in a steady uptrend relative to the S&P 500 since last October (Chart I-3, bottom panel). These three developments are not consistent with tight monetary policy. Chart I-3This Would Not Happen If Policy Were Tight This Would Not Happen If Policy Were Tight This Would Not Happen If Policy Were Tight The corporate sector confirms the message from the housing sector. While capex intentions have weakened, they remain at elevated levels, despite slowing profit growth and elevated global uncertainty. Moreover, the latest Fed Senior Loan Officer Survey shows that banks have again eased credit standards for commercial and industrial loans. Netting out all these factors, we are inclined to agree with the Fed that monetary policy in the U.S. is broadly neutral. If anything, the rebound in leading indicators of residential activity would argue that policy is even slightly accommodative. … But Not For The Rest Of The World Congress gave the Fed a U.S.-only mandate, but the U.S. dollar is the global reserve currency. Because the dollar is the keystone of the global financial architecture, between US$12 trillion and US$14 trillion of foreign-currency debt is issued in USDs, and the greenback is used as a medium of exchange in roughly US$800 trillion worth of transaction per year.2 Therefore, the Fed may target U.S. monetary conditions, but it sets the cost of money for the entire world. While U.S. monetary conditions may be appropriate for the U.S., they are not entirely appropriate for the world as a whole. Indeed, the green shoots of growth we highlighted two months ago are rapidly turning brown: Korean and Taiwanese exports, which are highly sensitive to the global and Asian business cycles, are still contracting at a brisk pace (Chart I-4, top panel). Japan, an economy whose variance in GDP mostly reflects global gyrations, is weakening. Exports are contracting at a 4.3% yearly pace, machine tool orders are plunging at a 33% annual rate and the coincident indicator is below 100 – a sign of shrinking activity. The semiconductor space is plunging (Chart I-4, second panel). Our EM Asia diffusion index, which tallies 23 variables, is near record lows (Chart I-4, third panel). Europe too is feeling the pain, led by Germany, another economy deeply dependent on global activity. The flash estimate for the euro area manufacturing PMI fell to 47.7 and plunged to 44.3 in Germany, its lowest level since July 2012 (Chart I-4, bottom panel). These developments show that the world economy remains weak, in part because the Chinese economy has yet to meaningfully regain any traction. The rebound in Chinese PMI in March proved short lived; in April, both the NBS and Caixin measures fell back to near the 50 boom/bust line. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor. A strong dollar is a natural consequence of an outperforming U.S. economy, especially when global growth weakens. Thus, the rally in the Fed’s nominal trade-weighted dollar to its highest level since March 2002 is unsurprising (Chart I-5). A strong Greenback will have implications for inflation, and thus the Fed. Chart I-4Global Growth: No Green Shoots Here Global Growth: No Green Shoots Here Global Growth: No Green Shoots Here Chart I-5A Strong Dollar Is A Natural Consequence Of Weak Growth A Strong Dollar Is A Natural Consequence Of Weak Growth A Strong Dollar Is A Natural Consequence Of Weak Growth   Transitory Inflation Weakness Is Not Over The Fed believes the current inflation slowdown is transitory. We agree. With a tight labor market and rising wages, the question is not if inflation will rise, but when. In the current context, it could take some time. As Chart I-6 shows, inflation has been stable for more than 20 years. From 1996 to today, core PCE has oscillated between 0.9% and 2.6%, while core CPI has hovered between 0.6% and 2.9%, with the peaks and troughs determined by the ebbs and flows of global growth. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor, likely around 1.3% and 1.5% for core PCE and core CPI, respectively. Chart I-6Stable U.S. Inflation Since 1996 Stable U.S. Inflation Since 1996 Stable U.S. Inflation Since 1996 A few dynamics strengthen this judgment: The strength in the dollar is deflationary (Chart I-7, top panel). Not only does an appreciating greenback depress import prices, it tightens U.S. and global financial conditions. It also undermines dollar-based liquidity, especially if EM central banks try to fight weakness in their own currencies. All these forces harm growth, commodity prices and ultimately, inflation. Chart I-7More Downside Ahead In Inflation For Now More Downside Ahead In Inflation For Now More Downside Ahead In Inflation For Now After adjusting for their disparate variance, the performance of EM stocks relative to EM bonds is an excellent leading indicator of global core inflation (Chart I-7, second panel). This ratio is impacted by EM financial conditions, explaining its forecasting power for prices. Since goods inflation – which disproportionally contributes to overall variations in core CPI – is globally determined, U.S. inflation will suffer as well. U.S. capacity utilization is declining (Chart I-7, third panel). The U.S. just underwent a mini inventory cycle. The 12-month moving averages of the Philadelphia Fed and Empire State surveys’ inventory indexes still stand above their long-term averages. U.S. firms will likely use discounts to entice customers, especially as a strong dollar and weak global growth point to limited foreign outlets for this excess capacity. Finally, the growth in U.S. unit labor costs is slowing sharply, which normally leads inflation lower (Chart I-7, bottom panel). Average hourly earnings may now be growing at a 3.2% annual pace, but productivity rebounded to a 2.4% year-on-year rate in the first quarter, damping the impact of higher salaries on costs. If global growth is weak and U.S. inflation decelerates further, the Fed is unlikely to raise interest rates anytime soon. As the Fed policy remains modestly accommodative and the labor market is at full employment, the balance of probability favors an extended pause over a cut. But keep in mind, next year’s elections may mean this pause could last all the way to December 2020. How Does The Trade War Fit In? An additional irritant has been added to the mix: the growing trade tensions between the U.S. and China. The trade war has resurrected fears of a repeat of the 1930 Smoot-Hawley tariffs, which prompted a wave of retaliatory actions, worsening the massive economic contraction of the Great Depression. There is indeed plenty to worry about. Today, global trade represents 25% of global GDP, compared to 12% in the late 1920s. Global growth would be highly vulnerable to a freeze in world trade. Besides, global supply chains are extremely integrated, with intra-company exports having grown from 7% of global GDP to 16% between 1993 and 2013. If a full-blown trade war were to flare up, much of the capital invested abroad by large multinationals might become uneconomic. As markets price in this probability, stock prices would be dragged down. Chart I-8Trade Uncertainty Alone Will Delay The Recovery Trade Uncertainty Alone Will Delay The Recovery Trade Uncertainty Alone Will Delay The Recovery The fear of a full-fledged trade war is already affecting the global economy. The fall in asset prices to reflect the risk of stranded capital is tightening financial conditions and hurting growth. Moreover, the rise in U.S. and global economic uncertainty is depressing capex intentions (Chart I-8). Since capex intentions are a leading variable for actual capex, global exports and manufacturing activity, the trade war is deepening and lengthening the current soft patch. Markets need to be wary of pricing in a quick end to the Sino-U.S. trade conflict. Table I-1 presents BCA’s Geopolitical Strategist Matt Gertken’s odds of various outcomes to the trade negotiations and their implications for stocks. Matt assigns only a 5% probability to a grand compromise between the U.S. and China on trade and tech. He also foresees a 35% chance that a deal on trade excluding an agreement on tech will be reached this year. This leaves 10% odds that the two sides agree to extend the negotiation deadline beyond June, 20% odds of no deal at all and a minor escalation, and 30% odds of a major escalation. In other words, BCA is currently assigning 60% odds of a market-unfriendly outcome, and only a 40% chance of a genuinely market-friendly one.3 Chart I- Chart I-9 Why the gloom? The U.S. and China are geopolitical rivals in a deadlock. Moreover, both parties are feeling increasingly emboldened to play hardball. On the U.S. side, President Donald Trump has threatened to expand his tariffs to all of China’s exports to the U.S., which would represent a major escalation in both the conflict and its cost (Chart I-9). However, despite the scale of the threat, even if it were fully borne by U.S. households, its impact should be kept in perspective. Imports of consumer goods from China only represent 2% of total household spending (Chart I-10, top panel). Moreover, households are not currently overly concerned with inflation, as goods prices are already muted (Chart I-10, middle panel) and family income is still growing (Chart I-10, bottom panel). Finally, a weak deal could easily be decried as a failure in the 2020 election. On the Chinese side, the 9.5% fall in the yuan is already absorbing some of the costs of the tariffs, and the RMB will depreciate further if the trade war escalates. Additionally, Chinese exports to the U.S. represent 3.4% of GDP, while household and capital spending equals 81% of output. China can support its domestic economy via fiscal and credit policy, greatly mitigating the blow from the trade war. The outlook for Chinese reflationary efforts is therefore paramount. In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. Not only do Chinese policymakers have the room to stimulate, they also have the will. In the first four months of 2019, Chinese total social financing flows have amounted to CNY 9.6 trillion, which compares favorably to the same period during the 2016 reflation campaign. Yet, the economy has not fully responded to the injection of credit and previously implemented tax cuts amounting to CNY 1.3 trillion or 1.4% of GDP. Consequently, GDP per capita is now lagging well behind the required path to hit the government’s 2020 development targets (Chart I-11). Moreover, Chinese policymakers’ recent comments have increasingly emphasized protecting employment. This combination raises the likelihood of additional stimulus in the months ahead. Chart I-10...But Do Not Overstate Trump's Constraints ...But Do Not Overstate Trump's Constraints ...But Do Not Overstate Trump's Constraints Chart I-11Chinese Stimulus: Scope And Willingness Chinese Stimulus: Scope And Willingness Chinese Stimulus: Scope And Willingness   Therein lies the paradox of the trade war. While its immediate effect on world growth is negative, it also increases the chance that Chinese authorities pull all the levers to support domestic growth. A greater reflationary push would thus address the strongest headwind shaking the global economy. It could take two to six more months before the Chinese economy fully responds and lifts global growth. Ultimately, it will. Hence, even as the trade war continues, we remain skeptical that the Fed will cut interest rates as the market is discounting. We are therefore sticking to our call that the Fed will not cut rates over the next 12 months and will instead stay on an extended pause. Investment Conclusions The Dollar So long as global growth remains soft, the dollar is likely to rally further. That being said, the pace of the decline in global growth is decelerating. As a corollary, the fastest pace of appreciation for the greenback is behind us (see Chart I-5 on page 6). The risk to this view is that the previous strength in the dollar has already unleashed a vicious cycle whereby global financial conditions have tightened enough to cause another precipitous fall in world growth. The dollar’s strong sensitivity to momentum would then kick in, fomenting additional dollar strength in response to the greater growth slowdown. In this environment, the Fed would have no choice but to cut interest rates. However, growing reflationary efforts around the world currently confine this scenario to being a risk, not a central case. Additional factors also limit how far the dollar can rally. Speculators have already aggressively bought the greenback (Chart I-12). The implication is that buyers have moved in to take advantage of the dollar-friendly fundamentals. When looking at the euro, which can be thought of as the anti-dollar, investors are imputing a large discount in euro area stocks relative to U.S. ones, pointing to elevated pessimism on non-U.S. growth (Chart I-13). It would therefore require a much graver outcome in global growth to cause investors to further downgrade the outlook for the rest of the world relative to the U.S. and bring in new buyers of greenbacks. Chart I-12USD: Supportive Fundamentals Are Already Reflected USD: Supportive Fundamentals Are Already Reflected USD: Supportive Fundamentals Are Already Reflected Chart I-13Plenty Of Pessimism In European Assets... Plenty Of Pessimism In European Assets... Plenty Of Pessimism In European Assets...   In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. The same factors that are currently putting the brakes on the dollar’s rise will fuel its eventual downturn. As global growth bounces, a liquidation of stale long-dollar bets will ensue. European growth will also rebound (Chart I-14), and euro pessimism will turn into positive surprises. European assets will be bought, and the euro will rise, deepening the dollar’s demise. We are closely following the Chinese and global manufacturing PMIs to gauge when global growth exits its funk. At this point, it will be time to sell the USD. Government Bonds Bonds are caught between strong crosscurrents. On the one hand, rising economic uncertainty caused by the trade war, slowing global economic activity and decelerating inflation are all bond-bullish. On the other hand, bond prices already reflect these tailwinds. The OIS curve is baking in 54 basis points of Fed cuts over the next 12 months, as well as a further 10 basis points over the following 12 months (Chart I-15, top panel). Meanwhile, term premia across many major bond markets are very negative (Chart I-15, middle panel). Finally, fixed-income investors have pushed their portfolio duration to extremely high levels relative to their benchmark (Chart I-15, bottom panel). Chart I-14...Creates Scope For Positive Surprises ...Creates Scope For Positive Surprises ...Creates Scope For Positive Surprises Chart I-15Fade The Treasury Rally Fade The Treasury Rally Fade The Treasury Rally   Last week, Treasury yields broke down below 2.34%. For this technical break to trigger a new down-leg in yields, investors must curtail their already-depressed expectations of the fed funds rate in 12-months’ time. However, the fed funds rate is not yet restrictive, and global growth should soon find a floor in response to expanding Chinese stimulus. Under these circumstances, the Fed is unlikely to cut rates, and will continue to telegraph its intentions not to do so. Hence, unless the S&P 500 or the ISM manufacturing fall below 2,500 and 50, respectively, any move lower in yields is likely to be transitory and shallow. Cyclically, yields should instead move higher. Our Global Fixed Income Strategy service’s duration indicator has already turned the corner (Chart I-16). Moreover, in the post-war period, Treasury yields have, on average, bottomed a year before inflation. Expecting an inflation trough in late 2019 or even early 2020 is therefore consistent with higher yields by year-end. Finally, when the Fed does not cut interest rates as much as the markets had been anticipating 12-months’ prior, Treasurys underperform cash. This is exactly BCA’s current Fed forecast. Chart I-16Global Yields Now Have More Upside Than Downside Global Yields Now Have More Upside Than Downside Global Yields Now Have More Upside Than Downside While we expect the bond-bearish forces to emerge victorious, yields may only rise slowly. The list of aforementioned supports for Treasury prices is long, the equity market will remain volatile and has yet to trough, and the trade war is likely to linger. We continue to closely monitor the AUD, the SEK versus the EUR, and copper to gauge if our view is wrong. These three markets are tightly linked to Chinese growth. If China’s stimulus is working, these three variables will rebound, and our bond view will be validated. If these three variables fall much further, U.S. yields could experience significantly more downside. Equities Equities are at a difficult juncture. The trade war is a bigger problem for Wall Street than for Main Street, as 43.6% sales of the S&P 500’s are sourced abroad. Moreover, the main mechanism through which trade tensions impact the stock market is through the threat that capital will be stranded – and thus worthless. This is a direct hit to the S&P 500, especially as global growth has yet to clearly stabilize and the Chinese are only beginning to make clearer retaliatory threats. Oil could also hurt stocks. Energy prices have proven resilient, despite weaker global economic activity. OPEC and Russia have been laser-focused on curtailing global crude inventories; even after the U.S. declined to extend waivers on Iranian exports, the swing oil producers have not meaningfully increased supply. Problems in Venezuela, Libya, and potential Iranian adventurism in Iraq could easily send oil prices sharply higher, especially as the U.S. does not have the export capacity to fulfill foreign demand. Thus, the oil market could suddenly tighten and create a large drag on global growth. This backdrop also warrants remaining overweight the energy sector. Stocks remain technically vulnerable. Global and U.S. stock market breadth has deteriorated significantly, as shown by the number of countries and stocks above their 200-day moving averages (Chart I-17). Moreover, since March, the strength in the S&P 500 has been very narrow, as shown by the very poor performance of the Value Line Geometric Average Index (Chart I-18). Meanwhile, the poor relative performance of small-cap stocks in an environment where the dollar is strong, where U.S. growth is holding steady compared to the rest of the world and where multinationals have the most to lose from a trade war, is perplexing. Chart I-17Stocks Remain Technically Fragile Stocks Remain Technically Fragile Stocks Remain Technically Fragile Chart I-18Dangerous Internal Dynamics Dangerous Internal Dynamics Dangerous Internal Dynamics   The U.S. stock market has the most downside potential in the weeks ahead. Like last summer, U.S. equity prices remain near record highs while EM and European stocks, many commodities and bond yields have been very weak. Moreover, the broad tech sector, the U.S.’s largest overweight, has defied gravity, despite weakness in the semiconductor sector, the entire industry’s large exposure to foreign markets, and the consequential slowdown in our U.S. Equity Strategy service's EPS model (Chart I-19).4 Thus, any bad news on the trade front or any additional strength in the dollar could prove especially painful for tech. This would handicap U.S. equities more than their already beaten-up foreign counterparts. Chart I-19The Tech Sector Profit Outlook Remains Poor The Tech Sector Profit Outlook Remains Poor The Tech Sector Profit Outlook Remains Poor These forces mean that the global equity correction will last longer, and that U.S. equities could suffer more than other DM markets. However, we do not see the S&P falling much beyond the 2,700 to 2,600 zone. Again, the fed funds rate is slightly accommodative and a U.S. recession – a prerequisite for a bear market (Chart I-20) – is unlikely over the coming 12 months. Moreover, global growth should soon recover, especially if China’s reflationary push gathers force. Additionally, an end to the dollar’s rally would create another welcomed relief valve for stocks. Chart I-20The Absence Of A Recession Means This Is A Correction, Not A Bear Market The Absence Of A Recession Means This Is A Correction, Not A Bear Market The Absence Of A Recession Means This Is A Correction, Not A Bear Market In this context, we recommend investors keep a cyclical overweight stance on stocks. Balanced portfolios should also overweight stocks relative to government bonds. However, the near-term risks highlighted above remain significant. Consequently, we also recommend investors hedge tactical equity risks, a position implemented by BCA’s Global Investment Strategy service three weeks ago.5 As a corollary, if stocks correct sharply, the associated rise in implied volatility will also cause a violent but short-lived pick up in credit spreads. In Section II, we look beyond the short-term gyrations. One of BCA’s long-term views is that inflation is slowly embarking on a structural uptrend. An environment of rising long-term inflation is unfamiliar to the vast majority of investors. In this piece, Juan-Manuel Correa, of our Global Asset Allocation team, shows which assets offer the best inflation protection under various states of rising consumer and producer prices. Mathieu Savary Vice President The Bank Credit Analyst May 30, 2019 Next Report: June 27, 2019 II. Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart II-1 Chart II- Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart II- Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. Chart II-1 What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities Chart II-2 The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-2 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-2 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-2 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset Classes Global Equity Sectors Chart II-3 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart II-3 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart II-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Chart II-4 Chart II-4   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation   III. Indicators And Reference Charts Last month, we argued that the S&P 500 would most likely enter a period of digestion after its furious gains from December to April. This corrective episode is now upon us as the S&P 500 is breaking below the crucial 2,800 level. Moreover, our short-term technical indicators are deteriorating, as the number of stocks above their 30-week and 10-week moving averages have rolled over after hitting elevated levels, but have yet to hit levels consistent with a durable trough. This vulnerability is especially worrisome in a context where pressure will continue to build, as Beijing is only beginning to retaliate to the U.S.’s trade belligerence. Our Revealed Preference Indicator (RPI) is not flashing a buy signal either. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. It will require either cheaper valuations, a pick-up in global growth or further policy easing before stocks can resume their ascent. On the plus side, our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Hence, stock weaknesses are likely to prompt buy-the-dip behaviors by investors. Therefore, the expected downdraft will remain a correction and stocks have more cyclical upside. Our Monetary Indicator remains in stimulative territory, supporting our cyclical constructive equity view. The Fed is firmly on hold and global central banks have been opening the monetary spigots, thus monetary conditions should stay supportive. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message of our Monetary Indicator, especially as our Composite Technical Indicator has moved back above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are slightly expensive. Moreover, our technical indicator flags a similar picture. However, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Taking this positioning into account, BCA’s economic view is consistent with limited yield downside in the short-run, and higher yields on a 6 to 12 month basis. On a PPP basis, the U.S. dollar is only getting ever more expensive. Additionally, our Composite Technical Indicator is not only in overbought territory, it is also starting to diverge from prices. Normally, this technical action points to a possible trend reversal, especially when valuations are so demanding. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes   Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Edward E. Leamer, "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233, 2007. 2       This includes both real and financial transactions. 3       Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President,” dated May 17, 2019, available at gps.bcaresearch.com 4       Please see Global Investment Strategy Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Trader's Paradise,” dated January 28, 2019, available at uses.bcaresearch.com 6       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 7       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 8       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 9       Excess returns are defined as asset return relative to a 3-month Treasury bill. 10       Sector classification does not take into account GICS changes prior to December 2018.  11       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 12       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 13       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights The risk premium in crude oil prices is rising again, as policy risk – and the potential for large policy-driven errors – increases (Chart of the Week).1 This is not being fully reflected in options markets, where implied volatilities are trading close to their long-term average levels (Chart 2). In the past month, risks to oil flows – military and otherwise – and supply have risen, which is keeping a bid under prices. The Sino – U.S. trade war has worsened, and threatens to put global supply chains at risk, along with EM demand growth in the medium term. Meanwhile, amid global monetary easing, the USD has strengthened, producing a more immediate headwind for EM commodity demand. Against this backdrop of opposing forces, oil prices remain elevated and relatively stable in the low $70/bbl range for Brent. Our balances estimates and price forecasts have not changed materially this month. However, the balance of risks has widened in both tails of the price distribution. We expect implied volatilities in the crude oil options markets – particularly Brent – to move higher, as a result. As for prices, we continue to expect Brent to average $75/bbl this year and $80/bbl next year, with WTI trading $7/bbl and $5/bbl below those levels in 2019 and 2020, respectively. Energy: Overweight. The U.S. EIA moved closer to our fundamental assessment and Brent forecast in its most recent market update, lifting its Brent spot-price expectation for this year to an average of $70/bbl, ~ $5/bbl above its April forecast. The EIA’s revision reflects “tighter expected global oil market balances in mid-2019 and increasing supply disruption risks globally.” Base Metals: Neutral. In the wake of Vale’s January supply disaster at its Córrego do Feijão mine, iron ore shipments from Brazil were down 60% in April y/y. Cyclones disrupted supply in Western Australia, pushing 62% Fe iron ore prices to a 5-year high above $100/MT last week. Chinese steelmakers registered a 12.7% y/y gain in crude steel output last month, which, along with dockside iron ore inventory draws of ~ 20 MT ytd, is supporting prices generally. Precious Metals: Neutral. A stronger USD is weighing on gold. Global geopolitical tensions – chiefly in the Persian Gulf and in Sino – U.S. trade relations – are keeping prices above $1,270/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Severe weather conditions in the Midwest continues to delay corn planting, and is contributing to a rally this week in corn prices to $3.94/bushel on Tuesday, up $3.48/bushel from last week’s level. Feature The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz, where ~ 20% of global supply transits daily.2 Bellicose rhetoric from the U.S. – some of it directed at materially reducing Iran’s influence in Iraq – alternately is ramped up and walked back, while attacks on soft targets in the Kingdom of Saudi Arabia (KSA) – e.g., oil shipping and west-bound oil pipelines – draw attention to the exposure of this critical infrastructure, upon which global oil markets rely.3 Iran, meanwhile, uses the media to prepare its population for further economic deprivation, and to lob its own vituperative rhetoric at the U.S. Chart 1 Venezuela’s collapse as an oil producer and exporter continues unabated, keeping markets for the heavier sour crude favored by U.S. refiners tight. Civil war threatens to cut into Libyan production, which we are carrying at just over 1mm b/d, while whiffs of another Arab Spring can be detected in Algeria, where popular discontent with ruling elites grows.4 On the demand side, the summer driving season is about to kick off in the Northern Hemisphere, heralding increased gasoline demand. Countering that, the Sino – U.S. trade war shows signs of devolving into a Cold War, which could force a re-ordering of supply chains globally, lifting costs and consumer-level inflation in the process. Longer-term, this could work against central-bank easing globally, and retard growth in EM consumer demand. The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz. For the present, we continue to expect EM demand growth to hold up, expanding by 1.5mm b/d this year and 1.6mm b/d next year. This will be supported by continued monetary easing globally, and additional fiscal stimulus from China if its trade war with the U.S. worsens. There is a chance weakness in DM demand will persist, but we think the odds of a normal seasonal pick-up in 2H19 will continue to support demand overall (Chart 3). That said, given the threats to demand growth – an expanded Sino – U.S. trade war and stronger USD, in particular – we will continue to monitor the health of EM demand closely. Chart 2Brent Implied Volatility Will Move Higher Brent Implied Volatility Will Move Higher Brent Implied Volatility Will Move Higher Chart 3DM Oil Demand Growth Wobbles, EM Steady DM Oil Demand Growth Wobbles, EM Steady DM Oil Demand Growth Wobbles, EM Steady   OPEC 2.0 Maintains Production Discipline Chart 4OPEC 2.0's Production Discipline, Strong Demand Drained Inventories OPEC 2.0's Production Discipline, Strong Demand Drained Inventories OPEC 2.0's Production Discipline, Strong Demand Drained Inventories The goal of OPEC 2.0 from its inception at the end of 2016 has been to drain OECD inventories, which swelled to 3.1 billion barrels in July 2016, on the back of a market-share war launched by the old OPEC under the leadership of KSA, and a surge in U.S. shale-oil production. KSA continues to stress the need to restrain crude oil production so as to draw down global oil inventories, and has done much of the heavy lifting this year to make that happen (Chart 4). The other putative leader of OPEC 2.0, Russia, continues to express misgivings with such a strategy, arguing instead the producer coalition should make more oil available to the market. We are more aligned with Russia’s view, and continue to believe OPEC 2.0 will need to increase production. In our balances (Table 1), our base case assumes those producers that can lift production – core OPEC and Russia – will do so to keep prices below $85/bbl (Chart 5). We expect OPEC 2.0 will be able to offset the loss of ~ 700kb/d from Iran exports by increasing production gradually from May to September in proportion to its quota agreement. In our base case, we have Iranian exports falling to 600k b/d. We continue to expect OPEC 2.0 to be able to offset the loss of Venezuela’s production throughout the year, which we expect to fall to 500k b/d by December (vs. ~ 735k b/d presently). Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. We also expect Russia to lift its production closer to 11.6mm b/d from ~ 11.4mm b/d at present. Even with OPEC 2.0 lifting production ~ 900k b/d in 2H19 vs. 1H19, the bulk of global production increases will be concentrated in the U.S., where we expect shale-oil output to grow 1.2mm b/d this year, and 840k b/d next year. This will account for 85% of the overall increase of 2.4mm b/d we expect in the U.S. this year and next. Our estimates of production growth in the U.S. shales is tempered by a growing conviction the large integrated oil majors and stand-alone E&P companies will continue to put the interests of shareholders above their desire to increase production just for the sake of increasing it, as was done in the past. This is driven by a desire to attract and retain capital, which will be critical to the majors and the big E&Ps in the years ahead.5 We continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories. Even with these production increases, we continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories (Chart 6). Chart 5Core OPEC 2.0 Will Lift Production Core OPEC 2.0 Will Lift Production Core OPEC 2.0 Will Lift Production Chart 6Balances Continue To Tighten Balances Continue To Tighten Balances Continue To Tighten   Spare Capacity Will Be Stretched Chart 7 In addition to Iran and Venezuela, we are closely following what appears to be the early stages of another civil war in Libya, which threatens the ~ 1mm b/d of production flowing from there. In addition, we are seeing signs of growing civil discontent in Algeria not unlike that of 2011, which was sparked by popular dissatisfaction with ruling elites throughout the Middle East in the lead-up to the Arab Spring. We have maintained existing spare capacity can handle the loss of Iranian and Venezuelan production and exports we’ve built into our balances and price-forecast models. However, covering these losses will stretch the capacity of global supply to accommodate unplanned outages, which could leave markets extremely tight in the event of production losses in Libya or Nigeria, or in producing provinces prone to natural disasters (e.g., Canadian wildfires or U.S. Gulf hurricanes). At present, markets appear to be comfortable with OPEC 2.0’s ability to cover losses from Iran and Venezuela, given current spare capacity of ~ 3mm b/d, most of which remains in KSA, and continued growth in non-OPEC output (Chart 7). As inventories continue to draw globally, markets’ attention will turn more toward this spare capacity.   Expect Higher Volatility We remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. Chart 8Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Our fundamental assessments of supply, demand and inventory levels remain fairly steady. Thus, our price forecasts – $75 and $80/bbl this year and next for Brent, with WTI trading $7 and $5/bbl under that – remain unchanged. With OPEC 2.0 maintaining production discipline and U.S. shale producers maintaining capital discipline, the rate of growth on the supply side will be restrained, and below the rate of growth in global demand. These forces combine to keep inventories drawing this year, which will lead to a steeper backwardation in forward curves, particularly Brent’s (Chart 8). Coupled with true uncertainty re how the U.S. – Iran confrontation in the Persian Gulf is resolved, and how the Sino – U.S. trade war plays out, this steepening backwardation will lead to higher implied volatility in crude oil options markets. Bottom Line: Our expectation of higher prices and steepening backwardation in forward curves is supported by our analysis of fundamentals and the current political economy of global oil markets, which emphasizes policy risk arising from the actions of geopolitically significant states. These factors also will push implied volatility in options markets higher. As a result, we remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. We also remain long 2H19 Brent vs. short 2H20 Brent futures in line with our view backwardation will increase; this position is up 155.4% since it was initiated in February, as a result of the steepening of backwardation in the forward curve. Steepening backwardation also will benefit our long S&P GSCI recommendation, which is heavily weighted to energy markets; this position is up 8% since inception. Lastly, we remain long spot WTI, which is up 34.6% since it was recommended in January.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 In the price decomposition shown in our Chart of the Week, we account for the contribution that changes in global supply, demand and inventory levels make to the evolution of Brent prices, using a proprietary econometric model. We treat the residual term of the model – what’s left of the price decomposition after these fundamental variables are accounted for – as a measure of the risk premium in prices. An expansion of the risk premium – in the positive or negative direction – is coincident with an expansion of the implied volatility of Brent crude oil options typically expands (sometimes with a lag or two), and vice versa. This is intuitively appealing, since risk premia and volatility expand as uncertainty in the market rises. 2 We considered this topic in depth in a Special Report written with BCA Research’s Geopolitical Strategy entitled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic,” published July 19, 2018, and in “Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf,” published July 5, 2018. Both reports are available at ces.bcaresearch.com. 3 Iran’s influence in Iraq is an internally divisive issue, and a focal point of the U.S., a view we share. Please see, “Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply,” a Special Report we published with BCA Research’s Geopolitical Strategy September 5, 2018. KSA and Western intelligence agencies allege Iran is behind the attacks on Saudi oil infrastructure. Please see “Saudi Arabia accuses Iran of ordering drone attack on oil pipeline,” published by reuters.com. The westbound pipelines in KSA are critical to maintaining the Kingdom’s export capacity, as we noted in “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity,” published by BCA Research’s Commodity & Energy Strategy October 25, 2018. This report is available at ces.bcaresearch.com. 4 Please see “Algeria Has a Legitimacy Problem,” posted on the LSE’s Middle East Centre Blog by Benjamin P. Nickels on May 20, 2019, and “Algeria’s Second Arab Spring?” by Ishac Diwan posted at project-syndicate.org March 28, 2019. 5 We will be exploring this topic in depth in a Special Report next month. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed in Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium