Commodities & Energy Sector

HighlightsU.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.FeatureSome 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: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 I-1A, top panel).Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart I-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.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 I-1A, bottom panel).Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart I-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.Demographics: The population in the U.S. is set to age in coming years (Chart I-1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart I-1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. Chart I-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 I-1BStructural Forces Point To Higher Inflation In The Coming Decade (II) Structural Forces Point To Higher Inflation In The Coming Decade (II) Structural Forces Point To Higher Inflation In The Coming Decade (II)  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 I-2 and Table I-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 I-2 Chart I- Summary Of ResultsTable I-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 I- 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?To answer this question, we construct four portfolios with different levels of inflation hedging:Benchmark (no inflation hedging): 60% equities / 40% bonds.Low Inflation Hedging: 50% equities / 40% bonds / 5% TIPS / 5% commoditiesMedium Inflation Hedging: 40% equities / 30% bonds / 15% TIPS / 15 % commoditiesPure Inflation Hedging: 50% TIPS / 50% commodities. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Chart I-3Inflation Hedging Comes At A Cost Inflation Hedging Comes At A Cost Inflation Hedging Comes At A Cost  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 I-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 I-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 I-3, panel 4).Investment ImplicationsHigh 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.Asset ClassesGlobal EquitiesThe 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-1, top panel). Chart II-1 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-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-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). 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). 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-3 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-3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-4 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-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-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-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-5 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-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.7The 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-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 ClassesGlobal Equity Sectors Chart III-1 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 III-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 III-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 III-1, panel 3).When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart III-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 III-2 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 III-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 III-2, panel 2). The dollar was roughly flat in this environmentU.S. stocks started to have negative excess returns when inflation was high (Chart III-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 III-2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart III-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8Total return for every commodity was lower than spot return when inflation was low (Chart III-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 III-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 III-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 III-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 AssetsU.S. Direct Real Estate Chart IV-1Direct Real Estate Is A Good Inflation Hedge Direct Real Estate Is A Good Inflation Hedge Direct Real Estate Is A Good Inflation Hedge  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 IV-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 IV-1, bottom panel). Cash Chart IV-2Very High Inflation Erodes The Value Of Cash Very High Inflation Erodes The Value Of Cash Very High Inflation Erodes The Value Of Cash  Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample. (Chart IV-2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart IV-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 OssaSenior Analystjuanc@bcaresearch.com Footnotes1      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, available at gis.bcaresearch.com and Global Investment Strategy Special Report, “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. 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 We’ve searched in vain for imminent domestic weakness in the U.S. economy, … : Much of our work this spring has focused on trying to poke holes in our view that the equilibrium fed funds rate remains above the target fed funds rate, but we haven’t found any evidence of overheating in the real economy, or worrisome excesses in financial markets. … but an exogenous shock could well precipitate a recession if it were serious enough: The U.S. is a comparatively closed economy, but there’s no such thing as full-on decoupling. The U.S. may react more slowly than other major economies to what’s going on in the rest of the world, but it’s not immune to it. A trade war would threaten global growth, … : U.S.-China trade negotiations have taken center stage over the last couple weeks, and escalating tension between the world’s two largest standalone economies will surely cast a pall over the global outlook. … but there are other potential threats that bear monitoring: Tensions with Iran could be the catalyst for an oil price shock, while a significant rollback of globalization could crimp corporate profit margins. Either would hasten the end of the equity bull market and the expansion. Feature Tight monetary policy is a necessary, if not sufficient, condition for a recession. We deem policy to be tight if the fed funds rate exceeds our estimate of the equilibrium fed funds rate, and easy if it is below our estimate of equilibrium. Over the six decades for which we compute an estimate of the equilibrium fed funds rate, the U.S. has only ever experienced recessions when the fed funds rate has exceeded our estimate of equilibrium (Chart 1). Tight policy isn’t always tantamount to a recession – nothing came of tight settings in 1984 or 1995 – but recessions don’t occur without it. Chart 1Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight We currently estimate that the equilibrium fed funds rate, a.k.a. the neutral rate, is about 3⅛%, and we continue to project that it will be around 3⅜% by the end of the year. Those estimates leave the Fed with plenty of headroom before it materially slows the economy. If our estimate is on the money, it will take four more rate hikes to induce an inflection in the business cycle. We have not seen anything in the ongoing flow of macro data, or evidence of excesses in the financial markets, that would suggest a recession is already under way or is lurking around the corner. Internal dynamics should continue to support the expansion, but threats from outside the U.S. are growing. We therefore conclude that the next recession may well not arrive for another two years, in the absence of a significantly adverse exogenous event. This week, we extend our focus beyond the U.S. to try to uncover the external threats that could stop the U.S. economy, and the bull markets in risk assets, in their tracks. Beyond the tariff fireworks, we also contemplate the possibility that conflict with Iran could lead to an oil price shock, and the impact of a significant rollback of globalization. It is not our base case that any of the various external threats will tip the U.S. into a recession, but investors should keep tabs on the biggest ones. Tariffs The U.S.-China trade saga has unfolded in three pairs of moves and counter-moves (Diagram 1). While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories included not only commodities such as base metals, chemical products and mineral fuels and oils, but also a broad swath of foods, textiles, electronics, vehicles and spare parts. After a three-month cease-fire, the developments of the last two weeks arguably marked the most significant escalation of tensions on both sides. The U.S. is now threatening to levy tariffs on the remaining $325bn of Chinese goods that have so far been spared. Diagram 1Anything You Can Do External Threats External Threats Our colleagues at BCA’s Geopolitical Strategy service suggest that recent foreign policy initiatives indicate that the White House does not feel any particular pressure to minimize economic risk this far ahead of the election. The risk of market-disruptive measures has therefore increased, and they see a 50-50 chance that the U.S. and China will fail to reach an accord (Table 1). Although the administration has delayed any action on autos and auto parts for now, Europe could be the next trade partner in its cross hairs. The odds that Section 232 (national-security-threat) tariffs will be levied on European auto imports is rising (Chart 2). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 External Threats External Threats Chart 2 These heightened trade tensions may delay the global growth recovery that we were expecting to bloom in the summer, and they may also allow the dollar to keep advancing. The greenback is a countercyclical currency, moving inversely with global activity (Chart 3), and a bump in the road for global growth would likely extend its upward run. Chart 3The Countercyclical Dollar The Countercyclical Dollar The Countercyclical Dollar Although a strong dollar would be a headwind for exporters, the U.S. economy is comparatively closed. Tariffs are likely to exert the greatest pressure on the economy via softer consumption and investment. So far, the available evidence suggests that U.S. consumers and corporations have borne the brunt of higher tariffs in the form of higher retail prices and lower profit margins.1 Iran Our geopolitical strategists contend that investors have underrated conflict with Iran as a market risk for a while. Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more delicacy than the more hawkish elements of the administration realize. In their view, the potential for a misstep increases the odds of a recession and poses a significant risk to the equity bull market. In a joint Special Report by our Commodity and Energy Strategy and Geopolitical Strategy services at the beginning of the month, our in-house experts stressed that there are multiple moving parts driving the supply-demand balance in the global oil market.2 Investors should realize that the world faces the prospect of the loss of Venezuelan production (approximately 600,000 barrels per day (b/d)) and significant outages in Libya (~600,000 to 800,000 b/d), in addition to our strategists’ base-case estimate of 700,000 b/d from Iran’s current 1.3 million b/d output. BCA does not expect that all of that output will be lost, but the key point is that Iran is not the only potential source of a supply shortfall. Our energy strategists believe that OPEC 2.0 – the producer coalition led by Saudi Arabia and Russia, and supported by Saudi Arabia’s OPEC allies – has the capacity to make up for even their larger shortfall scenarios (Chart 4). The problem is that OPEC 2.0 may not have the will to do so in a timely fashion. Saudi Arabia and the rest of the OPEC 2.0 coalition were caught completely off guard by the administration’s issuance of import waivers in November, after they had ramped up production at its request to limit the market disruptions that would have ensued when Iran’s output was taken off the market. The last-minute waiver decision caused oil prices to crater in the wake of a supply glut that OPEC 2.0 has been working to sop up ever since (Chart 5). Chart 4 Chart 5... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight   OPEC 2.0’s members may feel that they were badly used last fall, and may not be inclined to move proactively now. Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s estimates. If rising oil prices are often viewed as a tax on American consumers, a late summer/early fall release of holdings could be viewed as an election rebate, courtesy of the skilled economic managers in the White House. Our team expects that OPEC 2.0 will likely guard against an oversupply-driven swoon in oil prices by managing its production on something akin to a just-in-time inventory strategy. Our energy and geopolitical strategists caution that there are two other ways the administration may overplay its hand. First, it might overestimate U.S. shale drillers’ ability to export their production. While new pipeline construction will relieve the transportation bottleneck limiting the Permian Basin output that reaches the Gulf of Mexico, oil exports from the Gulf are limited by a shortage of deep-water harbor facilities. If global trade tensions do worsen, both the dollar and U.S. equities may attract safe-haven flows. There is also the possibility that Iran might strike at Iraq, putting some of its 3.5 million b/d output at risk. It could also make good on its repeated threat to close the Straits of Hormuz, through which nearly a fifth of global oil supplies travel daily. Either of these options would dramatically escalate the conflict, but a desperate Iran might pursue them if it felt cornered. The bottom line is that the probability of an oil price shock is not negligible. Brinkmanship with Iran could upset a delicate supply-demand balance in global oil markets, and a delicate geopolitical balance in the Middle East. If the Volcker double-dip is treated as a single event, a surge in oil prices has preceded every recession in the last 45 years, except for the 2001 recession precipitated by the bursting of the dot-com bubble (Chart 6). Chart 6Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Significant Rollback Of Globalization Our Geopolitical Strategy and Global Asset Allocation services have cited peak globalization as an important long-term investment theme for the last several years. The tariff tensions between the U.S. and its trading partners would seem to have borne out their predictions, especially if one views them as having been inspired by unskilled workers’ losses from globalization. Taking on foreign exporters is likely to play well in the electorally decisive Rust Belt states, where manufacturing job losses have hit especially hard. We fully subscribe to the theory of comparative advantage as formulated by David Ricardo in the early 19th century. By allowing individual countries to specialize in what they do best, free trade increases the size of the global economic pie. Empirical evidence suggests that globalization also re-slices the pie, however. In the developed world, outsourcing manufacturing has operated to the benefit of investors and the detriment of less-skilled workers. For U.S.-based multinationals, tariffs are a minor irritant compared to the prospect of having to reroute supply chains around China. The modest headwinds to globalization observed before the U.S. began engaging in serial bilateral trade conflicts did not undermine corporate profit margins in any material way. A bigger anti-globalization push that forced global supply chains to be rerouted or partially unwound would have much more negative effects. The U.S. is a comparatively closed economy, but the multinationals that dominate equity market capitalization rely heavily on interactions with the rest of the world. Unwinding the global supply chains that have been carefully constructed over the last 30 years would be disruptive and costly. The worst-case scenario envisioned by our geopolitical strategists, in which U.S.-China relations dramatically worsen and the tariff back-and-forth escalates in a major way, would hit equities hard, especially if supply chains had to be rebuilt. As a proxy for what globalization has meant for investors’ and blue-collar workers’ share of the pie, we consider the path of real wages relative to productivity over the last 50 years. From 1970 through 2001, U.S. wages generally kept pace with productivity gains, observing a fairly narrow, well-defined range (Chart 7). Once China entered the WTO (as denoted by the vertical line on the chart), productivity-adjusted wages fell precipitously, and even their periodic bounces have fallen well short of the level that marked the lower end of the previous range. Chart 7The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk Bottom Line: Temporary barriers to free trade, implemented as a negotiating tactic, are not a big deal for equities. A significant rollback of globalization would be, however, and a need to divert global supply chains away from China could stop the bull market in its tracks. Investment Implications Along with our Global Investment Strategy colleagues, we are somewhat more sanguine than our Geopolitical Strategy service that a worst-case outcome between the U.S. and China can be averted. We therefore continue to believe that the U.S. expansion, and the bull markets in risk assets, will persist until the Fed tightens monetary conditions enough to spark the next recession. We reiterate our recommendations that investors should maintain at least an equal weight position in equities and spread product. Enough is at stake in the conflicts with China and Iran, however, that a worsening of either could cause us to change our view, and we will be watching developments on each front closely. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com   Footnotes 1      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 2      Please see Commodity & Energy Strategy/Geopolitical Strategy Special Report, “U.S.-Iran: This Means War?,”dated May 3, 2019, available at ces.bcaresearch.com.

President Trump’s announcement this week of a new deployment of aid to U.S. farmers, to offset China’s retaliation to steeper tariffs, highlights that agriculture has been the sacrificial lamb in the U.S.’s hawkish trade policy. The $15 billion announcement follows last year’s $12 billion disbursement, and suggests that the path to a trade agreement with China remains fraught. Although China and the U.S. continue to negotiate, and President Trump has indicated that “maybe something will happen” within a “three or four week” timeframe, last week’s events indicate that a resolution is far from guaranteed. Both positive and negative trade war news will dominate the near term evolution of ag prices – stay on the sidelines as negotiations will sway markets. Highlights Energy: Overweight. Crude oil prices are up ~2% since the beginning of the week on escalating tensions in the Middle East, as expected. Two Saudi oil-pumping stations were targeted in a drone attack on Tuesday. This follows attacks on four oil tankers – including two Saudi ships – off the coast of the United Arab Emirates. These events highlight the increased risk of supply outages since the U.S. decision not to extend waivers on Iran sanctions.1 Base Metals: Neutral. The recent escalation in Sino-U.S. trade tensions pushed LMEX prices down 2% since the beginning of last week. Nevertheless, we believe that in the medium term Chinese authorities will manage to offset the negative economic impact on metals by ramping up fiscal-and-credit stimulus.2 Precious Metals: Gold’s geopolitical risk premium is rising amid escalating trade tensions. Gold rallied ~2% since May 3, amid declining global equities. Our gold trade is up 5.3% since inception. Ags/Softs: Underweight. Sino-U.S. trade tensions are weighing heavily on agriculture commodities. The grains and oilseed index is down 9% since the beginning of the year. Continued trade war uncertainty will keep risks elevated in the ags space (see below). Feature Several factors – including dollar strength and bearish fundamentals – have come together to drive down ag prices so far this year. However, the latest plunge highlights that trade risks remain a real threat to ag markets. This is in line with the sharp cutback in Chinese imports of U.S. ags, which make up a large share of Chinese imports from the U.S. and have been hit hard by tariffs (Chart of the Week). Soybeans in particular have become the poster child of the dispute. Uncertainty has taken their prices down to 10 year lows. In 2017, they accounted for $12.4 worth, or 9.3%, of U.S. exports to China. However, since the onset of the dispute, American soybean farmers have been struggling to market their crops. U.S. exports to China are down more than 80% y/y since 2H18 (Chart 2), and while there have been efforts to find other markets, they have yet to offset the impact of lower trade with China (Chart 3). Chart 1 Chart 2Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Chart 3 A long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. In fact, the Chinese tariffs add to ongoing trade disputes between the U.S. and some of its other major ag markets (Charts 4A & 4B). Canada, Mexico, and the EU have placed tariffs on a range of U.S. agricultural goods in response to the Section 232 tariffs on steel and aluminum. Chart 4 Chart 4 As such, American farmers are suffering the brunt of the trade war’s burden. Chinese retaliation comes at a time when U.S. ag stockpiles are already elevated (Chart 5). Inflation-adjusted farm income had been deteriorating prior to the trade dispute, falling to about half its 2013 level (Chart 6). The trade dispute has only reinforced this trend. In its most recent Ag Credit Survey, the Kansas City Fed found the pace of decline in farm loan repayment rates increased, while carry-over debt increased for many borrowers, ultimately causing a deterioration in ag credit conditions. Given that exports account for 20% of U.S. farm income, according to USDA estimates, a long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. Otherwise, tariffs will simply be another constraint on U.S. ag exports, which have been losing global market share since the mid-1990s (Chart 7). Chart 5U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated Chart 6Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Chart 7U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share Even though China briefly resumed some purchases of U.S. ags this year as a goodwill gesture during negotiations, these purchases stand significantly below those of previous years. They resulted from one-time purchases by Chinese state-owned enterprises, and barriers to trade remain in place. Such ad hoc attempts at reconciliation will not be sufficient to support a distrustful market going forward. The trade war is just one facet of a broader strategic U.S.-China conflict. This means a reso­lution would be only a cyclical improvement in an ongoing structural deterioration in relations. A number of potential outcomes can result from the ongoing negotiations: Most bearish: China raises the tariff rate on U.S. ag exports even further. A situation in which a fallout in the negotiations leads to strategic tensions – a scenario to which BCA’s geopolitical strategists attribute a 50% chance – could result in further ratcheting up of tariffs by China. Given that Chinese imports of U.S. ags are approaching zero, there is limited significant further downside even in this most pessimistic scenario. However, unless the U.S. is able to smoothly market its crops in other regions, upside will also be limited for some time. Since trade tariffs have already been initiated with many of the U.S.’s major ag consumers, securing reliable alternative markets may prove a challenge. Especially since Trump’s hawkish foreign policy raises risks and uncertainties for America’s trade partners. Bearish: Tariffs remain at current levels. Similar to the most bearish scenario, given that the U.S. is already having a difficult time marketing its crops abroad, significant further downside from current levels is also limited. However, any premium priced on the expectation of a resolution of the trade conflict will be eliminated. Again, as in the most bearish scenario, the loss of the Chinese market may be mitigated by an expansion of alternative markets, but challenges will remain. Bullish: Tariffs are cut back to pre-trade war levels. In this scenario, the tariffs imposed since the onset of the trade war will be unwound. This would once again raise the competitiveness of American crops in Chinese markets, and would entail higher ag prices as demand channels are re-established. Most Bullish: Tariffs fall to equalized levels. One of Trump’s key complaints is that U.S. and Chinese tariffs are not “reciprocal in nature and value” (Chart 8). Given that Chinese tariffs are above those of the U.S., this would entail a reduction in Chinese tariffs to below trade war levels (Table 1). Chart 8 Table 1... And They Have Gone Up American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship A lasting trade deal will likely include measures to close the bilateral trade deficit, which in 2018 stood at $379 billion. Last year Trump called on Beijing to reduce this deficit by $200 billion over two years. If we make the overly simplistic assumption that the share of imports remains unchanged, such a reduction would lead to an additional $19 billion in soybeans, $0.54 billion in wheat, and $0.23 billion in corn imports. This back of the envelope calculation implies a doubling of these U.S. exports to China, relative to 2017 levels. As we highlighted in our March ags update, investors had become overly optimistic with their expectation of a swift resolution of the trade war.3 In fact, according to BCA’s geopolitical strategists, the trade war is just one facet of a broader strategic U.S.-China conflict. This means a resolution would be only a cyclical improvement in an ongoing structural deterioration in relations. They assign only 40% odds that a deal will be finalized by year-end, with 30% odds that the frictions will escalate into strategic tensions. In the meantime, Trump’s palliatives – which include a “trade relief” program, an EU promise to purchase more U.S. soybeans, and last week’s suggestion of government purchases for humanitarian aid – are unlikely to lift ag prices. Bottom Line: The U.S.-China trade war has weighed on American ag exports. The impact on farmers – in terms of lower incomes, and higher stockpiles – has been significant. Granting that odds of a resolution this year are no greater than 40%, we recommend a cautious stance on ag markets. However, a trade deal that entails Chinese promises to import U.S. ags – either through more favorable tariff rates or commitments to purchase large volumes – would provide a buying opportunity. In any case, we suspect that prices are near the bottom, but will require a significant catalyst – in the form of a trade deal – to begin to climb materially. No Relief From Fundamentals, Either With spring planting underway, the recent escalation in trade tensions comes at a busy time of year for U.S. farmers. According to the USDA’s annual Prospective Planting Report, released at the end of March, the planted area of corn will likely increase by 4% in 2019, while soybean and wheat will fall 5% y/y and 4% y/y, respectively. If realized, the planting area that farmers intend to dedicate to wheat will be the lowest on record – that is, since 1919 (Chart 9). However, farms in the Midwest were hit by a “bomb cyclone” in March, which has damaged crops and delayed planting. Inundated fields mean farmers are forced to push back their schedule. The latest Weekly Crop Progress Report from the USDA, indicates that farmers have fallen behind relative to typical progress at this time of year (Table 2). Although farmers’ current lack of headway is cause for concern, they may still be able to catch up and attain their targeted acreage. Chart 9Record Low Wheat Acreage Record Low Wheat Acreage Record Low Wheat Acreage Table 2Flooding Has Delayed Spring Planting American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship Given that stockpiles are full, due to years of surplus, the impact of the flooding is unlikely to move international ag prices. Nevertheless, planting delays raise the possibility that corn farmers will switch to soybeans, which can be planted later in the season. In the May update of the World Supply And Demand Estimates – which includes the first estimates for the 2019/20 crop year — the USDA projected a decline in U.S. soybean ending stocks on the back of lower production and a pickup in exports. The switch in planting intentions towards soybeans at the expense of corn may at least partially reverse this expectation, raising global soybean inventories which are expected to remain unchanged (Chart 10). In addition to trade war, the African swine fever has hit pig herds in China – the main consumers of soybeans. According to China’s official statistics, more than a million pigs have been culled, and Chinese pork production is expected to be slashed by between a quarter and a half this year. This will depress demand for soybeans, further weighing on prices. So far this year the greenback has been a source of bearishness toward ags. Since the epidemic has spread to other Asian neighbors including Hong Kong and Vietnam, soybean demand from Asia will be reduced, regardless of the outcome of the trade war. This will also weigh on other major producers such as Brazil and Argentina, which have so far benefited from China’s shunning of the American crop. South American producers are also at risk if a positive outcome emerges from the negotiations. Chart 10No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year Chart 11Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories On the other hand, according to the latest USDA estimates, both global and U.S. year-end wheat inventories are expected to pick up in the 2019/2020 crop year (Chart 11). Greater European production will add to already elevated supplies. While global corn inventories are projected to come down, U.S. inventories will likely rise amid greater production and weaker exports. However, these acres are at risk given the flood delays (Chart 12). In addition to these supply-demand fundamentals, U.S. financial conditions – especially the U.S. dollar – will remain a key driver of ag prices. So far this year the greenback has been a source of bearishness toward ags. Ag prices have an inverse relationship with the U.S. trade-weighted dollar (Chart 13). While in our earlier report we had expected the dollar to peak by mid-year, the May 5 escalation in the trade war poses a risk to this view by threatening the global trade and growth outlook and spurring risk-off sentiment. Chart 12Another Deficit Expected ##br##For Corn Another Deficit Expected For Corn Another Deficit Expected For Corn Bottom Line: Farmers in the U.S. Midwest facing inundated fields are behind schedule in their spring planting. This poses a risk that a greater number of soybeans will be planted at the expense of corn – weighing down on an already depressed soybean market and potentially requiring the USDA to revise down its U.S. bean ending stocks in its next WASDE report. Chart 13U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags What is more, the African swine fever, which is spreading across East Asia, is reducing demand for animal feed there. Unless the trade conflict is resolved, we expect corn and wheat to outperform the soybean market.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Special Report titled “U.S.-Iran: This Means War?” dated May 3, 2019, available at ces.bcaresearch.com. 2      Please see BCA Research’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. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Financial Conditions, Trade War Continue To Dominate Ag Market,” dated March 28, 2019, available at ces.bcaresearh.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

While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. 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