Commodities & Energy Sector

Highlights A sooner-than-anticipated end to the Federal Reserve’s balance-sheet runoff should give a welcome boost to international liquidity conditions. Moreover, reflationary efforts in China, cautious global central banks, and easing global financial conditions all point to a rebound in economic surprises. This will support pro-cyclical versus defensive currencies and argues against a strong USD. At this point, it is too early to tell how long a pro-cyclical FX stance will be warranted. Sell NZD/CAD. Feature Since the turn of the year, this publication has argued that a correction in the dollar was increasingly likely, and that the main beneficiaries of this move should be the more pro-cyclical currencies. Because U.S. domestic fundamentals remain much stronger than the rest of the G10’s, our preference has been to favor commodity currencies versus the yen instead of playing dollar weakness outright. This theme remains in place for now. However, we are increasingly concerned about the dollar and think the outperformance of commodity currencies could last longer than originally expected. Essentially, an end to the Federal Reserve’s balance-sheet runoff, more cautious central banks, and easier global financial conditions could set the stage for a significant rebound in commodity currencies. U.S. Excess Reserves Vs. Commodity Currencies Whether it is from Governor Lael Brainard, Cleveland Fed President Loretta Mester, or the FOMC minutes, the message is clear: The days of the Fed’s balance sheet runoff are numbered. Ryan Swift, BCA’s Chief U.S. Bond Strategist, has written at length that the Fed’s balance sheet attrition has had a limited direct impact on U.S. growth. However, Ryan and the FOMC members both agree that a smaller balance sheet impacts the ability of the Fed to control the level of the fed funds rate.1 With less excess reserves in the banking system, the New York Fed has to intervene more often to keep the policy rate below its ceiling. This might seem like a very technical point, but it is an important one for many FX markets. Prior to the financial crisis, expanding excess reserves on U.S. commercial banks would coincide with improving dollar-based liquidity. Moreover, since 2011, reserves even lead our financial liquidity index (Chart I-1). Since there is 14 trillion of USD-denominated foreign-currency debt around the world, these fluctuations in U.S. excess reserves, and thus global liquidity, can have an impact on the price of assets most levered to global growth conditions. Chart I-1U.S. Excess Reserves Contribute To The Global Liquidity Backdrop Chart I-2 illustrates that commodity currencies are indeed very responsive to changes in U.S. excess reserves, particularly when these pro-cyclical currencies are compared to counter-cyclical ones like the JPY. Meanwhile, the trade-weighted dollar tends to move in the opposite direction of excess reserves, reflecting the dollar’s countercyclical nature (Chart I-3). This relationship, however, is not as tight as the one between commodity currencies and the reserves. Chart I-2Improving Growth In Excess Reserves Leads To Stronger Commodity Currencies... Chart I-3...And To A Weaker Greenback A corollary to the growing consensus within the FOMC to end the balance-sheet runoff sooner than later is that the contraction in excess reserves will end. A bottoming in the rate of change of the reserves is consistent with a rebound in commodity currencies, especially against the yen, and with a correction in the dollar. Gold prices are very sensitive to global liquidity conditions. Today, not only is the yellow metal moving closer to the US$1350-US$1370 zone that marked its previous highs in 2016, 2017, and 2018, but also, the gold rally is broadening, as exemplified by the advance / decline line of gold prices versus nine currencies, which is making new highs (Chart I-4, top panel). This indicates that the precious metal could punch above this resistance level. Gold is probably sniffing out an improvement in global liquidity conditions. Since rising gold prices tend to lead EM high-yield bond prices higher (Chart I-4, bottom panel), investors need to monitor this move closely. Chart I-4A Broadening Gold Rally Is Consistent With Easing Liquidity Conditions Bottom Line: The growing chorus among FOMC members singing the praises of the end of the Fed’s balance-sheet runoff points toward a significant slowdown in U.S. excess reserves attrition. While this may not be a significant development for U.S. domestic economic variables, it should help liquidity conditions outside the U.S. While this could weigh on the greenback, the probability is higher that it will help commodity currencies in the short run, especially against the yen. Global Policy And Commodity Currencies In China, new total social financing hit CNY 4.6 trillion in January, well above the normal seasonal strength. Accordingly, the Chinese fiscal and credit impulse is starting to improve (Chart I-5). While this rebound is currently embryonic, our Geopolitical Strategy team has argued that a massive increase in Chinese credit this January would indicate a change in Beijing’s economic priorities.2 The Chinese government may be trying to limit the downside to growth, and reflation may expand. This would result in a further pick-up in the credit impulse. Chart I-5The Chinese Credit Impulse May Be Bottoming Easing EM financial conditions – courtesy of rebounding EM high-yield bond prices – and rising Chinese credit flows should ultimately lead to improving growth conditions across EM. As a result, our diffusion index of EM economic activity – which tallies improvements across 23 EM economic variables – should bounce from currently very depressed levels. Such a recovery is normally associated with a weaker trade-weighted dollar, a stronger euro, rising commodity prices and rising commodity currencies – both against the USD and the JPY (Chart I-6). Chart I-6IF EM Growth Conditions Improve, This Will Have A Profound Impact On the FX Market We can expand this line of thinking to the global economy. Our Leading Economic Indicator Diffusion Index, which compares the number of countries with a rising LEI versus those with a falling LEI, already rebounded five months ago. Historically, this signals an upcoming rebound in the BCA global LEI. Additionally, other major central banks are also sounding an increasingly cautious tone. This should accentuate the easing in global financial conditions that began in late December, creating another support for global growth. However, global investors remain very pessimistic on global growth, as exemplified by this week’s very poor global growth expectations computed from the German ZEW survey (Chart I-7). This dichotomy between depressed growth expectations and burgeoning green shoots suggests that risk asset prices have room to rally further in the coming quarter or two. Chart I-7Investors Remain Pessimistic About Growth, Yet Green Shoots Are Popping Up These dynamics are positive for commodity currencies and negative for the dollar. This cycle, the pattern has been for the trade-weighted dollar to correct and hypersensitive pro-cyclical currencies like the AUD and the NZD to perk up only after our Global LEI diffusion index has trough, and around the same time as risk asset prices rebound (Chart I-8). Chart I-8Thinking About Growth, Asset Prices, The Dollar, And Commodity Currencies Treasury yields will most likely also be forced higher by improving risk asset prices and economic activity, especially as bond market flows suggest T-notes currently are a coiled spring. The U.S. Treasury International Capital System data released at the end of last week was very revealing. The press emphasized the large-scale selling of Treasurys from the Cayman Islands – interpreted as selling by hedge funds. Missing from the picture was the enormous buying from these same players over the past 12 months, which corresponded with falling yields and a rallying trade-weighted dollar (Chart I-9). It was a sign of growing fear that pushed up the price of bonds. Chart I-9Hedge Funds Have Room To Liquidate Their Treasury Holdings If, as we expect, global growth beats dismal expectations and risk assets rebound further, the countercyclical dollar should correct. This will further ease global financial conditions and justifying even more a wholesale liquidation of stale bond holdings by hedge funds and further pushing the Fed toward resuming its hiking campaign faster than the market is currently anticipating. This combination is highly bond bearish. Unsurprisingly, this means that the yen, which normally trades closely in line with U.S. Treasury yields, is likely to weaken. Hence, USD/JPY and EUR/JPY could experience significant upside over the coming months (Chart I-10). Chart I-10A Bond Bearish Backdrop Is Also Bad For The Yen Bottom Line: Global growth conditions are evolving away from a dollar-bullish, commodity currency-bearish backdrop. Not only is the dollar-based liquidity set to improve, but China is also releasing the proverbial brake. Additionally, a generally more cautious tone among global central banks will contribute to easing global financial conditions. These developments are likely to result in a period of positive global economic surprises – and an environment where the greenback weakens and where pro-cyclical currencies outperform. But For How Long? It remains a question mark as to how long this pro-growth cycle will last. Parts of the dynamics described above are very self-defeating. If global growth conditions and asset prices rebound strongly, the Fed will be in a better position to increase rates once again. This could quickly curtail the improvement in global financial conditions and favor a strong dollar. Additionally, it is not clear how far Beijing will go in terms of pushing reflation through the Chinese economy. Chinese policymakers are worried about too-pronounced a slowdown but are equally worried about too much debt in their economy, and do not want to repeat the debt binge witnessed in 2010 and 2016. Therefore, they may be much quicker to lift their foot off the gas pedal. This conflicting attitude is best illustrated by recent opposing remarks made by Chinese policymakers. On the one hand, Premier Li-Keqiang expressed concerns regarding the January credit surge, suggesting that some Chinese policymakers are already trying to dampen expectations that stimulus will be substantial. On the other hand, the PBoC sounded utterly unconcerned.  Moreover, as our Emerging Markets Strategy service highlights, EM earnings are likely to continue to suffer from the lagged effect of China’s previous tightening. This creates the risk that even if global growth rebounds, EM stock prices, EM FX and all related plays do not follow. This would maintain the dollar-bullish environment and hurt pro-cyclical commodity currencies while supporting the yen. Despite these risks, it is nonetheless too early to tell how short-lived this period of dollar softness and commodity currency strength will be.  After all, the dollar is a momentum currency. If the dollar weakness gathers steam, a virtuous cycle could emerge: improving global growth begets a weaker dollar, a weaker dollar begets easier global financial conditions, easier global financial conditions beget stronger growth, and so on.          Gold prices may hold the key to cut this Gordian knot. If gold cannot maintain its recent gains, then the pro-cyclical positioning will not be valid for more than three months. However, if gold prices can remain at elevated levels or even rally further, then this pro-cyclical positioning will stay appropriate for at least six to nine months. What is clear is that for now, buying risk in the FX space makes sense. Bottom Line: At this point, too many crosscurrents are at play to evaluate confidently the length of any rally in pro-cyclical currencies relative to defensive ones. Since easier financial conditions ultimately force the Fed to resume hiking and since it is far from clear how committed to reflation Chinese policymakers are, our base case remains that this move will last a quarter or so. However, the fact that a falling dollar further eases global financial conditions, fomenting greater global growth in the process, suggests that a virtuous circle that create additional dollar downside can also emerge. Gold may provide early signals as to when investors should once again adopt a defensive posture. Sell NZD/CAD Something exceptional happened three months ago. For the second time in 25 years, Canadian policy rates fell in line with New Zealand’s. As Chart I-11 shows, this last happened from 1998 to 1999, when NZD/CAD subsequently depreciated 26%. However, today Canada’s and New Zealand’s current accounts are roughly in line while back then New Zealand had a substantially larger deficit, such a decline is unlikely to repeat itself. Nonetheless, we posit that NZD/CAD possesses ample downside. Chart I-11Bad News For NZD/CAD First, like in 1998-‘99, the real trade-weighted NZD exhibits a larger premium to its fair value than the real trade-weighted CAD (Chart I-12). In fact, the relative premium of the NZD to the CAD is roughly comparable as it was back then. Moreover, our Intermediate-Term Timing Model for NZD/CAD reinforces this message as it suggests that short-term valuations are also stretched (Chart I-13). Chart I-12NZD/CAD Is Pricey... Chart I-13...And Our Short-Term Valuation Metric Agrees Second, the New Zealand economy is currently weaker than that of Canada. Relative consumer confidence and business confidence have been in a downward trend for three years. Historically, while NZD/CAD can deviate from such dynamics, ultimately this cross tends to revert toward relative growth trends. The recent collapse in New Zealand’s economic surprises relative to Canada’s suggests that the timing for such a reversion is increasingly ripe, as there is currently scope for investors to discount a more hawkish Bank of Canada than Reserve Bank of New Zealand. Indeed, 1-year/1-year forward yields in Canada have fallen much more relative to the BoC overnight rate than similar forwards have fallen relative to the RBNZ policy rate. Third, New Zealand real bond yields have collapsed relative to Canada’s. As Chart I-14 illustrates, NZD/CAD tends to follow real yield differentials. So far, NZD/CAD has been less-weak than the real-yield gap would imply, but from late 2003 to early 2005 this cross also managed to defy gravity for an extended time, only to ultimately succumb to the inevitable. Chart I-14Falling Real Yield Spreads Will Weigh On NZD/CAD Fourth, as the top panel of Chart I-15 illustrates, the performance of kiwi stocks relative to Canadian equities tend to lead NZD/CAD, especially at tops. While tentative, the ratio of New Zealand to Canadian stocks seems to have peaked in early 2016. Supporting this judgment, kiwi profits have fallen relative to their Canadian counterparts and relative net earnings revisions are following a similar path – a move normally associated with a weaker NZD/CAD (Chart I-15, bottom panel). Chart I-15Relative Stock Market Dynamics Look Poor Fifth, terms of trades are becoming a growing headwind for NZD/CAD (Chart I-16). The price of agricultural commodities relative to energy products drives this pair, reflecting the comparative advantages of the two countries. BCA’s Commodity & Energy service is currently much more positive on the outlook for the energy complex than the agricultural complex. NZD/CAD is a perfect instrument to implement this view, especially now that the NZD suffers from a very rare negative carry against the CAD. Chart I-16A Negative Tems-Of-Trade Shock For NZD/CAD Bottom Line: NZD/CAD is set to experience an important fall. The NZD currently suffers from a very rare negative carry against the CAD. The last time this happened, a large depreciation ensued. Moreover, valuations and economic trends argue in favor of shorting this pair. Finally, relative bond yields, equity dynamics and term-of-trade outlooks also point to a lower NZD/CAD. Sell at 0.900, with a stop at 0.927 for a target of 0.800.     Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, titled “Caught Offside”, dated February 12, 2019, and the U.S. Bond Strategy Weekly Report, titled “The Great Unwind”, dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019 available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity Utilization underperformed expectations, coming in at 78.2%. However, Michigan Consumer Sentiment outperformed expectations, coming in at 95.5. Finally, the NAHB Housing Market Index also surprised to the upside, coming in at 62. The DXY has fallen by 0.2% this week. We remain bullish on the U.S. dollar on a cyclical basis, given that the Fed will end up hiking rates more than expected. However, the current easing of monetary conditions by Chinese authorities should tactically hurt the dollar and help commodity currencies. Moreover, the fact that the Fed announced that it might bring about an end to the balance sheet runoff sooner than expected will further help global liquidity conditions. The real question now is how long the coming dollar correction will last? Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The annual growth in construction output underperformed expectations, coming in at 0.7%. The current account balance also surprised to the downside, coming in at 33 billion euros. However, the Zew Survey – Economic sentiment, though negative, surprised to the upside, coming in at -16.6. EUR/USD has risen by 0.4% this week. We remain bearish on EUR/USD on a cyclical basis; given that, we expect real rates to rise much faster in the U.S. than in the euro area. This is because we think that the U.S. economy  will remain stronger than Europe’s, a consequence of the fact that the former has experienced a significant private sector deleveraging since 2008 while the latter has not. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth outperformed to the upside, coming in at 0.9%. Hurt by a very sharp contraction in shipments to China, the yearly growth of Japanese exports also surprised to the downside, coming in at -8.4%. However, imports yearly growth outperformed to the upside, coming in at -0.6%. USD/JPY has risen by 0.2% this week. We are bearish towards the yen on a tactical basis as the current upturn in liquidity conditions should hurt safe haven currencies. Moreover, reflationary efforts by Chinese Authorities should provide a boon to risk assets and make low yield currencies like the yen even less attractive. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been strong: Retail sales and retail sales ex-fuel yearly growth both outperformed expectations, coming in at 4.2% and 4.1%. Moreover, the yearly growth of average hourly earnings excluding bonus also surprised positively, coming in at 3.4%. GBP/USD has risen by 0.9% this week. We expect that a soft Brexit deal remains the most probable outcome out of Westminster. Thus, this factor, along with how cheap the pound is, make us bullish on the pound on a long-term basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The wage price index yearly growth underperformed expectations, coming in at 0.5%. However, the employment change surprised to the upside, coming in at 39.1 thousand in January. The participation rate also surprised positively, coming in at 65.7%. AUD/USD has fallen 0.7% this week. We are positive on the AUD on a tactical basis. Global monetary conditions have eased thanks to the rising Chinese credit and more cautious global central banks. Moreover, the announcement that the Fed is looking to halt its balance sheet reduction sooner than expected has provided further relief. However, the fundamentals of Australia remain poor, and thus long-term investors should continue to avoid this currency, Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been mixed: The business PMI in January fell to 53.1. However, the input of the producer price index on a quarter-over-quarter basis surprised to the upside, coming in at 1.6%. NZD/USD depreciated by 0.7% this week. While NZD/USD might have some upside in the short term, we remain bearish on the NZD/USD on a cyclical basis. Both the short-term and long-term interest rates in New Zealand are lower than in the U.S., while the real trade-weighted NZD is trading at 7% premium to its fair value. Thus, the kiwi is relatively overvalued which means that any tactical upside of NZD won’t have legs.  Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been neutral: The December new housing price index stays unchanged at 0%, on both month-over-month and year-over-year basis. The CAD has risen by 0.2% against USD this week. As BCA anticipates oil prices to strengthen more, we also expect the CAD to outperform the AUD and the NZD over the next few months. However, we remain bearish on CAD/USD on a structural basis. The unhealthy housing market in Canada could be a potential risk to the Canadian financial industry and the economy as a whole. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent data in Switzerland has been positive: The December exports increased to 19,682 million, while the imports increased to 16,639 million. The trade balance in December thus increased to 3,043 million, surprised to the upside. EUR/CHF has been flat this week. We are bullish on EUR/CHF on a cyclical basis. Easy global financial conditions should hurt safe haven currencies like the franc. Moreover, we believe that the SNB will continue to play a heavily dovish bias in order to counteract the fall in inflation caused by the surge in the franc last year. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: January trade balance increased to 28.8 million, from previous 25 billion. USD/NOK was flat this week. In general, we are overweight the krone, since we believe the pickup in oil prices will help the Norwegian economy, ultimately boosting the performance of NOK against the EUR,  the SEK, the AUD and the NZD. Moreover, the NOK is undervalued and currently trading at a large discount to its fair value, which could further lift the performance of the NOK on a cyclical basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: January unemployment rate has increased to 6.5%. Moreover, the monthly inflation rate comes in at -1%, surprising to the downside. USD/SEK rallied by more than 1% this week. We remain bearish on EUR/SEK since the SEK is currently trading at a discount to its long-term fair value. Moreover, there are many signs pointing to a Swedish economy rebound. The negative rate in the country and easy financial conditions could stimulate the domestic demand and if global growth perks up, the weak inflation readings will prove transitory. The Riksbank has already abandoned it pledge to suppress the krona and it will move this year to lift rates again. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Political economy – i.e., the interplay between critical nation states’ policies and markets – often trumps straightforward supply-demand analysis in oil. This is because policy decisions affect production and consumption, along with global trade. These decisions, in turn, determine constraints states – central and tangential – confront in pursuit of their interests. Presently, U.S. policies toward Venezuela and Iran dominate oil supply considerations, while Sino – U.S. trade tensions and their effect on EM consumption dominate the demand side. In this month’s balances assessment, we revised some of our supply-side assumptions to include the high probability U.S. waivers on Iranian export sanctions will have to be extended until Venezuela stabilizes. OPEC 2.0 appears to be flexible -- positioning for either an extension of waivers, or sanctions. This keeps our baseline oil-supply assumptions fairly steady this year as the coalition adjusts to changes in Venezuela’s output. Adjustments could be volatile, however. On the demand side, we continue to expect growth of 1.49mm b/d this year and 1.57mm b/d in 2020. Steadier production and unchanged demand assumptions lower our price forecasts slightly to $75/bbl and $80/bbl this year and next for Brent, with WTI trading $7.0/bbl and $3.25/bbl below those levels, respectively (Chart of the Week). Chart of the WeekExpect OPEC 2.0 To Smooth Venezuelan Production Losses In 2019 Highlights Energy: Overweight. Nigeria’s elections, scheduled for this past weekend, were unexpectedly postponed until Saturday. Political leaders urged Nigerians to “refrain from civil disorder and remain peaceful, patriotic and united to ensure that no force or conspiracy derail our democratic development.”1 Nigeria produces ~ 1.7mm b/d of oil. Base Metals/Bulks: Neutral. Estimated LMEX, CME, SHFE and bonded Chinese warehouse copper inventories are down 29.8% y/y, which will continue to be supportive of prices. Precious Metals: Neutral. Palladium is trading ~ $111/oz over gold, as concerns over supply deficits persist. The last time this occurred was on November, 2002. Ags/Softs: Underweight. Chinese buyers are believed to have cancelled as much as 1.25mm bushels of soybean purchases last week, according to feedandgrain.com. Feature The analytical framework informing global political economy provides a useful augmentation to our standard supply-demand analysis, particularly now, when U.S. policy continues to play a pivotal role in the evolution of oil fundamentals. In particular, we believe the near-term evolution of oil prices hinges on how events in Venezuela play out, following the imposition of U.S. trade and financial sanctions directed against the state-owned PDVSA oil company and the Maduro regime. The evolution of the U.S.’s PDVSA sanctions will directly determine whether waivers on Iranian export sanctions granted by the Trump administration in November are extended when they expire in May.2 These tightly linked evolutions, in turn, will drive OPEC 2.0 production policy, and whether its production-cutting agreement is extended beyond its June 2019 termination. As we discussed recently, we see OPEC 2.0 building its flexibility to adjust quickly to either an extension of the waivers on Iranian sanctions, or to accommodate the termination of these sanctions at the end of May. Given the state of the market, which we discuss below, we believe waivers on Iranian export sanctions almost surely will be extended when they expire in May. Global Oil Markets Are Tightening Our supply assumptions are driven by our assessment that global spare capacity of just over 2.5mm b/d could accommodate the loss of Venezuelan oil exports with little difficulty (in a matter of months), aside from a further tightening at the margin in the heavy-sour crude oil market (Chart of the Week and Table 1). In fact, the loss of up to 1mm b/d or more of Iranian exports – versus the ~ 800k b/d we now expect if waivers are extended until December – could also be accommodated by OPEC 2.0’s spare capacity, given the rebuilding of this potential output on the back of OPEC production cuts, which have the effect of increasing spare capacity (Chart 2).3 Table 1BCA Global Oil Supply – Demand Balances (MMb/d) (Base Case Balances) However, should this combination of events be realized, an unplanned outage similar to the one that removed ~ 1mm b/d of Canadian production due to wildfires in the summer of 2016, with Venezuela production falling toward 650k b/d and Iranian exports even partially constrained, could move the oil market perilously close to the limits of global spare capacity, which now stands just over 2.5mm b/d, based on the EIA’s reckoning. This would increase the risk of dramatically higher prices, simply because the flex in the system would approach zero. Iranian Waivers Hinge On Venezuela The manner in which U.S. sanctions against PDVSA and the Maduro regime evolve – in particular, whether regime change is affected – will determine whether waivers on the oil-export sanctions the U.S. re-imposed on Iran last November are extended beyond their end-May terminal point. In turn, this will affect OPEC 2.0’s production policies, particularly after its production-cutting agreement expires in June. In our current model of OPEC 2.0 production, we now expect its 2019 production to continue to decline in 1H19, to drain the overhang resulting from the ramp-up member states undertook in preparation for U.S. sanctions against Iran. This policy was substantially reversed with the last-minute granting of waivers to eight importing countries by the Trump administration prior to sanctions kicking in in November. This led to a sharp sell-off in crude oil prices in 4Q18, as market participants re-calibrated the supply side of global balances. In 2H19, our base case assumes OPEC 2.0’s production rises by ~ 900mm b/d (December vs. July 2019 level), to smooth out the loss of Venezuelan output as it falls to 650k b/d by the end of this year from just under 1.1mm b/d now. The goal of this policy is to quickly drain global inventories to levels comfortably below the five-year average (in 1H19), and then to keep Brent prices in the $75/bbl to $80/bbl range over 2H19 – end-2020 (Chart 3). We expect core OPEC 2.0 countries, led by KSA, core GCC states and Russia production to rise by more than 500k b/d in 2H19 (vs. 1H19 levels), to maintain inventories at desired levels and prices in the $75/bbl to $80/bbl range. Chart 3Core OPEC And Non-OPEC Output Will Rise To Offset Venezuelan Losses To this end, we assume core OPEC 2.0’s production rises in 2020 to 33.52mm b/d from 32.98mm b/d in 2019, led by a ~ 200k b/d increase from KSA – which takes its output to ~ 10.4mm b/d from ~ 10.2mm b/d in 2019. We expect Russian production to rise to 11.7mm b/d from ~ 11.5mm b/d in 2019. Additional output hikes come from core OPEC and other non-OPEC producers (Chart 4, Table 1). Chart 4OPEC 2.0's Goal: Quickly Reduce Inventories In 1H19 We do not try to forecast how the sanctions against PDVSA and the Maduro government play out – i.e., whether the incumbent government survives, or whether a peaceful or violent regime change occurs. If Venezuela were to descend into civil war, or were to experience a violent revolution, the outcome would be unpredictable and the rebuilding of that economy – regardless of who emerges to take control of the state – would require years. Likewise, if President Maduro and the military leaders supporting him were to quietly decamp, it still would require years to rebuild that country’s oil industry and economy.4 We view the odds of a confrontation between the U.S. and Venezuela’s benefactors/creditors as extremely low. We believe the U.S. would revive the Roosevelt Corollary to the Monroe Doctrine, and that Russia and China most likely would concede Venezuela is within the U.S.’s sphere of influence, as neither intend to project the force and maintain the supply lines such a confrontation would require.5 Because the resolution of the political uncertainty in Venezuela is unsure and the outcome unknowable – particularly when unplanned outages represent such a non-trivial risk to global supply at the margin – we strongly believe waivers granted on U.S. sanctions against Iranian oil exports will be extended at least by 90 to 180 days when they expire at the end of May. As we discuss above, global spare capacity is insufficient to cover the loss of Venezuelan and Iranian output, and still have the flexibility required to meet a large unplanned outage over the course of this year or next. For this reason, Iranian sanctions will not be immediately re-imposed following the termination of U.S. waivers on exports from that state; importers most likely will be increasing their liftings of Iranian crude, in line with the extension of the waivers we expect over the course of 2H19 (Chart 5). Oil Demand Continues To Hold Up We continue to expect global oil demand to grow by 1.49mm b/d this year and 1.57mm b/d in 2020, led as always by strong EM demand growth, with China and India at the forefront (Table 1). DM demand growth is expected to slow this year, but put in a respectable performance, as well. EM commodity demand growth generally has been trending down at a slow and constant pace since the beginning of 2018, as we discussed last week when we presented our new Global Industrial Activity (GIA) index. The index indicates demand is not as stellar as it was during the synchronized global upturn of 2017, but that it also is not as bad as sentiment and expectations would indicate.6 Pulling It All Together On balance, we expect the combination of stronger OPEC 2.0 output, plus an 800k b/d increase in U.S. shale-oil production, which lifts total U.S. crude-oil output from 12.42mm b/d to 13.49mm b/d next year, is enough to keep Brent prices close to $80/bbl next year, vs. the $75/bbl we expect this year (Chart 6). We revised our expectation for WTI slightly, and now expect it to trade ~ $7.0/bbl under Brent this year and at a $3.75/bbl discount next year. Chart 6Balanced Oil Market Expected This Year and Next ... The OPEC 2.0 production discipline and lower U.S. shale-oil output, coupled with strong – not stellar – demand growth combine to allow OECD commercial oil inventories (crude and products) to resume drawing and to fall comfortably below OPEC 2.0’s 2010 – 2014 five-year average target (Chart 7). This will be supportive of the Brent backwardation trade we recommended on January 3, 2019 which now is up 265.5%, as of Tuesday’s close. Chart 7... And Oil Inventories Resume Falling Bottom Line: We revised our supply estimates, and now expect OPEC 2.0 to cover lost Venezuelan output arising from the imposition of U.S. sanctions on PDVSA and the continued deterioration of that state’s oil industry. Because global spare capacity cannot handle the loss of Venezuelan and Iranian oil exports at the same time and still cover a large unplanned outage, we expect the waivers on U.S. sanctions of Iranian oil exports to be extended for up to 180 days following their termination at the end of May. We expect Brent crude oil prices to average $75/bbl this year and $80/bbl next year as oil markets balance. We expect WTI to trade ~ $7.0/bbl below Brent this year, and $3.25/bbl under in 2020.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Please see “Nigeria Election 2019: Appeal For Calm After Shock Delay,” published February 16, 2019, by bbc.com. 2 OPEC 2.0 is the name we coined for the producer coalition of OPEC states, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC states led by Russia, which recently agreed to cut production by ~ 1.2mm b/d to drain commercial oil inventories and re-balance markets globally. OPEC 2.0’s market monitoring committee meets in April to assess the production-cutting deal it reached in November, which is set to expire in June. The full coalition meets in May to set policy going forward. This is just ahead of the expiration of U.S. waivers on Iranian oil exports. For a discussion of OPEC 2.0’s production optionality, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy January 24, 2019.  It is available at ces.bcaresearch.com. 3 We are watching the evolution of the partial closure of the offshore Safaniya field in KSA about two weeks ago closely. With 1mm b/d capacity, this is the world’s largest offshore producing field; no updates have been provided by KSA this week. 4 Please see “What Next For Venezuela,” by Anne Kreuger published by project-syndicate.org on February 15, 2019 for a discussion. 5 We note here that Gazprombank, the Russian bank, froze PDVSA’s accounts over the weekend to avoid running afoul of U.S. sanctions against the company. Please see “Russia’s Gazprombank decided to freeze PDVSA accounts – source,” published by reuters.com February 17, 2019. See also “What Comes Next For Venezuela’s Oil Industry,” published by the Center for Strategic and International Studies February 12, 2019, which details how U.S. sanctions amount to the equivalent of a full-on embargo by forcing payment for Venezuelan oil to be deposited in accounts that cannot be accessed by the government or PDVSA. 6 We discuss our global demand outlook in last week’s Commodity & Energy Strategy Weekly Report, in an article entitled “Oil, Copper Demand Worries Are Overdone.” It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed in

Highlights Investors like to hear non-consensus views, … : Part of our role is to help clients think about all of the potential outcomes, including ones that may not be as improbable as commonly believed. … but it seems that our Fed/rates call is starting to strike them as a little too non-consensus: Clients are having a hard time seeing the potential for inflation after ten years of errant predictions that it’s just around the corner. From our perspective, the probability of higher-rate outcomes is considerably higher than the probability of lower-rate outcomes, … : An investor with a low-duration bias has a whole lot more ways to win than an investor with a high-duration bias. … so we’re staying the course: We continue to recommend underweighting Treasuries and maintaining below-benchmark duration exposure, which aligns with our constructive take on markets and the economy. It’s too early to get defensive if a recession is at least a year away. Feature BCA clients like to hear contrarian calls, and there is little that’s more deflating from a strategist’s perspective than to be told in a meeting that his/her views are the same as everyone else’s. Except for the handful of strategists who make their living from provocative views that have almost no chance of coming to fruition, however, the calls have to be plausible. For many investors, our inflation concerns seem to be straining the bounds of plausibility. Even if BCA has only lately begun to beat the inflation drums, investors have had enough of warnings about inflation and interest-rate spikes that have repeatedly failed to come to pass. Regular readers are familiar with our contention that the sizable injection of fiscal stimulus into an economy already operating at capacity is a sure-fire recipe for inflation. They are also familiar with our view that an extremely tight labor market will necessarily give rise to robust wage gains. We have repeatedly argued that the Fed will respond to the combination of inflation pressures by hiking the fed funds rate above its equilibrium level, bringing the curtain down on the expansion and the equity bull market. With a Special Report examining the links between wage gains, consumer price inflation, and the Fed’s reaction function on the way, we’re instead devoting this week’s report to several other reasons why an investor would want to maintain below-benchmark duration in a fixed-income portfolio. Oil Prices Will Rise There is a good reason for devising core price indexes that smooth out the volatility inherent in food and energy prices. Core indexes provide a better read on the underlying inflation trend, and are a better predictor of moves in headline inflation than the headline indexes themselves. Inflation-linked Treasuries (TIPS) are tied to headline CPI, however, leaving the long-run inflation break-evens at the mercy of swings in oil prices (Chart 1). As we have previously written, our commodity strategists view the October-November swoon as a one-off event disconnected from market fundamentals that will quickly be unwound1 (Chart 2). Chart 1As Oil Goes, So Go Inflation Expectations, ... Chart 2... And Oil Prices Are Poised To Rise One need not fear that a rise in oil prices, while giving a fillip to headline inflation, would slow the economy and thereby offset inflation’s upward pressure on rates. Now that the U.S. is the world’s largest oil producer, its economy and financial markets are no longer negatively correlated with oil prices (Chart 3). It is still true that falling oil prices amount to a tax cut for American businesses and households, but they now also amount to fewer high-paying jobs in the oil patch, reduced earnings in an important domestic industry, and tighter monetary conditions as fracking bond spreads widen. Chart 3No Longer A Contrary Indicator Bottom Line: Higher oil prices will push headline inflation and inflation expectations higher, while also boosting the economy at the margin. The combination promotes higher bond yields, all else equal. The Economy’s Improved. Yields Haven’t Budged. Though we attributed the bulk of the fourth-quarter selloff to misplaced fears that the Fed was pulling the rug out from under the expansion, the economy was finding it harder and harder to produce positive surprises. By late January, however, the expectations bar had been reset low enough that new releases began surpassing it, day in and day out (until the end of last week). So far, though, the 10-year Treasury yield has stubbornly failed to reflect the improvement (Chart 4). Chart 4Surprises Turned Around, But Yields Didn't Financial conditions tightened sharply upon the sudden widening in corporate bond spreads and the sudden drop in equity prices. We viewed the seize-up as equivalent to at least a quarter-point increase in the fed funds rate and thereby found pausing to be a perfectly logical course of action for the Fed. The swiftness of the subsequent bounce in risk assets – the S&P 500 has retraced more than two-thirds of its losses and high-yield bonds have retraced close to 60% of their spread widening – has gone a long way toward undoing last quarter’s tightening. With the recovery in financial conditions, all three components of our Fed monitor now point to a need for tighter monetary conditions (Chart 5). Chart 5The Fed Can Pause, But It Can't Stop Adaptive Expectations’ Sluggish Response Investors’ inflation outlooks adhere closely to an adaptive expectations framework in which future predictions are largely a function of inflation’s recent path (Chart 6). This is not unreasonable; one could do a lot worse than pick the Patriots to reach the Super Bowl or only South American and European (ex-England) teams to win the World Cup. Adaptive expectations can fall prey to the recency bias, however, in which individuals overemphasize the most recent data points to the exclusion of older, potentially more representative data when forming their future views. From a recency-bias perspective, adaptive expectations can trap investors like the mythical frog contentedly lingering in a pot of water that’s only slowly brought to a boil. Chart 6Inflation Forecasts Take Their Cue From The Past ... We are skeptical of the notion that there will be no more inflation because there’s been no inflation since the crisis. The trend may be your friend, but not once the output gap has closed and the unemployment gap is persistently negative. Using the 10-year CPI forecast from the Philly Fed’s Survey of Professional Forecasters as an inflation-expectations proxy, one could argue that the lion’s share of the outsized gains in the pre-crisis phase of the bond bull market resulted from excessively generous inflation compensation (Chart 7, bottom panel). Chart 7... Which Is Great For Investors When Inflation Trends Lower The excessive compensation was a by-product of adaptive expectations. After the experience of the mid-seventies and early eighties (Chart 8), investors and issuers both assumed inflation would be higher than it turned out to be. Today’s bond-market participants, conditioned by ten years of soggy post-crisis readings, could well assume that inflation will be lower than it ultimately turns out to be. That may leave long-maturity bondholders with insufficient compensation, just like their early-fifties forebears. Chart 8Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Reversal Of Globalization The apex of globalization has been a key theme of our Geopolitical Strategy service since its launch. We cannot go as far as they sometimes do, arguing that globalization did more to bring inflation to heel than Paul Volcker, but it surely has been an important factor in limiting wage gains for low- and semi-skilled workers (Chart 9), and has helped to stymie retail price increases. The imposition of new tariffs have exacerbated globalization’s reversal, but it had already begun before the 2016 presidential election. The Reagan-Thatcher-Koizumi policies that were ascendant after the fall of the Berlin Wall, boosting global growth while tamping down inflation, have been in retreat in the developed world ever since the crisis. Chart 9China Syndrome Decomposing Core CPI When assessing inflation’s future direction, our U.S. Bond Strategy colleagues decompose the core CPI series into its primary components: Shelter (42% of the index); Goods (25%); Services, excluding shelter and medical care (25%); and Medical Care (8%). They then look at the drivers for each of the largest three components for an advance read on their future direction. Home price appreciation and the rental vacancy rate power their shelter costs model. With home price appreciation decelerating but still positive, and the rental vacancy rate hovering around its all-time lows, the model projects that shelter costs will remain well above 3% (Chart 10, top panel). Chart 10Core Inflation Isn't About To Melt Core goods inflation lags non-oil import prices by about a year and a half. The path of import prices suggests that core goods inflation will have a tailwind for much of the rest of the year before facing a headwind next year that will push it back to its current levels (Chart 10, second panel). Wage growth is the best predictor of core services inflation, ex-shelter and medical care (Chart 10, third panel). We expect continued upward pressure on services inflation, as labor-market slack continues to be absorbed, keeping wage growth accelerating. The Golden Rule Of Bond Investing Simplicity is a virtue in investment recommendations, models, and rationales, and our U.S. Bond Strategy colleagues’ golden rule of bond investing is elegantly simple.2 If Fed rate hikes exceed market expectations over a given time horizon, overweight duration positions will underperform over that horizon, and if Fed hikes fail to meet market expectations, overweight duration positions will outperform. Now that the money market has entirely priced out any rate-hike prospects over the next two years (Chart 11), overweight duration positions face a challenging backdrop. How will the fed funds rate surprise to the downside from here? Chart 11The Money Market Is Calling For A Rate Cut It can’t unless the Fed carries out more than one 25-basis-point cut in the next year or so. Given the underlying strength of the economy, gathering inflation pressures, and the swift unwinding of much of the tightening in financial conditions, rate cuts are a stretch. Against the current backdrop, the golden rule is a stern warning away from the longer-maturity reaches of the Treasury curve. Investment Implications We continue to stay the course with our fixed-income recommendations. If the Fed’s pause will extend the expansion for a few more months, it will extend the shelf life of our underweight Treasuries and overweight spread product recommendations, as well. As outlined above, we see many more potential catalysts for higher interest rates than we do for lower rates. We reiterate our recommendation that investors maintain below-benchmark duration across fixed-income segments. The expansion, and the bull markets in risk assets, will eventually end, but it’s too soon to position portfolios for it.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Does Oil’s Slide Mean?,” published November 26, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Trepidation engulfs commodity markets like a fog weaving through half-deserted streets. Central bankers huddle in muttering retreats, growing more cautious by the day. EM growth concerns – particularly slowing trade volumes, and the drama surrounding Sino – U.S. trade negotiations – contribute to this. Europe’s slowdown as Brexit approaches, and a U.S. government that seems forever at loggerheads also sap investor confidence. Nonetheless, the level of industrial commodity demand – oil and copper in particular – continues to hold up. By our reckoning, EM growth still is positive y/y. And central bank caution – along with less-restrictive policies – provides a supportive backdrop for industrial commodities down the road. The production discipline we expect from OPEC 2.0 this year sets the stage for a continued rally in oil prices. Given our view on EM growth, we continue to favor staying long oil exposure, and remaining exposed to industrial commodities generally via the S&P GSCI position we recommended on December 7, 2017. Highlights Energy: Overweight. We are closing our open long call spreads in 2019 Brent, having lost the ~ $1/bbl premium in each. We are opening a new set of similar positions in anticipation of the next up-leg in Brent. At tonight’s close of trading, we will go long Brent $70 Calls vs. short $75 Calls in June, July and August 2019. Base Metals/Bulks: Neutral. Metal Bulletin’s benchmark iron ore price index for China traded through $90/MT earlier this week, as supply concerns continue to weigh on markets in the wake of evacuations from areas close to tailings dams used by miners.1 Precious Metals: Neutral. Bullion broker Sharps Pixley reported the PBOC’s gold reserves total almost 60mm ounces, up 380k ounces from end-2018 levels. Russia’s state media outlet RT proclaimed: “China on gold-buying spree amid global push to end US dollar dominance” on Tuesday. Ags/Softs: Underweight. Last week’s USDA WASDE report estimates world ending stocks for grains will be up slightly for the 2018-19 crop year at 772.2mm MT vs 766.6mm MT previously estimated in December. A January report was not issued due to the U.S. government shutdown. Feature In discussions with clients in the Middle East last week, few contested the assertion OPEC 2.0 is determined to keep supply below demand this year, in order to draw down global oil and refined product inventories.2 This strategy worked well for the coalition after it was stood up in November 2016. Back then, production cutbacks, an unexpected collapse of Venezuelan output, and random outages in Libya and elsewhere combined with above-average global demand to keep consumption above production. This led to a drawdown in OECD inventories of 260mm barrels between January 2017 and June 2018. OPEC 2.0 is off to a strong start on its renewed effort to rein in production and draw down inventories. OPEC (the old Cartel) cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d.3 The largest cut once again came from KSA, which reported it reduced output by just over 400k b/d m/m in January. This follows a 450k b/d reduction in December 2018 reported by the Kingdom in last month’s OPEC Monthly Oil Market Report. For March, KSA already is indicating it plans to drop production to 9.8mm b/d – 1.3mm b/d less than it was pumping in November 2018. There are some signs of discord within OPEC 2.0. Rosneft CEO Igor Sechin once again is arguing against the coalition’s production-cutting strategy, this time in a letter to Russian President Vladimir Putin.4 This is not the first time such disagreements were aired: In November 2017, leaders of Russia’s oil industry walked out of a meeting with Energy Minister Alexander Novak following a disagreement with the government on extending OPEC 2.0’s production-cutting deal launched at the beginning of the year. In the end, the deal was extended after President Putin weighed in.5 A Deeper Look At Demand Uncertainty These supply-side issues are not trivial, and pose significant risks to our price view. All the same, Russia does benefit from higher oil prices, in that inelastic global demand in the short-to-medium term produces a non-linear price increase when supply is reduced. Russia’s OPEC 2.0 quota calls for production to fall from 11.4mm b/d production basis its October 2018 reference level (11.6mm b/d at present) to 11.2mm b/d in 2019. As long as Russia’s participation in the OPEC 2.0 coalition advances its economic and geopolitical interests – i.e., higher revenues than could be expected without having a direct role in global production management, and in deepening its ties with KSA – we expect it to remain a member in good standing in OPEC 2.0. At the moment, the bigger issues center on the state of global demand for industrial commodities. Unlike the situation that prevailed during the first round of OPEC 2.0 cuts, global markets no longer are seeing a synchronized global recovery in aggregate demand. Rather, EM commodity demand growth – the engine of global growth – has been trending down at a slow and constant pace since the beginning of 2018. This is not news: It shows up in our new Global Industrial Activity (GIA) index, and we’ve been writing about it and accounting for it in our metals and oil demand projections for months (Chart of the Week). Chart of the WeekCommodity Demand May Be Bottoming BCA’s GIA index is heavily weighted to EM commodity demand. Based on our estimates, it appears to be close to or in a bottoming phase and ready to turn up within the next quarter. It is worthwhile pointing out that even with the slowdown over the past year or so, BCA’s GIA index still stands significantly higher than the level registered during the manufacturing downturn of 2015-16. This also adds color as to why the OPEC market-share war launched in November 2014 was so devastating to prices – demand was contracting while supplies were surging from OPEC 2.0 states and from U.S. shale-oil producers. Pessimism Is Overdone We have maintained for some time commodity markets are overly pessimistic on the global growth outlook, mainly because of their gloomy view on the Chinese economy, and anticipated knock-on effects for EM growth arising from this view. Our colleagues at BCA’s Global Fixed Income Strategy succinctly capture the current mood pervading global markets: “… this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors.”6 We continue to expect the slowdown in EM to persist in 1H19 based on our modeling and actual consumption data. Part – not all – of this is due to the slowdown in China, where policymakers are moving to reverse earlier financial tightening with modest fiscal and monetary stimulus in 1H19. We continue to expect the Communist Party leadership in China will want to start increasing stimulus later this year or in 1H20, so that it hits the economy full force in 2021 in time for the 100th anniversary of the founding of the CCP. Such stimulus will bolster industrial commodity demand. Still, this is difficult to call, particularly the form stimulus will take. President Xi appears committed rebalancing China’s economy – i.e., supporting consumer-led growth – and may want to keep policy powder dry, so to speak, to counter a recession in 2020 or thereafter. Stimulating the consumer economy in China could boost consumption of gasoline, and demand for white goods like household appliances at the expense of heavy industrial demand. Oil and base metals used in stainless steel would benefit in such an environment. Timing this rebound remains difficult. It appears to us that oil and, to a lesser extent, base metals have undershot their fair-value levels (based on our modeling) on the back of negative expectations and sentiment. If we are correct in this assessment, this should limit the negative surprises going forward and open upside opportunities for commodity prices (Chart 2). Chart 2Technically, Oil's Oversold Under The Hood Of BCA’s Newest Model Because demand is so difficult to capture, we continually are looking for different gauges to measure it and cross-check against each other. We developed our Global Industrial Activity index to target the actual performance of commodity-intensive activities globally. Each component is selected based on its sensitivity to the cycle in global industrial activity, hence on the cycle of global commodity demand. This is different from the BCA Global Leading Economic Indicator (LEI), which uses a GDP-weighted average of 23 countries’ LEI. By relying on GDP, the LEI weights in the indicator favor DM countries and do not account for the growing share of the service sector in these economies (Chart 3).7 Chart 3GIA Captures Commodity Demand Our GIA index focuses on commodity demand, which is fundamentally different from proxies of global real GDP growth or global economic activity. Nonetheless, we included the BCA global LEI with a small weight (~ 10%) in our index to capture DM economies. This inclusion does add information to our new gauge. Our GIA index correlates with Emerging Markets’ GDP, copper and oil prices with lags of one to three months. This index is designed to measure the strength of the underlying demand for commodities. It does not account for the supply side and other idiosyncratic shocks that affects each commodity. For instance, our index captures ~ 55% of the variation in the y/y movement in oil prices; adding our oil market supply and sentiment indicators on top of the demand variable raises this to more than 80% (Chart 4). Chart 4Combined Indicators Work Best The index is divided into four main components, which gauge the demand-side impacts of (1) trade; (2) currency movements; (3) manufacturing demand; and (4) the Chinese economy, given its importance to overall commodity demand. The GIA index’s Trade Component combines EM import volumes and an estimate of global dry bulk shipping rates to gauge demand. Readers of the Commodity & Energy Strategy are familiar with our use of EM trade volumes as a proxy for EM income.8 This week, we introduce a new proxy for shipping rates using the Baltic Dry Index (BDI) as a proxy of global economic activity. Our methodology is based on the approaches taken by James D. Hamilton and Lutz Kilian in their respective models that use the BDI to proxy global growth.9 We created two alternative measures based on each of their approaches and average them to come up with our own proxy of the cyclical factor of global shipping rates driven by demand. Both of our alternative measures use a rebased version of the real BDI, which uses the U.S. CPI to deflate the nominal value. Because it picks up the surge in shipping activity in 2H18 resulting from the front-running of tariffs in the Sino – U.S. trade war, the Trade Component of our GIA index gives the most positive readings of all the components (Chart 5, panel 1). By the end of this month, we expect the effects of this front-running to avoid tariffs will wash through the gauge, and we will have greater clarity on the state of global trade. Chart 5Performance Of GIA Components The Currency Component uses a basket of currencies that are sensitive to global growth – i.e., the currencies of countries heavily engaged in trade – and the Risky vs. Safe-haven currency ratio built by BCA’s Emerging Market Strategy.10 This allows us to capture the information regarding the state of global economic activity contained in the highly efficient and forward-looking currency markets. This component collapsed in March 2018, but seems to have bottomed recently (Chart 5, panel 2). The Manufacturing Component looks at the PMIs and various business conditions and expectations surveys for countries that have large industrial exposures to the economic health of EM.11 Currently, this component signals a continuation of the downward trend first observed at the beginning of 2018 (Chart 5, panel 3). Lastly, the Chinese Economy Component uses two indicators of the country’s industrial output: the Li Keqiang Index, and our China Construction Indicator. Despite the fact that the slowdown in China is at the center of investor pessimism re global demand, this component is still holding well (Chart 5, panel 4). It has a moderate negative trend, but is not alarming for commodity demand. Moreover, we expect some stimulus in the second half of the year, which should keep this component supportive for commodity prices. Industrial Commodity Demand Still Holding Up Our GIA index proxies demand for industrial commodities, which is closely aligned with EM GDP – as GDP grows, demand for industrial commodities grows (Chart 6, panel 1). The GIA index is more correlated with copper prices than with oil prices, but it still provides an excellent snapshot of the state of demand for these commodities (Chart 4). Chart 6GIA, Meet Dr. Copper Also, it is interesting to note there appears to be only one large specific supply shock that affected the copper market’s relationship with global demand (Chart 6, panel 2). Our new index supports the Market’s “Dr. Copper” argument, in the sense that copper prices are pretty much always aligned with global industrial activity. We also note that the recent Sino – U.S. trade tensions have pushed copper below the value that is explained by our demand proxy. Bottom Line: The resolve of OPEC 2.0 to reduce production is not in doubt. OPEC (the old Cartel) reported this week its member states cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d. On the demand side, new GIA index indicates things are not as bad as sentiment and expectations would indicate. If anything, we expect the combination of OPEC 2.0’s resolve and rising demand for industrial commodities – oil and copper in particular – to lift prices as the year progresses.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1      Please see “Brazil evacuates towns near Vale, ArcelorMittal dams on fears of collapse,” published by reuters.com on February 8, 2019. 2      OPEC 2.0 is the name we coined for the producer coalition of OPEC states, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC states, led by Russia, which recently agreed to cut production by ~ 1.2mm b/d to drain commercial oil inventories and re-balance markets globally. 3      Please see the February 2019 issue of OPEC’s Monthly Oil Market Report, which is available at opec.org. 4      Please see “Exclusive: Russia’s Sechin raises pressure on Putin to end OPEC deal,” published by uk.reuters.com February 8, 2019. 5      Please see “Russian oil unsettled by talk of longer production cuts,” published by ft.com November 15, 2017. 6      Please see “A Crisis Of Confidence?” published by BCA Research’s Global Fixed Income Strategy, published February 12, 2019.  It is available at gfis.bcaresearch.com. 7      The components of the global LEI are also different from our GIA index, and more market-oriented. For details on each series included in the LEI, please see “OECD Composite Leading Indicators: Turning Points of References Series and Component Series,” published February 2019. It is available at oecd.org. 8      Please see BCA Research’s Commodity & Energy Strategy Weekly Report “Trade, Dollars, Oil & Metals ... Assessing Downside Risk,” where we discussed the relationship between EM imports volume, EM income and commodity prices, published August 23, 2018, and is available at ces.bcaresearch.com. 9      The best approach is still debated in the literature. For more details on Hamilton and Kilian’s measurements, please see James D Hamilton, “Measuring Global Economic Activity,” Working paper, August 20, 2018 and Lutz Kilian, “Measuring Global Real Economic Activity: Do Recent Critiques Hold Up To Scrutiny?” Working paper, January 12, 2019. By selecting EM only import volumes and our proxy shipping rate based on the BDI, we narrow our Trade Component to factors that are mainly linked to industrial activity and commodity-intensive sectors. 10     Our basket of currencies includes Korea, Sweden, Chile, Thailand, Malaysia and Peru. The risky vs. safe-haven currency ratio average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). 11     This includes Korea, Singapore, Sweden, Germany, Japan, China and Australia. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades     TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018

Highlights Stay tactically overweight to equities for the time being. Close the overweight to industrial commodities versus equities. The financials, basic resources, and industrials equity sectors can continue to outperform for a few months longer. EM can also continue to outperform DM for a few months longer. Overweight Germany’s DAX versus German bunds. The second half of the year is going to be much tougher than the first half. Feature Chart of the WeekPessimism Was Overdone: The Classical Cyclicals And EM Are Rebounding Locked In An Intimate Embrace Last week, we highlighted a frustrating truth: for the past 16 months the broad equity market has been on a journey to nowhere. Yet the journey has been far from boring. There have been exciting detours of 10-15 percent in both directions, albeit these moves have been short-lived, lasting no more than three months at a time. The same truth applies to the broad bond market: for the past sixteen months the global long bond yield – defined here as the average of the yields on the 30-year German bund yield and 30-year T-bond – has also ended up going nowhere. On this journey too, there have been exciting detours of up to 50 basis points in both directions, but these moves have also lasted no more than three months before retracing. It follows that for the past 16 months, the strategic allocation to equities, bonds and cash has had zero impact on investment performance, but the tactical allocation to the asset classes has had a huge impact. Yet here’s the thing: the sharp tactical moves in the bond market and in the stock market have been intimately embraced. When the global long bond yield has approached the top of its range, it has catalysed a sharp sell-off in equities; and when the bond yield has approached the bottom of its range, it has catalysed a sharp rally in equities (Chart I-2). In fact, over the past 16 months, asset allocation has boiled down to a very simple trading rule based on the global long bond yield: above 2.2 percent, sell equities; below 1.95 percent, buy equities. Today, the yield stands at 1.85 percent, suggesting a tactically overweight stance to equities. Chart I-2The Sharp Tactical Moves In The Bond Market And Stock Market Are Intimately Connected The Persistent Trends Are In Sectors Some investors cannot shift their portfolios quickly enough to exploit the tactical opportunities in the markets. They need trends that persist for at least six months to a year. The good news is that these more persistent trends do exist, but to find them you have to look at equity sectors, and specifically the classically cyclical sectors (Chart of the Week). The financials and basic resources sectors were in strong relative downtrends through most of 2018; but for the last four months these classically cyclical sectors have flipped into very clear uptrends (Chart I-3 and Chart I-4). The same is true for industrials, albeit the end of the downtrend has happened more recently (Chart I-5). Chart I-3Financials Are Rebounding Chart I-4Basic Resources Are Rebounding Chart I-5Industrials Are Rebounding For the avoidance of doubt, technology is not a classically cyclical sector because the sales of technology products – particularly to consumers – are relatively insensitive to short-term fluctuations in the economy. In fact, the relative performance of technology is an almost perfect mirror-image of financials (Chart I-6). Chart I-6The Technology Sector Is Not A Classical Cyclical Neither is the chemicals sector a classical cyclical. Given that raw material prices are an input cost for chemical manufacturers, the chemicals sector can underperform when raw material prices are rising in a cyclical up-oscillation (Chart I-7). It follows that the three true classically cyclical sectors are: financials, basic resources and industrials. Chart I-7The Chemicals Sector Is Not A Classical Cyclical What if your investment process does not allow you to invest in sectors and benefit from their well-defined and longer trends? The good news is that you can play these same trends through regional and country stock market indexes. We refer readers to previous reports for the details, but the crucial message is that regional and country relative performances stem from nothing more than the stock markets’ defining sector skews combined with sector relative performances.1 This revelation of what truly drives regional and country relative performance is bittersweet. It is sweet because it simplifies an investment process that can be very complicated. But it is also bitter because it highlights that the investment industry is still replete with unnecessary layers of complexity. Still, just to drive home the point, we would like the charts to do the talking. The relative performance of financials, the relative performance of Italy’s MIB, and the relative performance of Emerging Markets (EM) versus Developed Markets (DM) are all effectively one and the same story (Chart I-8 and Chart I-9). Chart I-8One And The Same Story: Financials And Italy... Chart I-9...And Financials And EM Versus DM What Are The Markets Telling Us, And Do We Agree? Another very common question we get is: what is our forecast for economic growth and profits growth? For example, two questions on everyone’s lips right now are: can Germany avoid a technical recession, and what is our forecast for Germany’s growth from here? These are indeed important questions, but for investors they are not the most important questions. Financial markets are a discounting mechanism. So for investors, the most important question should always be: what is discounted in the current market price, and is that too optimistic or too pessimistic? Over-optimism and over-pessimism on the economy are especially important for the classically cyclical sectors because their profits have a very high operational gearing to their sales: a small change in the sales outcome has a huge impact on the profit outcome and, therefore, the price.  If the price is discounting a booming economy and what actually transpires is that the economy grows modestly, then a seemingly benign outcome of respectable growth will paradoxically cause the price to slump. Conversely, if the price is discounting a very pessimistic outcome and what actually transpires is anything better than the ultra-pessimism, then even a bad outcome will paradoxically cause the price to soar. In this regard, the recent underperformance of Germany’s DAX versus German bunds is at an extreme not far from that during the euro sovereign debt crisis in 2011-12 (Chart I-10). So the important question for investors is: will the actual economic outcome transpire to be as extreme as that? Our answer is that the extreme underperformance of the DAX versus bunds is discounting an overly pessimistic outcome, and on that basis the correct stance is to be overweight the DAX versus bunds.   Chart I-10Overly Pessimistic: The DAX Versus Bunds Turning to the classical cyclicals, these sectors have rebounded because their embedded assumptions for growth reached peak pessimism in October. Since then, the pessimism has abated at the margin because of improving short-term impulses from Chinese stimulus, lower global bond yields, and sharply lower energy prices. Given that positive (and negative) impulse phases reliably tend to last for six to eight months, our expectation is that this tailwind for the classical cyclical sectors – financials, basic resources, and industrials – can continue for a few months longer. Which means that the outperformance of EM versus DM can also continue for a few months longer. In terms of asset allocation, long industrial commodities versus equities worked very powerfully at the end of last year, but the relative merits of the two asset classes are now more evenly balanced. Hence, we are now closing this position in profit. Finally, our major concern is for later in the year when the aforementioned improving short-term impulses will inevitably fade, and even potentially reverse. Bear in mind that the impulses arise from the short-term changes in credit flows, bond yields, and the oil price. It follows that to recreate these positive impulses for later in the year, bond yields and/or the oil price have to keep falling. This is not our base case, so enjoy the positive impulses while they last! As the year progresses the investment environment is going to get much tougher. Fractal Trading System* The sharp underperformance of the Nikkei 225 versus the Hang Seng is at the limit of tight liquidity that has signaled all of the recent trend reversals in this relative position. Accordingly, this week’s recommended trade is to go long the Nikkei 225 versus the Hang Seng. Set a profit target of 4.5 percent with a symmetrical stop-loss. We now have seven open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Please see the European Investment Strategy Weekly Report “Oil, Banks, And Bonds: The Oddities Of 2018”, dated November 29, 2018 available at eis.bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Underweight The S&P oil & gas refining & marketing index has typically performed in line with their profitability (second panel); the absolute price of inputs and outputs are far less important than the spread between them and here the news is not encouraging. Crack spreads, the key determinant of relative profitability have been contracting for the better part of the last year but, curiously, sell side consensus earnings expectations continue to have EPS in the S&P oil & gas refining & marketing index outgrowing the broad market (third panel). Considering the persistence of falling crack spreads, an outright relative contraction in earnings seems the most likely scenario, implying the slashing of forward estimates still has room to go. On the valuation front, the S&P oil & gas refining & marketing index has already seen a significant derating (bottom panel). Still, with only an average relative valuation and a looming decline in earnings estimates, this remains optimistic in our view. Accordingly, we reiterate our underweight recommendation, despite the nearly 19% relative outperformance this recommendation has returned since our mid-summer downgrade to underweight.1 The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC.   1 Please see BCA U.S. Equity Strategy Weekly Report, “Soldiering On,” dated July 16, 2018, available at uses.bcaresearch.com.

Key Portfolio Highlights The S&P 500 has started 2019 with a bang as dovish cooing from the Fed has proven a tonic for equities. While we have not entirely retraced the path to the early-autumn highs, our strategy of staying cyclically exposed, based on our view of an absence of a recession in 2019, has proven a profitable one as investor capitulation reached extreme levels (Charts 1 & 2). Chart 1CapitulationChart 2Selling Is Exhausted Importantly, risk premia have been deflating as the end-of-year spike in volatility has subsided and junk spreads have narrowed from the fear-induced heights in December (Chart 3). Chart 3Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A continuation of the earnings juggernaut A positive U.S./China trade resolution With respect to the first of these, the S&P 500 convulsed following the December 19 Fed meeting and suffered a cathartic 450 point peak-to-trough fall two months ago. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Charts 4 & 5). Chart 4Powell's Resolve Getting Tested Chart 5Fed Policy Mistake The rising odds of a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome respite for equities. Our second catalyst has been gaining steam through the Q4 earnings season which has seen continuation of the double-digit earnings growth of the prior three quarters. Our earnings model points to a moderation of earnings growth in the year to come, in line with sell-side expectations (Chart 6). Our 2019 year-end target remains 3,000 for the SPX, based on $181 2020 EPS and a 16.5x multiple.1 This represents a 6% EPS CAGR, assuming 2018 EPS ends near $162. Chart 6EPS Growth > 0 In Chart 7, we show that financials, health care and industrials are responsible for 61% of the SPX’s expected profit growth in 2019 while technology’s contribution has fallen to a mere 7.2%. While the risk of disappointment encompases financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 8 & 9). Chart 8Earnings Revisions... Chart 9...Really Weigh On Tech Lastly, the negativity surrounding the slowdown in China is likely fully reflected in the market (Chart 10), implying an opportunity for a break out should a positive resolution to the U.S./China trade spat be delivered. China’s reflation efforts suggests that the Chinese authorities remain committed to injecting liquidity into their economy (Chart 11). Chart 10China Slowdown Baked In The Cake Chart 11Reflating Away Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (Chart 12). All of these underlie our style preferences for cyclicals over defensives2 and international large caps over domestically-geared small caps. Chart 12Heed The PBoC Message Chris Bowes, Associate Editor chrisb@bcaresearch.com S&P Financials (Overweight) The divergence between the directions for our CMI and valuation indicator (VI) for S&P financials has reached stunning levels, with the former accelerating into pre-GFC territory and the latter falling to two standard deviations below fair value. Our technical indicator (TI) is sending a relatively neutral message, though this does not diminish the most bullish signal in our cyclical indicator’s history (Chart 13). Chart 13S&P Financials (Overweight) The ongoing strength of the U.S. economy is the driver of such a positive indicator, particularly with respect to the key S&P banks sub index. Our total loans & leases growth model and BCA’s C&I loan growth model (second & bottom panels, Chart 14) are in positive territory. The latter is significant given that C&I loans are the single biggest credit category in bank loan books. Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Further, multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 14). In the context of the generationally high employment rate, the implied lower defaults should drive amplified profit improvement from this credit growth. We reiterate our overweight recommendation. Chart 14Loan Growth Drives Profits S&P Industrials (Overweight) The still-solid domestic footing has maintained our industrials CMI close to its cyclical highs, which are also some of the most bullish in the history of the indicator. However, stock prices have not responded accordingly and our VI has descended mildly from neutral to undervalued. Our TI sends a much more definitive message and stands at a full standard deviation into oversold territory (Chart 15). Chart 1515. S&P Industrials (Overweight) While their cyclical peers S&P financials are almost exclusively a domestic play, S&P industrials have been weighed down by trade flare ups for most of the past year (bottom panel, Chart 16). Accordingly, much of the benefit of positive domestic capex indicators and the more tangible capital goods orders maintaining a supportive trajectory has failed to show up in relative EPS growth (second & third panels, Chart 16), though the latter has recently hooked much higher. Chart 16Industrial Earnings Growth Has Recovered S&P Materials (Overweight) Our materials CMI has made a turn, rising off its lowest level in 20 years. This has coincided with our VI bouncing off its cyclical low, though it remains in undervalued territory. The signal is shared by our TI which has only recently recovered from a full standard deviation into the oversold zone, a level that has historically presaged S&P materials rallies (Chart 17). Chart 17S&P Materials (Overweight) When we upgraded the S&P materials sector to overweight earlier this year, we noted that China macro dominates the direction of U.S. materials stocks. On the monetary front, the Chinese monetary easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 18). The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNY/USD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 18). Chart 18Chinese Data Drives Materials Performance S&P Energy (Overweight) Our energy CMI has moved horizontally for the past six quarters, though this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Meanwhile both our VI and TI have descended steeply into buying territory with the former approaching two standard deviations below fair value (Chart 19). Chart 19S&P Energy (Overweight) As with the CMI, the relative share price ratio for the S&P energy index has moved laterally since our mid-summer 2017 upgrade to overweight. Interestingly, the integrated oil & gas energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (top panel, Chart 20). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 2020. The Stage Is Set For A Recovery In Crude Prices Nevertheless, the roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, bottom panel, Chart 20). This echoes BCA’s Commodity & Energy Strategy service, which continues to forecast higher oil prices into 2019, a forecast which should set the stage for a sustainable rebound next year in S&P energy profits, the opposite of what analysts currently expect (Chart 7). S&P Consumer Staples (Overweight) An improving macro environment is reflected in our consumer staples CMI that has vaulted higher in recent months. However, the strong recent relative outperformance has also shown up in our VI which, though still in undervalued territory, has recovered significantly. Our TI has fully recovered and now sends a neutral message (Chart 21). Chart 21S&P Consumer Staples (Overweight) The surging S&P household products sector has been carrying the S&P consumer staples index on its back as solid pricing efforts have been dragging results and forward guidance higher. While household product sales have been enjoying a multi-year growth phase (second panel, Chart 22), it has largely been driven by volumes. However, the recent resurgence in pricing power (third panel, Chart 22) has given volume gains an added kick, pushing sales further. Meanwhile, exports have continued their two-year ascent despite the tough currency environment and the upshot is that relative EPS growth will likely remain upbeat (bottom panel, Chart 22). In light of challenged EM consumer spending growth, this signal is very encouraging. Chart 22Household Products Is Carrying Staples S&P Health Care (Neutral) Our health care CMI has been treading water recently. Further, a recovery in pharma stocks has taken our VI from undervalued to a neutral position, while our TI sends a distinctly bearish message as health care stocks have been overbought (Chart 23). Chart 23S&P Health Care (Neutral) Healthcare stocks have outperformed in the back half of 2018. Recently a merger mania that has swept through the pharma and biotech spaces has underpinned relative share prices. The last three months have seen an explosion of deals, including the largest biopharma deal ever (Bristol-Myers Squibb buying Celgene for approximately $90 billion) with other global deals falling not too far behind (Takeda buying Shire for $62 billion mid-last year). Such exuberance has clearly confirmed that merger premia are alive and well in the S&P pharma index. It is not merely rising premia that have taken pharma higher either. Pricing power has entered the early innings of a recovery (top panel, Chart 24) while the key export channel points to increasingly bright days ahead (second panel, Chart 24). However, the rise of regulatory pressure from the Trump administration may cause better pricing to prove fleeting. Chart 24Merger Mania In Pharma Further, pharma’s consolidation phase has come at a cost to sector leverage ratios that have dramatically expanded (bottom panel, Chart 24). Such profligacy may come to haunt the sector should the pricing power recovery falter. S&P Technology (Neutral) Our technology CMI has been moving laterally for the better part of the last three years, though the S&P technology index has ignored the macro headwinds and soared higher over that time. Our VI remains on the overvalued side of neutral, despite the recent tech selloff while our TI has been retrenching into oversold territory (Chart 25). Chart 25S&P Technology (Neutral) Until the end of last year, we maintained a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. However, we recently upgraded the niche semi equipment to overweight for three reasons. First, trade policy uncertainty has dealt a blow to this tech subindex. Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Second, emerging market financial indicators are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (second panel, Chart 26). Third, long term semi equipment EPS growth estimates have recently collapsed to a level far below the broad market, indicating that the sell side has thrown in the towel on this niche sector (third panel, Chart 26). Chart 26A Bottom In Semi Equipment Overall, and despite our more bullish view on semi equipment, we continue to recommend a neutral weighting in S&P technology. S&P Utilities (Underweight) Our utilities CMI has recovered recently, bouncing off its 25-year low, driven by the modest easing in interest rates, (Chart 27). This has also manifested in a recovery in the S&P utilities index as this fixed income proxy has reacted to the recent fall in Treasury yields (change in yields shown inverted, top panel, Chart 28) and jump in natural gas prices. Further, utilities are typically seen as a domestic defensive play and the recent trade troubles have made utilities soar in a flight to safety. Chart 27S&P Utilities (Underweight) We think the tailwinds lifting utilities are transitory and likely to shift to headwinds. First, one of our key themes for the back half of the year is rising interest rates; a move higher in yields will have a predictably negative impact on these high-dividend paying equities. Second, a flight to safety looks fleeting; the ISM manufacturing new orders index usually moves inversely in lock step with utilities and the most recent message is negative for the S&P utilities index (ISM manufacturing new orders index shown inverted, second panel, Chart 28). Meanwhile, S&P utilities earnings estimates have continued to trail the broad market, having taken a significant step down this year (third panel, Chart 28). Chart 28Rising Rates In Late-2019 Will Be A Headwind For Utilities Our VI and TI share this bearish message as the VI is deeply overvalued and the TI is in overbought territory (Chart 27). S&P Real Estate (Underweight) Our real estate CMI has recently started to turn up, though this is off the near decade-low set last year and remains deeply depressed relative to history (Chart 29). This is principally the result of the backup in interest rates since late last year and the lift they have given to the sector, which has been a relative outperformer over the past six months (top panel, Chart 30). Much like the S&P utilities sector in the previous section, and in the context of BCA’s higher interest rate view, we continue to avoid this sector. Chart 29S&P Real Estate (Underweight) Along with the modest reprieve in borrowing rates, multi family construction continues unabated (second panel, Chart 30), likely driven by all-time highs in CRE prices (third panel, Chart 30). In the absence of an outright contraction in construction, recent weakening in occupancy (bottom panel, Chart 30) will likely prove deflationary to rents, and thus profit prospects. Chart 30Falling Occupancy Will Hurt REIT Profits Our VI suggests that REITs are modestly overvalued, though the recent outperformance has driven our TI to an overbought condition (Chart 29). S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI has ticked up recently, pushed higher by resiliency in consumer data. However, the S&P consumer discretionary index has clearly responded, pushing against 40-year highs relative to the S&P 500 and taking our VI to two standard deviations above fair value (Chart 31). Much of this should be attributed to Amazon (roughly 30% of the S&P consumer discretionary index) and their exceptional 12% outperformance relative to the broad market over the past year. Chart 31S&P Consumer Discretionary (Underweight) While we have an underweight recommendation on the S&P consumer discretionary index, we have varying intra-segment preferences, highlighted by the recent inception of a pair trade going long homebuilders and short home improvement retailers (HIR). Housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (top & middle panels, Chart 32). Further, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (momentum in lumber prices shown inverted and advanced in bottom panel, Chart 32). Chart 32Long Homebuilders / Short Home Improvement Retailers S&P Communication Services (Underweight) As the newly-minted communication services has little more than four months of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 33 with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Chart 33S&P Communication Services (Underweight) Rather, we refer readers to our still-fresh initiation of coverage on the sector3 and look forward to being able to deliver something more substantive in the future. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years (Chart 34). Despite the neutral CMI reading, we downgraded small caps in the middle of last year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (bottom panel, Chart 35). This size bias remains a high conviction call for 2019. Chart 34Favor Large Vs. Small Caps Macro data too has turned against small caps. Recent NFIB surveys have shown that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel, Chart 35). This has coincided with the continued slide of small cap stocks relative to their large cap peers. Chart 35Small Caps Have A Big Balance Sheet Problem Further, the percentage of small businesses with planned labor compensation increases continues to set new all-time highs and deviates substantially from the national trend (second panel, Chart 35). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel, Chart 35), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of small cap balance sheet discipline during the past five years, ongoing large cap outperformance seems ever more likely. Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “ Catharsis,” dated January 14, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “ Don't Fight The PBoC,” dated February 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Daily Insight, “New Lines Of Communication,” dated October 1, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Daily Insight, “Small Caps Have A Big Balance Sheet Problem,” dated May 10, 2018, available at uses.bcaresearch.com.