Commodities & Energy Sector

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 Commodity Demand May Be Bottoming Commodity 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 Technically, Oil's Oversold Technically, 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 GIA Captures Commodity Demand GIA 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 Combined Indicators Work Best Combined 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 Performance Of GIA Components Performance 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 GIA, Meet Dr. Copper GIA, 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 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018 Image

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 Pessimism Was Overdone: The Classical Cyclicals And EM Are Rebounding Pessimism 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 Sharp Tactical Moves In The Bond Market And Stock Market Are Intimately Connected The 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 Financials Are Rebounding Financials Are Rebounding Chart I-4Basic Resources Are Rebounding Basic Resources Are Rebounding Basic Resources Are Rebounding Chart I-5Industrials Are Rebounding Industrials Are Rebounding Industrials 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 The Technology Sector Is Not A Classical Cyclical The 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 The Chemicals Sector Is Not A Classical Cyclical The 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... One And The Same Story: Financials And Italy... One And The Same Story: Financials And Italy... Chart I-9...And Financials And EM Versus DM ...And Financials And EM Versus DM ...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 Overly Pessimistic: The DAX Versus Bunds Overly 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 Long Nikkei 225 Vs. Hang Seng Long Nikkei 225 Vs. Hang Seng 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

More Pain Coming For Refiners More Pain Coming For Refiners 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 1Capitulation Capitulation Capitulation Chart 2Selling Is Exhausted Selling Is Exhausted Selling 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 Risk Premia Renormalization Risk 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 Powell's Resolve Getting Tested Powell's Resolve Getting Tested Chart 5Fed Policy Mistake Fed Policy Mistake Fed 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 EPS Growth > 0 EPS Growth > 0 Chart 7 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... Earnings Revisions... Earnings Revisions... Chart 9...Really Weigh On Tech ...Really Weigh On Tech ...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 China Slowdown Baked In The Cake China Slowdown Baked In The Cake Chart 11Reflating Away Reflating Away Reflating 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 Heed The PBoC Message Heed 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) S&P Financials (Overweight) S&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 Loan Growth Drives Profits Loan 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) 15. S&P Industrials (Overweight) 15. 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 Industrial Earnings Growth Has Recovered Industrial 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) S&P Materials (Overweight) S&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 Chinese Data Drives Materials Performance Chinese 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) S&P Energy (Overweight) S&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 20. The Stage Is Set For A Recovery In Crude Prices 20. 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) S&P Consumer Staples (Overweight) S&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 Household Products Is Carrying Staples Household 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) S&P Health Care (Neutral) S&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 Merger Mania In Pharma Merger 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) S&P Technology (Neutral) S&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 A Bottom In Semi Equipment A 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) S&P Utilities (Underweight) S&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 Rising Rates In Late-2019 Will Be A Headwind For Utilities Rising 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) S&P Real Estate (Underweight) S&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 Falling Occupancy Will Hurt REIT Profits Falling 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) S&P Consumer Discretionary (Underweight) S&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 Long Homebuilders / Short Home Improvement Retailers Long 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) S&P Communication Services (Underweight) S&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 Favor Large Vs. Small Caps Favor 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 Small Caps Have A Big Balance Sheet Problem Small 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.

Highlights Hyman Minsky famously said that “stability begets instability.” The converse is also true: Instability begets stability. None of the preconditions for a U.S. recession are in place yet. The Fed’s decision to press the pause button on further rate hikes ensures that it will take at least another 18 months for monetary policy to turn restrictive. Global growth should accelerate by mid-2019, as Chinese stimulus kicks in and the headwinds facing Europe dissipate. Investors should overweight global equities and underweight bonds over the next 12 months. The leadership role in the equity space will gradually shift outside the United States. Feature The Long Shadow Of The Financial Crisis   "Stability begets instability” declared Hyman Minsky in his widely cited, seldom-read book.1 By this, Minsky meant that periods of economic tranquility often encourage excessive risk-taking, sowing the seeds of their own demise. We would not quarrel with Minsky’s assessment, but we would point out that the converse is also true: Instability begets stability. Following periods of intense financial stress, lenders become more circumspect about whom they lend to, while borrowers become reluctant to take on debt. The result is economically bittersweet. On the plus side, the newfound caution of lenders and borrowers alike ensures that financial imbalances are slow to build up again. On the negative side, sluggish credit growth restrains spending. The net effect is a recovery that is often slow and uneven, but one which lasts longer than expected. Few Signs Of Major U.S. Economic Imbalances This is the world in which we find ourselves today. It took a decade following the subprime crisis for the U.S. to return to full employment. Much of Europe is not even there yet. Lenders continue to take risks. However, they have been quicker than usual to scale back exposure at the first sign of trouble. For example, as U.S. auto loan defaults began rising in 2015, banks tightened lending standards. As a result, the share of auto loans transitioning into delinquency peaked in Q4 of 2016 and has since drifted down modestly (Chart 1). Chart 1Lenders Are More Circumspect These Days: The Case Of Autos Lenders Are More Circumspect These Days: The Case Of Autos Lenders Are More Circumspect These Days: The Case Of Autos A similar thing happened when corporate credit spreads blew out in 2015 following the crash in oil prices (Chart 2). Banks tightened lending standards starting in late 2015. Once defaults peaked in early 2017, banks started easing standards. Chart 2Banks Were Quick To Tighten Lending Standards In 2015 Banks Were Quick To Tighten Lending Standards In 2015 Banks Were Quick To Tighten Lending Standards In 2015 Tellingly, the distress in corporate debt markets in 2015-16 did not cause the financial system to seize up, as evidenced by the fact that financial stress indices only increased marginally during that period. This suggests that financial imbalances never had a chance to rise to a level that threatened the overall economy. The Preconditions For The Next U.S. Recession Are Not Yet In Place Today, the U.S. private-sector financial balance – the difference between what the private sector earns and spends – stands at a healthy surplus of 2.1% of GDP. Both of the last two recessions began when the private-sector balance was in deficit (Chart 3). Chart 3The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions This raises an intriguing question: If the U.S. private sector is not suffering from any major imbalances, what is going to cause the next recession? That’s a very good question, with no obvious answer! The past two recessions were triggered by the bursting of asset bubbles – first the dotcom bubble and then the housing bubble. Today, U.S. equities are far from cheap, but with the S&P 500 trading at 16.1-times forward earnings, they are hardly in a bubble (Chart 4). The housing market is also on much firmer footing: The homeowner vacancy rate is near all-time lows, while the quality of mortgage lending has been very high (Chart 5). Chart 4While U.S. Stocks Are Not Cheap, They Aren't In A Bubble While U.S. Stocks Are Not Cheap, They Aren't In A Bubble While U.S. Stocks Are Not Cheap, They Aren't In A Bubble Chart 5Housing Fundamentals Are Solid Housing Fundamentals Are Solid Housing Fundamentals Are Solid Of course, recessions can occur for reasons other than the bursting of asset bubbles. The 1973-74 recession and the recessions of the early 1980s were triggered by a surge in oil prices, requiring the Fed to hike rates aggressively. Luckily, such an oil-induced recession is highly unlikely today. Inflation expectations are better anchored, while oil consumption represents a much smaller share of GDP than it did back then (Chart 6). In addition, the U.S. has become a major oil producer, which implies that the drag to consumers from higher oil prices would be partly offset by increased capital spending in the energy sector. At any rate, the ability of shale producers to respond to higher prices with additional output limits the extent to which prices can rise in the first place. Chart 6An Oil Price Shock Is Unlikely To Cause A Recession An Oil Price Shock Is Unlikely To Cause A Recession An Oil Price Shock Is Unlikely To Cause A Recession Past economic downturns have also been caused by major adjustments in the cyclical parts of the economy. As a share of GDP, cyclical spending is lower today than it has been at the outset of most recessions (Chart 7). The proliferation of just-in-time inventory systems has also reduced the influence that inventory swings have on the economy (Chart 8). Chart 7Cyclical Spending Is Not Extended Cyclical Spending Is Not Extended Cyclical Spending Is Not Extended Chart 8 A severe tightening of fiscal policy can also trigger a recession.2 Fortunately, the end of the government shutdown reduces the risk of such an outcome. Rightly or wrongly, voters blamed President Trump for the recent closure (Chart 9). As we speak, the Trump administration is negotiating with Democrats to avert another shutdown slated to begin on February 15. The key item of contention concerns funding for a border wall with Mexico. Even if a deal falls through, rather than shuttering the government again, Trump will probably pursue funding for the wall by declaring a national emergency. Our geopolitical strategists believe such an action will be challenged by the Democrats, but is likely to be upheld by the Supreme Court. Chart 9''I Am Proud To Shut Down The Government'' ''I Am Proud To Shut Down The Government''' ''I Am Proud To Shut Down The Government''' Global Growth Should Improve Admittedly, the external environment now has a greater influence on the U.S. economy than in the past. Nevertheless, given that exports are only 12% of GDP, it would take a sizeable external shock to knock the U.S. into recession. We think that such a shock is not in the cards. The trade war is likely to go on hiatus as Trump seeks to take credit for a deal with China. In addition, as we discussed two weeks ago, China will scale back its deleveraging campaign now that credit growth has fallen close to nominal GDP growth (Chart 10).3    Chart 10China: Time To Scale Back Deleveraging China: Time To Scale Back Deleveraging China: Time To Scale Back Deleveraging Euro area growth should reaccelerate over the coming months thanks to lower oil prices, a revival in EM demand, modestly more stimulative fiscal policy, and the palliative effects from the decline in government bond yields across the region. We have also argued that the risks of a “Hard Brexit” should abate.4   Waiting... And Waiting For Inflation To Rise When the next recession rolls around, it will probably be sparked by a surge in inflation, which forces the Fed to raise interest rates much more rapidly than it has so far. Here is the thing though: Inflation is a highly lagging indicator. It usually only peaks long after a downturn has started and troughs after the recovery is well underway (Chart 11). Chart 11   Consider the example of the 1960s. The unemployment rate fell below NAIRU in 1964, but it took another four years for inflation to break out in earnest (Chart 12). The U.S. unemployment rate has been below NAIRU only since 2017. The unemployment rate in Germany and Japan has been below NAIRU for much longer, yet inflation remains stubbornly low in both countries (Chart 13). Chart 12It Took An Overheated Economy For Inflation To Take Off In The Late-1960s It Took An Overheated Economy For Inflation To Take Off In The Late-1960s It Took An Overheated Economy For Inflation To Take Off In The Late-1960s Chart 13The U.S., Japanese, And German Economies Are At Full Employment The U.S., Japanese, And German Economies Are At Full Employment The U.S., Japanese, And German Economies Are At Full Employment Cheer Up This leaves us with a striking conclusion: Perhaps the next U.S. recession is not around the corner, as some grumpy economists seem to think. Perhaps this economic expansion can endure beyond 2020. The recent U.S. data has certainly been consistent with that thesis. The ISM manufacturing index rose 2.3 percentage points to 56.6 in January. New orders jumped by 6.9 percentage points to 58.2. Payroll growth has also accelerated. Real aggregate earnings are up 4.2% from a year earlier, the fastest pace since October 2015 (Chart 14). Chart 14U.S. Labor Income Growth Has Been Accelerating U.S. Labor Income Growth Has Been Accelerating U.S. Labor Income Growth Has Been Accelerating Housing data are showing tentative evidence of stabilization. New home sales are rebounding, while mortgage applications are back near cycle-highs (Chart 15). Chart 15Housing Activity Is Stabilizing After Last Year's Weakness Housing Activity Is Stabilizing After Last Year's Weakness Housing Activity Is Stabilizing After Last Year's Weakness Reflecting these positive developments, the Citigroup economic surprise index has jumped into positive territory (Chart 16). The New York Fed’s estimate for Q1 2019 GDP growth has also moved up to 2.4%. Chart 16U.S. Economic Data Are Beating Low Expectations U.S. Economic Data Are Beating Low Expectations U.S. Economic Data Are Beating Low Expectations Investment Conclusions Recessions and bear markets usually overlap (Chart 17). With the next recession still at least 18 months away, it is premature to turn bearish on equities. We upgraded stocks in December following the post-FOMC sell-off. Although our tactical MacroQuant model is pointing to an elevated risk of a setback over the next few weeks, we continue to see global equities finishing the year 5%-to-10% above current levels. As global growth bottoms out mid-year, the leadership role in equity markets should increasingly move away from the U.S. towards EM and Europe. Chart 17Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Bonds are a tougher call. We do not expect the Fed to raise rates again at least until June. This will limit the upside for bond yields, as well as the dollar, in the near term. Nevertheless, with the fed funds futures pricing in no rate hikes for the next few years, even a modest shift back to tightening in the second half of this year and beyond will push up bond yields, dampening total returns to fixed income. Looking beyond 2019, the case for maintaining a short duration stance in fixed-income portfolios is very strong. The longer the Fed allows the economy to overheat, the greater the eventual overshoot in inflation will be. Inflation expectations have fallen over the past few months (Chart 18). They should have risen. Ultimately, Gentle Jay Powell’s decision to press the pause button on further rate hikes means that rates will end up peaking at a higher level during this cycle than they would have otherwise. Chart 18Inflation Expectations Have Declined Inflation Expectations Have Declined Inflation Expectations Have Declined   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      As argued in Hyman P. Minsky, “Stabilizing an Unstable Economy,” Yale University Press, (1986). 2      Severe episodes of fiscal tightening have normally followed military demobilizations. These include the recessions following WW1, WW2, and the Korean War, and to a much lesser extent, the 1990-91 recession which was exacerbated by cuts to the defense budget at the end of the Cold War. 3      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 4      Please see Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 19 Tactical Trades Strategic Recommendations Closed Trades

As the world’s second most populous country with an economy projected to grow over 7% annually, India’s potential as a commodity consumer is massive. However, years of distortionary and unfriendly policies have held back the Indian manufacturing sector – the prime consumer of commodities. This has translated into weak “consumption intensity” of industrial commodities. The past four years have witnessed a shift to more business-friendly policies. These policies and an eventual expansion of the manufacturing base will support steeper demand for industrial commodities over the longer term. India’s economic model stands in stark contrast with China’s, which became a voracious consumer of commodities as it industrialized. It is not “the next China” when it comes to metals demand, but it will play an important and growing global role. In terms of agricultural commodities, favorable demographic trends will raise aggregate demand, regardless of the success of India’s industrialization. Highlights Energy: Overweight. Russia’s production was down 42k b/d in January, a trifle compared to the ~ 450k b/d reduction by the Kingdom of Saudi Arabia (KSA) in December. Officials indicate Russia will cut production by 228k b/d in 1Q19. Base Metals/Bulks: Neutral. Indian steelmakers are seeking relief from increasing imports in the form of higher duties, as slowing Asian demand leads to higher shipments from China, Korea, and Japan, according to Reuters.1 Precious Metals: Neutral. Gold markets appear more confident in the Fed’s capitulation on its rates-normalization policy, at least in 1H19, as prices rallied above USD 1,320/oz in end-January. Gold traded slightly lower this week. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA releases its WASDE report tomorrow. Feature The impact of China’s rapid industrialization since 2000 on commodity markets is well known. Its share of global consumption of copper and crude oil rose from a modest 10.9% and 6.0% in 2000 to 51.1% and 13.5%, respectively (Chart of the Week). As such, China fueled global demand growth over this period (Chart 2) and, in large part, is responsible for the commodity price boom that ensued. Chart of the WeekChina Now Dominates Industrial Commodity Demand China Now Dominates Industrial Commodity Demand China Now Dominates Industrial Commodity Demand With such a large chunk of demand originating in China, its economic health remains a dominant variable in accurately predicting the path of industrial commodity prices globally. However, with economic priorities shifting from the industrial sector to consumer-driven services, the era of insatiable Chinese commodity demand growth looks to be nearing its end. Chart 2 In search of a replacement to take up the slack, India has often been singled out as a potential leading source of commodity demand growth going forward, and for good reason: India is massive. In terms of population, it is roughly on par with China, boasting a population of 1.3 billion people. And while its share of global wealth is dwarfed by China’s, India’s economy is growing at a rapid pace. According to the most recent IMF projections, its GDP will expand at a 7.5%, and 7.7% clip this year and next – faster than China’s projected 6.2% for both years. Typically, as low income economies develop, their manufacturing sector outpaces economy-wide growth, raising the contribution of industry to overall GDP. Stronger activity in this sector correlates well with industrial commodity demand, which rises accordingly. Meanwhile ag demand is determined by both population and income growth. India, however, has missed the boat (Table 1). Its share of global demand is disproportionate to its current size and its future potential. Table 1India’s Consumption Of Industrial Metals Stands Out As Disproportionately Low India's Commodity Demand, With Or Without Modi India's Commodity Demand, With Or Without Modi In fact, the intensity of commodity usage per dollar of GDP is low even relative to countries at similar income levels (Chart 3). This is most clear in the case of metals. It can be put down to the relatively small role of manufacturing in India’s economy. Chart 3 India did not follow the traditional path of growing its manufacturing base first before re-orienting its economy towards services. Rather, the manufacturing sector has been held back by poor infrastructure and distortionary policies. In fact, services – such as financial services, business services, and telecom – already dominate India’s economy, accounting for 53.9% of GDP, compared to 16.7% in the case of manufacturing (Chart 4). This is in stark contrast with other economies such as China, Korea, and Thailand, in which manufacturing accounts for 29%, 28%, and 27%, respectively (Chart 5). Chart 4 Chart 5No Pickup In Manufacturing Yet No Pickup In Manufacturing Yet No Pickup In Manufacturing Yet Given that the services sector is relatively less metals- and energy-intensive, India’s contribution to global demand for industrial commodities has been disproportionately low. Bottom Line: India’s growth model to date is oriented toward the services sector. As a result, the intensity of industrial commodity demand there – measured as consumption per dollar of GDP – is significantly lower than its peers. This has prevented India from playing a larger role in global commodity markets. The Case For Greater Commodity Demand: Theories And Evidence Economist Walt Whitman Rostow postulated that economies develop through five distinct phases: Traditional society: subsistence agriculture, low level of technology, labor-intensive Preconditions to takeoff: regional trade, the development of manufacturing Take off: the beginning of industrialization Drive to maturity: rising living standards, economic diversification, strong use of technology High mass consumption: mass production and consumerism Along this path, economies in phases (2), (3), and (4) are the most notable in terms of rising appetite for industrial commodities. During these stages, the industrialization and urbanization processes require an expansion of electricity grids, infrastructure and housing. As such, these stages are characterized by high base metals demand. Yet as illustrated by the sigmoid, or S curve, the period of exponential growth in commodity demand eventually slows down and in many cases falls after the country reaches a certain level of GDP per capita (Chart 6). Chart 6 Evidence from metals and oil corroborate this theory. In fact, if we single out the commodity intensity path of DM economies as their incomes were rising, we find that commodity intensity there has already started to decline (Chart 7). Chart 7 This S-curve is also evident in the commodity intensity of emerging economies (Chart 8). China’s path to development stands out as an extreme case of high consumption usage. While not all economies follow China, the paths are similar. Chart 8 In the case of oil, it appears that the consumption intensity of countries that have developed more recently peaked at both a lower income level and a lower oil usage level than countries that developed earlier. This is clearly the case for Korea and Malaysia, and suggests that technology has raised the efficiency of oil. On this basis, we do not expect India’s commodity intensity to reach the same peaks as its more wealthy peers. However, India’s usage has remained stagnant and in some cases fallen. This highlights the relatively muted role of manufacturing in India’s economy. As India’s economy grows and evolves, this should change. We project India’s commodity intensity path as it grows its manufacturing base (Chart 9). Based on this exercise, we find that by the year 2040, India’s consumption of refined copper will account for 12% of global consumption -- up from 2% today.  The impact is more muted in the oil sector -- we expect it will account for almost 12% of global crude oil demand, from the current 5%. Chart 9 This trajectory reveals that the scope for rising demand is greater for metals than for the oil sector, implying that industrial commodities are set to benefit in the case of a boom in Indian manufacturing. Bottom Line: Both theory and evidence suggests that the intensity of India’s commodity usage is set to rise over time as its manufacturing sector expands. This is especially true in the case of metals. Even in our most conservative projection, India’s copper consumption is set to rise more than 10-fold by 2040. The Path Forward: “Make In India” While the Rostow model is instructive in framing our thinking on the path to development, it is a crude theory – not all countries will necessarily follow the same path to development. These are the lessons from economist Alexander Gerschenkron’s theory of economic backwardness, which highlights that countries’ growth paths may not be identical or replicable due to cross-country differences, and differences in the state of technology available at varying points of time. Applying these ideas to India means that while India is able to access current technology, which supports a more rapid industrialization process, its economic model is also very different. The China model rested on a powerful single-party state, with privileged access to the American market, that used its control of the financial system to funnel a swell of national savings into an aggressive industrialization effort. On the other hand, the India model required the government to move forward incrementally. Indian leaders had to pursue industrialization while grappling for democratic consensus in the context of extreme social diversity and a more restrictive trade environment. Thus, India is likely to mimic the circuitous path of emerging markets like Brazil or Mexico. Over the past four years, Indian policymakers have tried to unwind unfavorable business policies and spur growth in the manufacturing sector. The “Make in India” initiative of Prime Minister Narendra Modi seeks to encourage both foreign and domestic investment, and to raise the manufacturing sector’s contribution to GDP to 25% by the year 2025. In the process it aims to create 100 million jobs. This target is unrealistic. In fact, the manufacturing sector’s contribution to GDP has come down slightly, with economists blaming the demonetization drive and the chaotic, complicated and unclear roll out of the new Goods and Services Tax. Modi also faces tough elections this spring, which could put his initiative on ice. Nevertheless, there is a positive omen in the automobile industry. According to figures from the Society of Indian Automobile Manufacturers, roughly 4 million cars were manufactured last year – up from 3.2 million just five years ago (Chart 10). This is in line with India’s Automotive Mission Plan 2026, which aims for the auto industry to become one of the top three, accounting for 40% of the manufacturing sector and contributing 12% to India’s GDP by 2026. Chart 10An Encouraging Trend For Manufacturing An Encouraging Trend For Manufacturing An Encouraging Trend For Manufacturing Moreover, Modi’s impact has been a net positive in making India more welcoming for investment. While poor infrastructure, red tape, and restive labor laws are still constraining industry, measures of institutional performance are improving (Chart 11). This is a prerequisite for a brighter manufacturing future. As for the election, even if India’s opposition Congress Party should come to power, it will have learned from its five years in the political wilderness that Modi’s message of economic development resonates with the public. Their current stance on economic policy calls for import substitution, economic liberalization, and a faster pace of development – consistent with a growing manufacturing sector. Chart 11The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving Bottom Line: While the “Make In India” campaign says as much about Modi’s flair for public relations as anything, India’s business environment is now more conducive to growth and investment. This bodes well for commodity demand going forward. Ags In The Age Of Manufacturing While a much-needed push in India’s manufacturing sector would clearly have a direct impact on its demand for industrial metals, the resulting improvement in the economy and employment would also raise incomes. In theory, this would support the consumption of agricultural commodities. Nonetheless, a couple of observations suggest that India is less of an opportunity for ags as it is for metals (Chart 12): Chart 12 In terms of the level of ag consumption per capita, rice usage is actually relatively high in India. While corn intensity levels are still quite low, wheat consumption per capita is near the level at which China plateaued. The differences across these grains likely reflects differences in preferred sources across countries and implies there is not as much room for catch up. Furthermore, ag consumption per capita generally plateaus at fairly low-income levels, in stark contrast to the industrial metals. A clear outlier is corn consumption in the United States, where high-usage patterns can be put down to the rising use of corn for ethanol production on the back of biodiesel mandates. We do not expect growth in ag consumption intensity on the back of rising incomes. Nevertheless, India’s population is projected to continue rising, in turn supporting aggregate food consumption there. That said, policies promoting India’s self-sufficiency in agriculture have generally prevented rising demand from spilling over into global markets. In fact, in terms of the trade balance, India is usually a net exporter of these grains, especially in the case of rice (Chart 13). This is a positive for India – in that it has so far avoided the risk of food shortage that occasionally rears its head – but it is a negative for global ag demand. Chart 13Self-Sufficiency Policies Insulate The Indian Ag Sector Self-Sufficiency Policies Insulate The Indian Ag Sector Self-Sufficiency Policies Insulate The Indian Ag Sector Bottom Line: Unlike industrial commodities, we do not anticipate a rise in per capita ag consumption in India. Nevertheless, a rapidly growing population will mean that aggregate demand for ags will grow briskly.    Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “Exclusive: Indian steel firms seek higher duties on steel imports as prices drop,” published by Reuters.com on February 5, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Summary of Trades Closed in 2018   Image

Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations Monthly Portfolio Update Monthly Portfolio Update True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? How Worrying Is The U.S. Slowdown? How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive U.S. Data Surprisingly Positive U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize Housing Market Should Stabilize Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming Consumption Booming Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 5 Chart 6Tighter Conditions Mean More Cautious Fed Tighter Conditions Mean More Cautious Fed Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Trump Won't Be Reelected In A Recession Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Analysts Have Overdone Downward Revisions Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Inflation Expectations Should Recover Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Corporate Leverage Is A Concern Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Can ECB Really Hike In 2019? Can ECB Really Hike In 2019? Chart 12 Chart 13...U.S. Loan Growth Accelerating... ...U.S. Loan Growth Accelerating... ...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further ... Which Will Tighten Liquidity Further ... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months.  Chart 15Oil Balance In Deficit This Year Oil Balance In Deficit This Year Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown China Sticking To Credit Crackdown China Sticking To Credit Crackdown   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   GAA Asset Allocation Footnotes 1      Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2      Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3      For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com

The hiatus in the Fed’s rates-normalization policy in 1H19 in the wake of its capitulation to financial markets, supports our bullish view on gold prices, as it raises the risk of an inflation overshoot later this year. Per the Fed’s dual mandate, inflation and employment gauges are signaling the need for tighter policy, according to BCA’s proprietary Fed Monitor. The pause in hiking fed funds raises the likelihood the Fed will find itself behind the inflation curve, as the economy enters a late-cycle phase. Gold will outperform other commodities and equities in this phase. We remain long gold as a portfolio hedge. Highlights Energy: The U.S. imposed sanctions on state-owned Petróleos de Venezuela, S.A. (PDVSA), including a ban on the company’s Houston-based Citgo remitting earnings back to the parent company.  This raises the likelihood production and exports will fall sharply as we expect.  Separately, Saudi Energy Minister Khalid al-Falih said the country will reduce output below its recently agreed 10.3mm b/d cap in 1H19, in line with our own balances expectation.1 Base Metals/Bulks: Neutral.  Iron ore prices likely will continue to move higher, following the collapse of a wet-processing dam at Vale’s Córrego do Feijão mine.  The company suffered a similar breach at its Samarco mine in March 2016, which still has not re-opened. Output will fall, if it follows through with additional dam closures. Precious Metals: Neutral.  Gold prices will continue to move higher, as the Fed’s near-term capitulation on its rates-normalization policy raises the odds the U.S. central bank will find itself behind the inflation curve.  (See below.) Ags/Softs: Underweight.  USDA reported soybeans inspected for export to China during the week ended January 24 accounted for close to 37% of the total beans inspected.  This made China the No. 1 importer of American soybeans again. Feature In February 2018, we wrote that “price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here.” In line with this expectation, we suggested remaining long gold as a portfolio diversifier and hedge against mounting equity risks. This turned out to be an accurate call. Despite losing 8.4% between January and September 2018 because of an aggressive Fed, gold rose by 7.6% in 4Q18 amid the rising equity volatility and ended the year down a minor -1.5% compared to -6.2%, -11.2% and -7.1% for the S&P 500, global equities and the CRB commodity index. This reflects the convexity in gold returns and is the reason we favored gold in 2018. Gold returns are not simply a function of the U.S. dollar and real interest rates. As highlighted in our 2019 Key Views report last December, in mature economic cycles, gold’s ability to hedge against equity and inflation risks dominate its price formation, while its correlation with the U.S. Treasury yields diminishes (Chart of the Week).2 Chart of the WeekGold's Correlation With U.S. Rates Declines As The Cycle Matures Gold's Correlation With U.S. Rates Declines As The Cycle Matures Gold's Correlation With U.S. Rates Declines As The Cycle Matures As the current cycle extends to 2019, the skewness in gold return will prove profitable. The Fed’s retreat on its quarterly rate-hike cycle only adds to our positive view, as it increases the probability the U.S. central bank falls behind the curve. Stay long gold as a portfolio hedge. Fed’s Short-Term Capitulation Strengthens Our View The recent downward revision in the Fed’s rate-hike path reinforces our positive stance on gold prices, as risks of an overshoot in inflation rises. The dichotomy in U.S. vs. rest of the world growth puts the Fed in a difficult position. The current capitulation was mainly driven by tightening financial conditions – chiefly, the rising U.S. dollar, declining stock prices, and widening credit spreads. However, under the Fed’s dual mandate, inflation and employment still are signaling “tightening-required” per BCA Research’s Fed Monitor, a model maintained by our U.S. Bond strategists (Chart 2). Since economic growth cannot remain above-trend indefinitely, short-term productive capacity constraints (i.e. capital and labor factors of production) are already binding and will force the Fed to raise rates later this year as inflation creeps up. Chart 2Growth And Inflation Signal Tighter Money Is Required Growth And Inflation Signal Tighter Money Is Required Growth And Inflation Signal Tighter Money Is Required As it reaffirms its data dependence, the Fed is opening the door to falling behind the inflation curve, given inflation is a lagging indicator of the price pressures that are building up in the economy (Chart 3). As a result, we expect gold’s ability to hedge against inflation will support its price in 2H19. Chart 3Inflationary Pressure Will Rise In 2019 Inflationary Pressure Will Rise In 2019 Inflationary Pressure Will Rise In 2019 Short-term, a Fed pause also supports gold by readjusting investors’ expectations regarding the U.S. dollar and real interest rates lower. Our bond strategists identified two previous periods where similar conditions led to a false start in the Fed hiking cycle, 1997 and 2015. In both cases, the Fed’s capitulation led to a reversal in gold’s downward price trajectory, as the market perceived the central bank was keeping its short-term policy rate at a level that was inconsistent with the so-called R-star rate or natural rate of interest – i.e., “the real interest rate expected to prevail when the economy is at full strength” (Chart 4).3 Chart 4AGold Price's Trajectory Reversed In 1997... Gold Price's Trajectory Reversed In 1997... Gold Price's Trajectory Reversed In 1997... Chart 4B ... And In 2015 ... And In 2015 Using a conceptual four-quadrant framework developed by our colleagues at The Bank Credit Analyst to describe the Fed’s behavior, we currently believe the outcome with the highest probability of being realized by the Fed’s capitulation is Policy Mistake 2 (Table 1, lower right quadrant). If we’re right, this raises the odds of an inflation overshoot above the Fed’s 2% target later this year.4 Table 1Four Fed Policy Scenarios Inflation Overshoot More Likely; Stay Long Gold Inflation Overshoot More Likely; Stay Long Gold This is not a foregone conclusion. However, generally speaking, the higher the inflation uncertainty and the higher the perception the Fed will fall behind the curve, the higher gold is bid up. Recent price action seems to corroborate this. Chart 5 shows that the recent downward revision in the median long-term fed funds rate projection coincides with a rise in gold prices. At present, gold investors are signaling that the fed funds rate is below the neutral rate consistent with R-star. Chart 5Gold Markets Signal Monetary Policy Is Accommodative Gold Markets Signal Monetary Policy Is Accommodative Gold Markets Signal Monetary Policy Is Accommodative Gold And The U.S. Economic Cycle Gold prices are difficult to model and predict, given the collection of time-varying, often conflicting, components determining their evolution. Its core determinants change as we move through the economic cycle. In their current late-cycle environment, inflation and equity risks – i.e., fears of a sharp correction – usually gain in importance. In this report, we characterize the market’s late-cycle phase using two metrics: (1) the fed funds rate relative to R-star, (2) the phase of the yield curve cycle.5 We have already discussed (1) in our outlook and found that when the fed funds rate is rising yet still below the estimate of R-star, gold returns are highly skewed to the upside (Chart 6).6 For (2), we compared the yellow metal’s return to other assets returns in different phases of the U.S. Treasury yield curve’s evolution. We define these yield-curve phases as follow: Chart 6 Phase 1: Normal (i.e., positively sloped: 10-year rates are greater than 3-month rates). The 3-month/10-year treasury slope is above 75 bps. Phase 2: On its way to flattening and returning to normal. The 3-month/10-year Treasury slope is between 0 bps and 75 bps. We divide this in two sub-phases: (a) steepening, and (b) flattening. Phase 3: Inverted (i.e., negatively sloped). The 3-month/10-year Treasury slopes is below 0 bps (Chart 7).7 Chart 7Phases Of The Yield Curve Cycle Phases Of The Yield Curve Cycle Phases Of The Yield Curve Cycle We found that: first, DM and EM equities are the best performers in the group we looked at during Phase 1, when the slope of the yield curve is steep (above 75 bps). Second, there is wide difference between the steepening and flattening sections of Phase 2. EM equities and copper experience the largest rebound once the slope’s curve steepens from below zero. Lastly, gold performs best in the flattening section of Phase 2 and, critically, it outperforms oil, copper, broad commodity indices and equities (Table 2). Table 2Gold Returns Are Positive When The Yield Curve’s Slope Flattens Inflation Overshoot More Likely; Stay Long Gold Inflation Overshoot More Likely; Stay Long Gold Our U.S. Investment and Bond Strategists believe the Fed’s policy rate will remain in the below-r-star-and-rising range, and in Phase 2 of the yield curve cycle for most of 2019. We agree, and believe our analysis indicates gold prices will increase this year on the back of these factors. Recession Fear And Equity Risks Will Drive Gold For most of 2018, investor sentiment and positioning were primarily determined by the U.S. dollar and real rates. As these variables rose last year, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in the oversold territory (Chart 8).8 In our view, the other (important) drivers of gold prices were ignored during that period. The end-of-year equity selloff led to a reshuffle of the core determinants of the yellow metal’s price, pushing the equity risk factor higher on the list of variables explaining its price. Chart 8Sentiment Collapsed In 1H18 Sentiment Collapsed In 1H18 Sentiment Collapsed In 1H18 Chart 9 shows gold and the U.S. equity risk premium disconnected in 2018, until the October equity selloff. In general, these variables are positively linked. When risk aversion is elevated, investors demand higher compensations for holding risky assets, and increase their demand for safe-haven assets. This pushes up both the equity risk premium and gold prices. Chart 9Gold And Equity Risk Premium Correlation Picked Up Gold And Equity Risk Premium Correlation Picked Up Gold And Equity Risk Premium Correlation Picked Up Gold’s performance in 4Q18 supports our recommendation for holding it as a portfolio diversifier in 2018, and why we continue to do so this year (Chart 10). Chart 10 Separately, our U.S. dollar and rates-only model moved up recently, easing the downward pressure on gold (Chart 11). While we believe these two variables’ marginal impact diminished since 4Q18, they are included in our gold “fair-value” model, which currently indicates it is fairly valued and that its support remains intact. Chart 11Upside Pressures Are Building Upside Pressures Are Building Upside Pressures Are Building Bottom Line: The Fed’s near-term capitulation raises the odds the U.S. economy will experience an inflation overshoot. Our fair-value model also is supportive of gold prices. We remain long as a diversification and portfolio hedge. 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 “Saudis Pledge Deeper Oil Cuts in February Under OPEC+ Deal,” published by bloomberg.com January 29, 2019.  See also “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone” published January 24, 2019, for our latest supply-demand balances and price forecasts.  It is available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 3      Please see John C. Williams’s remarks delivered to the Economic Club of Minnesota May 15, 2018, entitled “The Future Fortunes of R-Star: Are They Really Rising?”  Williams was president and CEO of the Federal Reserve Bank of San Francisco at the time, and now has the same role at the NY Fed..  We explore this further below.  See also BCA Research’s U.S. Bond Strategy Weekly Report titled “An Oasis Of Prosperity,” published August 21, 2018. It is available at usb.bcaresearch.com. 4      Please see BCA Research’s The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. It is available at bca.bcaresearch.com. 5      The San Francisco Fed defines R-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. R-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 6      We presented this analysis in BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 7      For a similar analysis applied to different asset classes, please see BCA Research’s U.S. Bond Strategy Weekly Report titled “2019 Key Views: Implication For U.S. Fixed Income,” published December 11, 2018, and The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. These reports are available at usb.bcaresearch.com and bca.bcaresearch.com. Our approach is slightly different from our colleagues’ methodology. We used a threshold of 75 bps instead of 50 bps in order to increase the sample size of the Phase 2, flattening section. This improves the accuracy of using the average as our main descriptive statistic. Note that the yield curve can remain inverted for some time before a recession occurs, this explains why equity returns are positive in Phase 3 (curve inversion). 8      Our Gold Composite Indicator has three components: (1) Sentiment, (2) Speculative positioning and (3) Technical. It is meant to assess if there is any mismatch between our fundamental analysis and investors’ sentiment and expectations. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table Summary Of Trades Closed In 2018 Image