Emerging Markets

Highlights Money supply, not central banks’ assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Changes in the velocity of money are as important as those in money supply. Yet, forecasting changes in the velocity of money is a near impossible task as it entails foreseeing the behavior of economic agents. A large and expanding stock of money in and of itself does not guarantee greater liquidity for asset markets. Gauging liquidity flows to asset markets boils down to predicting investors’ behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Feature Investors and market commentators often refer to “liquidity” as a driving force for financial markets. Yet definitions and calculations of liquidity vary tremendously. This report aims to define and differentiate among various categories of liquidity and assess their relevance for asset markets. What investors refer to as “liquidity” can by and large be classified into three groupings: (1) banking system liquidity; (2) broad money supply (all deposits and cash in circulation) available to purchase goods, services and assets, including securities; and (3) liquidity in asset markets - the portion of broad money supply that is channeled to purchase financial assets. Diagram I-1 on page 2 provides visual representation of money and liquidity groupings. All other measures of “liquidity” generally fall into one of these three groupings. Diagram I-1Liquidity Groupings And Linkages A Primer On Liquidity A Primer On Liquidity Banking System Liquidity At the core of any monetary system is the monetary base, which is also referred to as high-powered money. This consists of commercial banks’ reserves at the central bank, and cash in circulation. Provided the quantity of cash in circulation is determined by the economy’s demand for cash, it is beyond the control of central banks and commercial banks.1 Besides, cash in circulation is a part of broad money supply, while bank reserves at the central bank are not. Broad money is the focal point of the next section. In this section, we deliberate on the genuine liquidity within the banking system, which is banks’ excess reserves at the central bank. Banks require excess reserves to settle payments with other banks arising both from their own and their clients’ transactions. Only the central bank can create bank reserves, and does so “out of thin air” when it purchases assets or lends. The central bank creates reserves electronically simply by crediting commercial banks’ reserve accounts held at the central bank. Chart I-1Excess Reserves And Share Prices: No Strong Correlation Excess Reserves And Share Prices: No Strong Correlation Excess Reserves And Share Prices: No Strong Correlation The amount of excess reserves each individual bank holds as well as the cost of borrowing these reserves influence commercial banks’ willingness to expand their balance sheets – i.e., originate loans and purchase assets. Yet excess reserves do not flow into the economy and financial markets. Banks do not lend out excess reserves to borrowers. Banks require excess reserves to settle payments with other banks arising both from their own and their clients’ transactions.   Furthermore, banks do not use deposits – which are liabilities owed by banks – to settle payments with other banks or the central bank. Rather, they draw down their excess reserves to conduct settlements. When banks are short on excess reserves, they borrow them from the central bank or other banks. In short, all types of deposits at banks – those of households, companies, organizations and governments – do not constitute liquidity for banks. The incentive for banks to attract deposits from their peers is not the deposits themselves but rather the handover of excess reserves that occurs when a deposit is transferred from one bank to another. In a nutshell, banks compete with one another not for deposits, per se, but for excess reserves. How well do excess reserves correlate with share prices? Chart I-1 reveals that there has been no stable correlation between excess reserves and share prices in the US, the Euro Area, Japan and China. Bottom Line: Excess reserves do not constitute broad purchasing power for goods and services as well as real and financial assets. Excess reserves can be thought of as “core” liquidity that has a bearing on banks’ willingness to create money “out of thin air.” Money Supply Broad money supply is the sum of all types of deposits and cash in circulation. Narrow money (M1) supply is comprised of demand deposits and cash in circulation. Thereby, broad money supply determines potential purchasing power for goods, services and all types of assets. Outside of quantitative easing (QE), central banks do not typically create deposits/broad money; they typically create reserves only. When a central bank lends to or purchases an asset from a bank, it creates reserves, but not deposits. When a central bank purchases an asset from a non-bank, it creates both deposits (money) and reserves. Critically, as highlighted previously, reserves are not a part of narrow or broad money supply. Chart I-2Money Multiplier = Broad Money / Excess Reserves Money Multiplier = Broad Money / Excess Reserves Money Multiplier = Broad Money / Excess Reserves This is why fears that QE will immediately lead to high inflation are false. QE in advanced economies have generated a lot of reserves but little in the way of new money supply. Ultimately, it is deposits/money – not reserves – that determine purchasing power. Outside of QE, money is created by banks, not central banks. Both a loan origination to and a purchase of a security from a non-bank by a bank leads to new deposit/money creation “out of thin air.” Also, savings versus spending decisions by economic agents (non-banks) do not change the amount of money supply. We have deliberated on these topics at length in past reports. In turn, the willingness of banks to expand their assets for a given level of excess reserves and interest rates is measured by the money multiplier. The latter is computed as a ratio of broad money to excess reserves. Chart I-2 illustrates money multipliers in the US and China. The US money multiplier has been rising since late 2014. America’s broad money supply (M2) has been expanding in recent years, even though the Federal Reserve – until this past September – had been draining banking system excess reserves. In China, by contrast, the money multiplier has been declining since late 2017.  Remarkably, the level of the money multiplier is considerably higher in China (62) than in the US (11). In other words, for each unit of excess reserves, there are 62 outstanding units of broad money in China, and only 11 units in the US. China’s higher money multiplier signifies the following: (1) Its banks are more overextended in terms of liquidity – i.e., they are more likely to experience liquidity shortages than their US peers; and (2) mainland banks have been acquiring more assets and originating more loans per unit of excess reserves. The willingness of banks to expand their assets (captured by the money multiplier) is often more important for money creation than excess reserves provisions by central banks. For example, since January 2009 - the onset of the credit boom in China - the country’s excess reserves have almost doubled. Yet broad money has expanded more than 4-fold (Chart I-2, bottom panel). This compares with an 85% rise in US broad money and 40% in the euro area's since January 2009 (Chart I-3, top panel).   Chart I-3“Helicopter” Money In China Helicopter Money In China Helicopter Money In China Chinese commercial banks have literally been dropping “helicopter” money from the time when the country embarked on a massive credit binge in early 2009. Since that time, Chinese banks have created 178 trillion yuan ($25 trillion) of new broad money, based on our measure of broad (M3) money supply. This is almost triple the $8.4 trillion broad money supply created in the US and euro area combined over the same period. China’s broad (M3) money supply2 now stands at 232 trillion yuan, equivalent to US$33 trillion (Chart I-3, bottom panel). What is astonishing is that Chinese broad money is larger than the sum of broad money in both the US and euro area, which is roughly equivalent to $30 trillion (i.e., the sum of all outstanding US dollars and euros in the world). Yet China’s nominal GDP is equivalent to only 40% of US and euro area GDP combined. In China, broad money supply has been a good leading indicator for its business cycle (Chart I-4, top panel). In the US and Europe, however, broad money has been much less successful in predicting the direction of the business cycle (Chart I-4, middle and bottom panels). Money supply is liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Why does money supply correlate better with business cycles in some economies than others? The answer is the velocity of money. Even when two economies experience similar rates of money growth, the pace of their economic growth will differ due to differences in their velocity of money. Specifically: Nominal GDP Income = Money Supply x Velocity Of Money Hence, a change in nominal GDP growth is driven by both changes in the money supply and the velocity of money. Therefore, it is a mistake to think that new money creation is the only source of new demand and growth. When the existing money supply turns faster – i.e. the velocity of money rises – nominal GDP will expand without new money being created. The velocity of money reflects households’ and companies’ willingness to spend versus save. For the same amount of outstanding money supply, households and businesses can spend more (turn over money faster) or less (turn over money more slowly). It is much harder to gauge changes in the velocity of money than in money supply. Changes in the velocity of money reflect variations in the willingness to spend, save and invest among households, companies and institutions. Chart I-5 illustrates the velocity of money in China, the US, the euro area and Japan have not been constant. Chart I-4Money And The Business Cycle Money And The Business Cycle Money And The Business Cycle Chart I-5Velocity Of Money Changes Over Time Velocity Of Money Changes Over Time Velocity Of Money Changes Over Time   Therefore, forecasting money growth is in and of itself insufficient to predict the business cycle. One also needs to consider changes in the velocity of money – i.e. the spending versus saving preferences of economic agents. How do interest rates impact money supply and the velocity of money? Low and falling interest rates boost demand for credit and lead to more loan origination, resulting in greater money supply. In addition, low interest rates encourage more spending versus savings. As a result, the velocity of money rises. Faster money growth accompanied by an acceleration in the velocity of money ensures more rapid nominal GDP growth.  Bottom Line: Money supply is liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. However, knowing money supply’s future trajectory is insufficient to gauge the prospects for economic growth or direction of financial markets. Changes in the velocity of money are as important as those in money supply. Yet, forecasting changes in the velocity of money literally amounts to predicting the behavior of economic agents. Liquidity In Asset Markets Deposits/money supply can be used to acquire both financial and real assets as well as purchase goods and services. They could also be kept idle. In a given period of time, it is impossible to envisage what portion of deposits in the banking system will be allocated to securities investments. Ultimately, this decision rests with each individual and institution. There is no way to foresee both the amount of deposits that will be channeled to purchase financial assets as well as the velocity of these funds. Therefore, it is impossible to forecast the true size of liquidity overflow into and out of asset markets. Overall, gauging liquidity flows to asset markets boils down to predicting investors’ behavior. Liquidity flows into financial assets when “animal spirits” among investors improve, and vice versa. Please refer to Diagram I-1 on page 2 for a visual illustration. Many market participants monitor fund flows to gauge liquidity tides into and out of various asset classes. Nevertheless, there are some common problems with these fund-flow datasets. First, reported data on fund flows into an asset class or a region are often old news. The basis is that capital has already been allocated – i.e., transactions have already taken place, and asset prices already reflect these flows. In fact, fluctuations in asset prices are the best timely reflection of fund flows into a particular asset class. Second, to our knowledge, there is no comprehensive fund flows dataset that encompasses fund flows across all types of investors globally – including but not limited to all pension and sovereign funds, institutional money managers, wealth managers and family offices as well as hedge funds. Hence, existing fund flows datasets are incomplete.  Chinese broad money is larger than the sum of broad money in both the US and euro area. How do we deal with the lack of comprehensive fund flow data? Our framework is as follows: We assume that liquidity (money) will flow into/out of countries offering a superior/poor risk-reward profile, respectively. Our analysis of each asset class/country takes into consideration both the ability of this particular asset class/country to generate sustainable cash flows as well as valuations. Our underlying conjecture is that capital will ultimately flow into the areas that generate high or improving return on capital, and will flow out of segments that experience low or falling return on capital. Thereby, we try to predict whether capital will flow in or flow out based on these fundamentals, and position a portfolio accordingly. This approach assumes that global capital allocation in the medium to long term is efficient and rational – i.e., financial markets will reward good companies/countries and penalizes bad ones. Finally, we constantly monitor various liquidity proxies to make sense of marginal shifts in money supply as well as investors’ risk tolerance – the latter being a proxy for the velocity of money in the investment industry. Both are critical to gauging liquidity circulation in financial markets. Bottom Line: A large and expanding stock of money in and of itself does not guarantee plentiful liquidity for asset markets. Investors’ willingness to invest is required for money (liquidity) to flow into financial assets. In turn, deteriorating investor confidence can lead to a dearth of liquidity in asset markets, despite abundant broad money supply.  Key Questions And Summary What is the connection between interest rates and liquidity? Why do many investors use interest rates and liquidity inter-changeably? Low and/or declining interest rates entail rising odds that substantial liquidity will flow into various risk assets, and vice versa. This is why many commentators use interest rates as a proxy for liquidity for financial assets. Is there too much liquidity in the world? Apart from China, broad money supply has not expanded tremendously since 2009 (please refer to Chart I-3 on page 6). The QE efforts by central banks in advanced economies have significantly boosted bank reserves, but broad money supply has expanded relatively modestly.   In China, however, broad money supply in RMB has more than quadrupled to $33 trillion. In brief, China has a money bubble. Is there a shortage of financial assets relative to available liquidity? Yes. QE programs in advanced economies have removed high-quality financial assets – valued at about $9 trillion – from global markets (Chart I-6). Yet money supply has expanded. This has left money chasing few assets. Also, low policy rates reduce the opportunity cost of owning financial securities. These two phenomena have led investors to bid up prices of available financial assets. Consequently, high-quality financial assets have become expensive, and those that appear attractive are likely “cheap for a reason.” Does the Fed’s balance sheet expansion since September amount to additional QE and more liquidity provision for financial markets? There is a difference between a central bank’s balance sheet/assets and banks’ excess reserves. They are not always the same. For example, since September, the Fed has expanded its assets by about $400 billion but US banks’ excess reserves have risen by only $190 billion (Chart I-7, top panel). Chart I-6QE Removed $9 Trillion Worth Of Financial Assets From Global Markets QE Removed $9 Trillion Worth Of Financial Assets From Global Markets QE Removed $9 Trillion Worth Of Financial Assets From Global Markets Chart I-7Beware Of Difference Between Fed’s Assets And Excess Reserves Beware Of Difference Between Fed Assets And Excess Reserves Beware Of Difference Between Fed Assets And Excess Reserves   This discrepancy is largely due to the rise in the Treasury’s General Account (TGA) at the Fed. Since September, the US Treasury has shifted $200 billion of deposits from banks to its TGA at the Fed (Chart I-7, middle panel). By doing so, the Treasury has destroyed a similar amount of banks’ excess reserves. Overall, the net excess reserves injection by the Fed has been shallower than is generally perceived by looking at its balance sheet. A large and expanding stock of money in and of itself does not guarantee plentiful liquidity for asset markets. Is the Fed’s balance sheet expansion a reason behind strong US money growth since September? Not really. Most of the US money supply (deposits) is created by US banks – not the Fed. When banks originate a loan or purchase a security from a non-bank, they create a new deposit/money “out of thin air.” Not only has US banks’ loan origination growth been brisk, but they also have purchased a substantial amount of US Treasurys since late 2018 to meet Basel III liquidity requirements. These operations have created new money supply, as evidenced in Chart I-8.  Chart I-8US Commercial Bank Assets And Components US Commercial Bank Assets And Components US Commercial Bank Assets And Components In short, US money supply growth has been robust due to strong loan demand and the willingness of banks to lend as well as to their purchases of high-quality securities for regulatory reasons. The latter has depressed US government bond yields facilitating the rally in risk assets. Are fluctuations in global narrow and broad money reliable indicators for global share prices? Chart I-9 illustrates that both the global narrow and broad money impulses – their second derivatives – have some correlation with global share prices, but not a strong one. Chart I-9Global Money Impulse And Global Share Prices Global Money Impulse And Global Share Prices Global Money Impulse And Global Share Prices On the whole, banking system reserves, money supply and interest rates are important drivers of liquidity allocated to financial assets. Nevertheless, the amount of liquidity flowing into and out of financial assets is ultimately contingent on investor behavior. When investors are willing to invest, liquidity flows into asset markets. On the contrary, when investors turn cautious, they withhold liquidity and asset prices drop.    Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Commercial banks in this report are referred to as banks. 2     China’s broad money (M3) is calculated by BCA as the sum of deposits of non-financial institutions, households and other financial corporations at commercial banks; the calculation also includes commercial banks’ other liabilities as well as nonfinancial institutions’ deposits at PBoC but excludes commercial banks’ borrowing from the PBoC, interbank borrowing, foreign liabilities and bonds issued. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Clients, Please note that this week we are re-publishing a Special Report written by our Emerging Market Strategy team and published on January 7, 2020. The report, authored by Ellen JingYuan He, is an extension of the Special Report published in September 2017 and examines the progress made in China’s “Belt and Road Initiative (BRI)” since its implementation in 2013.  This Special Report concludes that going forward, the Chinese government will likely shift to a stricter regulatory stance in BRI project financing. The shift will lead to a modest pullback in realized BRI investment in 2020. However, given the small size of BRI investments relative to China’s total capital spending, the recovery in Chinese capital goods imports still hinges on the domestic property and infrastructure spending cycle.  I trust you will find this report insightful. In addition, we are closing our long USD/CNH trade, initiated in May 2019 as a currency hedge for our cyclical overweight in Chinese stocks and corporate bonds (denominated in USD terms). As we mentioned in last week’s China Macro and Market Review, upon the signing of the Phase One trade deal on January 15, we expect further modest strengthening in the Chinese currency as China’s economy continues to improve. Therefore, the currency hedge is no longer needed and we recommend that investors favor Chinese stocks and bonds versus the global benchmark in unhedged terms.  Best regards, Jing Sima, China Investment Strategist   Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Chart I-11BRI Helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Remain short the DXY index. The key risk to this view is a US-led rebound in global growth, or a pickup in US inflation that tilts the Federal Reserve to a relatively more hawkish bias. Stay long a petrocurrency basket. The latest flare-up in US-Iran tensions is just a call option to an already bullish oil backdrop. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for maintaining a pro-cyclical stance. Feature The consensus view is rapidly converging to the fact that the dollar is on the precipice of a decline, and cyclical currencies are bound to outperform. This is good news for our forecast but bad news for strategy. The fact that speculators are now aggressively reducing long dollar positions, one of our favorite contrarian indicators, is disconcerting (Chart I-1). The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions (Chart I-2). That said, we are not dogmatic. In FX, momentum investors eventually get vilified, while contrarians get vindicated. This suggests revisiting the core risks to our view, especially in light of recent market developments. Chart I-1A Consensus Trade? A Consensus Trade? A Consensus Trade? Chart I-2The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency An Oil Spike: US Dollar Bullish Or Bearish? The latest story on the global macro front is the possibility of an oil spike, driven by escalation in US-Iran tensions. Our geopolitical strategists believe that while Middle East tensions are likely to remain elevated for years to come, a full-scale war is not imminent.1 This view is fomented by a few key factors. First, the Iranian response to the assassination of Qasem Soleimani was relatively muted, given no US lives were claimed. This was also reinforced by the Iranian foreign minister’s claim that the actions were concluded. As we go to press, the Kyiv-bound Ukrainian aircraft that crashed in Tehran is being characterised as an “act of God” so far. In a nutshell, this suggests de-escalation. Second, sanctions against Iran have been causing real economic pain, given rampant youth unemployment and falling government revenues. This means that Tehran will have to be strategic in any confrontation with the US, since the risks domestically are asymmetrically negative. Renegotiating a new nuclear deal seems like a better bargaining chip than an all-out war. The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions. The biggest risk for oil prices is the possibility of a more marked drop in Iranian production, or possibly the closure of the Strait of Hormuz, though this is a low-probability event for the moment (Chart I-3). Our commodity strategists posit that while a closure of the strait could catapult prices to $100/bbl, there are some near-term offsetting factors.2 These include strategic petroleum reserves in both China and the US, as well as OPEC spare capacity that could benefit from the newly expanded pipeline to the port of Yanbu. This suggests that a flare up in US-Iran tensions remains a call option rather than a catalyst on an already bullish oil demand/supply backdrop. Chart I-3The Risk From Iran The Risk From Iran The Risk From Iran Risks to oil demand remain firmly tilted to the upside. Oil demand tends to follow the ebb and flow of the business cycle. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers, and heavy trucks to a halt (Chart I-4). Any increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. Not to mention, unplanned outages typically wipe out 1.5%-2% of global oil supply. Any such occurrence in 2020 will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-4Oil Demand And Global Growth Oil Demand And Global Growth Oil Demand And Global Growth Chart I-5Opec Spare Capacity Is Low On Oil, Growth And The Dollar On Oil, Growth And The Dollar Traditionally, a pick-up in oil prices has tended to be bearish for the US dollar. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payment dynamics also tend to improve during oil bull markets. Altogether, these forces combine to become powerful undercurrents for petrocurrencies. That said, it is important to distinguish between malignant and benign oil price increases. There have been many recessions preceded by an oil price spike, and rising prices on the back of escalating tensions are not a recipe for being bullish petrocurrencies. That said, absent any escalating tensions or a marked pickup in global demand, which is not our base case, the rise in oil prices should be of the benign variety – pinning Brent towards $75/bbl. OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. In terms of country implications, rising oil prices will go a long way towards improving Canada’s and Norway’s trade balances. In the case of Norway, net trade fell in 2019 due to lower exports of oil and natural gas, but still stands at 5.1% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 4.4% of GDP. On the other hand, the Canadian trade deficit has been hovering near -1% of GDP over the past few years. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices (Chart I-6). We are bullish both the loonie and Norwegian krone, but have a short CAD/NOK trade as high-conviction bet on diverging economic fundamentals. Chart I-6NOK Will Outperform CAD NOK Will Outperform CAD NOK Will Outperform CAD Shifting Correlation Even though rising oil prices tend to be bullish for petrocurrencies, being long versus the US dollar requires an appropriate timing signal for a downleg in the greenback. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, there has been a divergence between the price of oil and the performance of petrocurrencies. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-7).  Chart I-7Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies This is especially pivotal as the US inches towards becoming a net exporter of oil. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. The strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar down-leg. Another strategy is to be long a basket of oil producers versus oil consumers. We are long an oil currency basket versus the euro as a dollar neutral way of benefitting from rising oil prices. Chart I-8 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Chart I-8Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Risks To The View Above all, the dollar remains a counter-cyclical currency. As such, when global growth rebounds, more cyclical economies benefit most from this growth dividend, and capital tends to gravitate to their respective economies. This holds true for global oil and gas sectors that tend to have a higher concentration outside of US bourses. As such, one key risk is that if the S&P 500 keeps outperforming oil, as has been the case over the past decade, the dollar is unlikely to weaken meaningfully (Chart I-9). We understand this is a call on sectors (US tech especially), rather than relative growth profiles, but what matters for currencies is the impulse of capital flows. That said, improving global growth should allow EM energy consumption (a key driver of oil prices), to pick up. Chart I-9Oil Prices And The Stock Market Oil Prices And The Stock Market Oil Prices And The Stock Market The second risk is a pickup in US inflation expectations that tilts the Fed towards a relatively more hawkish bias. The economic linkage between US inflation and oil is weak, but financial markets assign a strong correlation to the link (Chart I-10). In our view, given that higher gasoline prices tend to hurt US retail sales, and the consumer is the most important driver of the US economy, higher oil prices can only be inflationary if the overall US economy is also robust (Chart I-11). This combination is unlikely to occur if rising oil prices are being driven by a flare-up in geopolitical tensions.   Chart I-10A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations Chart I-11Gasoline Prices And US Consumption Gasoline Prices And US Consumption Gasoline Prices And US Consumption A US inflation spike in 2020 is a low-probability event. There have been two powerful disinflationary forces in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. This was further exacerbated by the trade war. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-12). Meanwhile, the recent rise in the dollar and fall in commodity prices are likely to continue to anchor US inflation expectations downward, which should keep the Fed on the sidelines. Chart I-12Velocity Of Money Versus Inflation Velocity Of Money Versus Inflation Velocity Of Money Versus Inflation The gaping wedge between the US Markit and ISM PMIs remains a cause for concern. Given sampling differences, where the Markit PMI surveys more domestically-oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-13). Looking across global PMIs, there has been a notable pickup in Asia, specifically in Korea, Taiwan and Singapore, though weakness in Japan and Europe has persisted. This warrants close monitoring. Chart I-13The Risk To A Bearish Dollar View The Risk To A Bearish Dollar View The Risk To A Bearish Dollar View We continue to view further deceleration in the global manufacturing sector as a tail risk rather than our base case. Trade tensions have receded, global central banks remain very dovish, and Brexit uncertainty has diminished. This should allow global CEOs to begin deploying capital, on the back of pent-up investment spending. More importantly, the slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. On the political spectrum, it has been historically rare for the Fed to raise interest rates a few months ahead of an election cycle, which should allow a weaker dollar to help grease the global growth supply chain. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden.  Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, this remains a tail risk. Housekeeping We will soon be taking profits on our long NOK/SEK position. Reduce the target to 1.09 and tighten the stop to 1.06. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden. Most importantly, the cross will approach a profitable technical level in the coming weeks, on the back of our call a few weeks ago to rebuy the pair (Chart I-14). 2020 will be a year of much more tactical calls. Stay tuned. Chart I-14Take Profits On NOK/SEK Soon Take Profits On NOK/SEK Soon Take Profits On NOK/SEK Soon   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1  Please see Geopolitical Strategy Special Alert "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Iran Responds To US Strike; Oil Markets Remain Taut," dated January 9, 2020, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: ISM manufacturing PMI fell to 47.2 from 48.1 in December. However, Markit and ISM services PMIs both increased to 52.8 and 55, respectively.  The trade deficit narrowed by $3.8 billion to $43.1 billion in November. ADP recorded an increase of 202K workers in December, the largest increase since April. Initial jobless claims fell from 223K to 214K, better than expected. MBA mortgage applications soared by 13.5% for the week ended December 27th. The DXY index recovered by 0.7% this week from its recent decline. Trump's speech has eased tensions between the US and Iran, making an escalation towards a full-scale war unlikely. Moreover, recent data point to a continued expansion in the US through 2020. That being said, we believe that the global growth will outpace the US, which is bearish for the dollar, but this is an important risk to monitor. Tomorrow’s payroll report will be an important barometer. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: Markit services PMI increased to 52.8 from 52.4 in December. Headline inflation jumped to 1.3% year-on-year from 1% in December, while core inflation was unchanged at 1.3%.  Retail sales accelerated by 2.2% year-on-year in November, from 1.7% the previous month. The Sentix investor confidence soared to 7.6 from 0.7 in January. The expectations versus the current situation component continues to point to an improving PMI over the next six months. EUR/USD fell by 0.7% this week. Recent data from the euro area have been consistent with our base case view that the euro area economy is rebounding, and is likely to accelerate in 2020. We remain long the euro, especially against the CAD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been disappointing: The manufacturing PMI fell slightly to 48.4 from 48.8 in December; the services PMI also fell to 49.4 from 50.3 in December. Labor cash earnings fell by 0.2% year-on-year in November. Consumer confidence increased to 39.1 from 38.7 in December. USD/JPY increased by 1.2% this week. The Japanese yen initially surged on the back of US-Iran headlines, then fell as tensions faded after Trump's speech. While we don't expect a full-scale war between the US and Iran for the moment, geopolitical risks will likely persist before the elections later this year. We continue to recommend the Japanese yen as a safe-haven hedge, though our long position is currently out of the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: Nationwide housing prices increased by 1.4% year-on-year in December. Halifax house prices also grew by 4% year-on-year in December. Markit services PMI surged to 50 from 49 in December. The British pound fell by 0.4% against the US dollar this week. On Thursday, BoE Governor Mark Carney said in a speech that “with the relatively limited space to cut the Bank Rate, if evidence builds that the weakness in activity could persist, risk management considerations would favor a relatively prompt response.” This has been viewed by the market as dovish and the pound fell on the message. In the long term, we like the pound as Brexit risk fades. In other news, the BoE has announced Andrew Bailey as the successor to Mark Carney, scheduled to take over in March 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The Commonwealth bank services PMI increased to 49.8 from 49.5 in December. Moreover, the AiG manufacturing index slightly increased to 48.3 from 48.1. Building permits fell by 3.8% year-on-year in November. On a monthly basis however, it increased by 11.8%. Exports increased by 2% month-on-month in November, while imports fell by 3%. The trade surplus widened to A$5.8 billion. The Australian dollar plunged by 1.5% against the US dollar amid broad US dollar strength this week. The Aussie is the weakest currency so far this year.  This is especially the case given demand destruction from the ongoing severe bushfires in Australia. On the positive side, a weaker Australian dollar could support exports and the current account as international trade picks up in 2020. The extent of fiscal stimulus will be an important wildcard for both the RBA and the AUD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mostly positive: House prices increased by 4% year-on-year in December.  The ANZ commodity price index fell by 2.8% in December. The New Zealand dollar fell by 1% against the US dollar this week. On January 1st, China's central bank announced that it would inject additional liquidity into the economy. This is bullish for global growth along with a "Phase I" trade deal. As a small open economy, New Zealand is one of the countries that will benefit the most from a global growth recovery. We will be monitoring whether the scope for improvement in agricultural commodity prices is bigger than that for bulks, which underscores our long AUD/NZD position. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Exports fell slightly by C$0.7 million in November. Imports also fell by C$1.2 million, which led to a narrower trade deficit of C$1.1 billion. Ivey PMI dropped sharply to 51.9 from 60 in December. Housing starts fell to 197K from 204K in December. Building permits also fell by 2.4% month-on-month in November. The Canadian dollar fell by 0.5% against the US dollar along with the decline in energy prices this week, erasing the gains earlier this year. While we expect the Canadian dollar to outperform the US dollar from a cyclical perspective, the CAD is likely to underperform against other cyclical currencies as global growth picks up steam through 2020. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The manufacturing PMI rose to 50.2 from 48.8 in December, the first expansion since March 2019, mainly driven by increases in both production and new orders. Headline inflation shifted back to positive territory at 0.2% year-on-year in December, following negative prints for the past two consecutive months.  Real retail sales were unchanged in November on a year-on-year basis. The Swiss franc was little changed against the US dollar this week, while it rose against other major currencies including the euro on the back of positive PMI and inflation data. More importantly, recent Middle East tensions have reignited safe-haven demand, increasing bids for the Swiss franc. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: The unemployment rate fell further to 3.8% from 3.9% in October. The Norwegian krone has been fluctuating with the ebb and flow of US-Iran tensions and oil prices. This week it fell by 0.8% against the US dollar after Trump implied that both the US and Iran are backing off from an escalation into war. Moreover, the bearish oil inventory data from EIA managed to pull down oil prices even further. Despite the recent fluctuation in oil prices, we maintain an overweight stance on a cyclical basis based on a global growth recovery in 2020.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There has been scant data from Sweden this week:  Retail sales increased by 1.3% year-on-year in November. On a month-on-month basis however, it fell by 0.4% compared with October. The Swedish krona fell by 0.8% against the US dollar this week amid broad dollar strength. Despite rising geopolitical tensions, we remain optimistic and expect the global economy to recover this year given the US-China trade détente and increasing stimulus from China. The Swedish krona is poised to rise with global growth and a stronger manufacturing sector. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global Investment Strategy View Matrix Time For A Breather Time For A Breather Receding trade tensions; diminished risks of a hard Brexit; reduced odds of a victory for Elizabeth Warren in the US presidential elections; liquidity injections by most major central banks; and improved sentiment about the state of the global economy all helped push stocks higher late last year. Some clouds have formed over the outlook since the start of the year, however. The December US ISM manufacturing index fell to the lowest level since 2009, while the PMIs in the euro area, UK, and Japan gave up some of their November gains. The conflict between the US and Iran also flared up. Although tensions have abated in recent days, BCA’s geopolitical strategists worry that the détente may not last. The US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. They argue that this could create a dangerous power vacuum in the Middle East. Stock market sentiment is quite bullish at the moment, which makes equities more vulnerable to any disappointing news. While we are maintaining our positive 12-month view on global equities and high-yield credit in anticipation that global growth will rebound convincingly later this year, we are downgrading our tactical 3-month view to neutral. Ho Ho Ho After handing investors a sack of coal last Christmas, Santa was back to his true self this past holiday season. Global equities rose 3.4% in December, finishing the year off with a stellar fourth quarter which saw the MSCI All-Country World index surge by 8.6%. Five forces helped push stocks higher: 1) Receding trade tensions; 2) Diminished risks of a hard Brexit; 3) Reduced odds of a victory for Elizabeth Warren in the US presidential elections; 4) Liquidity injections by the Fed, ECB, and the People’s Bank of China; and arguably most importantly 5) Improved sentiment about the state of the global economy. Tarrified No More Trade tensions subsided sharply after China and the US reached a “Phase One” agreement. The deal prevented tariffs from rising on December 15th on $160 billion of Chinese imports. It also rolls back the tariff rate from 15% to 7.5% on about $120 billion in imports that have been subject to levies since September (Chart 1). Chart 1The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War In addition, the Trump Administration allowed the November 13th deadline on European auto tariffs to lapse. This suggests that the US is unlikely to impose tariffs under the Section 232 investigation of auto imports. The auto sector has been at the forefront of the global manufacturing slowdown, so any good news for that industry is welcome. To top it all off, the US House of Representatives ratified the USMCA, the successor to NAFTA, on December 19th. We expect it to be signed into law in the first quarter of this year. Brexit Risks Fading... Chart 2The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit Boris Johnson’s commanding victory in the UK elections has given him the votes necessary to push a withdrawal bill through parliament by the end of the month. The British government will then seek to negotiate a free trade agreement by the end of the year. A “no-deal” Brexit is unacceptable to the majority of British voters (Chart 2). As such, the Johnson government will have no choice but to strike a deal with the EU. ... While Trump Gains On the other side of the Atlantic, President Trump’s re-election prospects improved late last year despite (and perhaps because of) the ongoing impeachment process. There is an uncanny correlation between the probability that betting markets assign to a Trump victory and the value of the S&P 500 (Chart 3). Chart 3An Uncanny Correlation An Uncanny Correlation An Uncanny Correlation Chart 4Who Will Win The 2020 Democratic Nomination? Time For A Breather Time For A Breather It certainly has not hurt market sentiment that Elizabeth Warren’s poll numbers have been dropping recently (Chart 4). Warren’s best hope was to squeeze out Bernie Sanders as soon as possible, thereby leaving the far-left populist lane all to herself. That dream appears to have been dashed, which suggests that even if Trump loses, a centrist like Joe Biden could emerge as president. An Uneasy Truce It remains to be seen how President Trump’s decision to assassinate General Qassem Soleimani, a top Iranian commander, will affect the election outcome. A YouGov/HuffPost poll taken over the weekend revealed that 43% of Americans approved of the airstrike against Soleimani compared to 38% that disapproved.1 History suggests that the public’s patience for war will quickly wear thin if it results in American casualties or significantly higher gasoline prices. Neither side has an incentive to allow the conflict to spiral out of control. Foreign minister Mohammad Javad Zarif tweeted on Tuesday shortly after Iran lobbed missiles at two US military bases that Iran had “concluded” its retaliatory strike, adding that “We do not seek escalation or war.” Despite claims on Iranian public television that 80 “American terrorists” were killed in the attacks, no US troops were harmed. This suggests that the Iranians may be putting on a show for domestic consumption. The US economy is less vulnerable to spikes in oil prices than in the past. Nevertheless, plenty of things could still go wrong. BCA’s geopolitical team, led by Matt Gertken, has argued that the US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. This could create a dangerous power vacuum in the Middle East. There is also a risk that President Trump overplays his hand. Contrary to the President’s claims, Soleimani was quite popular in Iran (Chart 5). If Trump begins to mock the Iranian leadership’s feeble response, Iran will have no choice but to take more aggressive action. Chart 5Soleimani Was More Popular In Iran Than Trump Claims Time For A Breather Time For A Breather Chart 6US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past One thing that could embolden Trump is that the US economy is less vulnerable to spikes in oil prices than in the past. US oil output reached as high as 12.9 mm b/d in 2019, allowing the country to become a net exporter of oil for the first time in history (Chart 6). Any increase in oil prices would incentivize further domestic production, which would help bring prices back down. The US economy has also become less energy intensive – it takes less than half as much oil to produce a unit of GDP today than it did in the early 1980s. Finally, unlike in the past, the Fed will not need to raise rates in response to higher oil prices due to the fact that inflation expectations are currently well anchored. In fact, as we discuss below, we expect the Fed and other central banks to continue to provide a tailwind for growth over the course of 2020. The Fed’s “It’s Not QE” QE Program The jump in overnight lending rates in mid-September torpedoed the Federal Reserve’s efforts to shrink its balance sheet. Thanks to a steady stream of Treasury bill purchases since then, the Fed’s asset holdings have swelled by over $400 billion, reversing more than half of the decline observed since early 2018 (Chart 7). Chart 7Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Chart 8The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed has insisted that its latest intervention does not amount to a new QE program, stressing that it is buying short-term securities rather than long-dated bonds. In so doing, it is simply creating bank reserves, rather than seeking to suppress the term premium by altering the maturity structure of the private sector’s holdings of government debt. Nevertheless, even such straightforward interventions have proven to be powerful signaling tools. By growing its balance sheet, a central bank is implicitly promising to keep monetary policy very accommodative. It is worth remembering that the run-up in the NASDAQ in 1999 coincided with a significant balance-sheet expansion by the Fed in response to Y2K fears, which came on the heels of three “insurance cuts” in 1998 (Chart 8). Gentle Jay Paves The Way Chart 9Inflation Expectations Remain Muted Inflation Expectations Remain Muted Inflation Expectations Remain Muted In 2000, the Fed moved quickly to reverse the liquidity injection it had orchestrated the prior year. We do not expect such a reversal anytime soon. Moreover, unlike in 2000, when the Federal Reserve kept raising rates – ultimately bringing the Fed funds rate up to 6.5% in May 2000 – the Fed is likely to stay on hold this year. The Fed’s ongoing strategic policy review is poised to move the central bank even closer towards explicitly adopting an average inflation target of 2% over the course of a business cycle. Since inflation tends to fall during recessions, this implies that the Fed will seek to target an inflation rate somewhat higher than 2% during expansions. Realized core PCE inflation has averaged only 1.6% since the recession ended. Both market-based and survey-based measures of long-term inflation expectations remain downbeat (Chart 9). This suggests that the bar for raising rates this year is quite high. More Monetary Easing In The Euro Area And China Chart 10Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out The ECB resumed its QE program in November after a 10-month hiatus. While the current pace of €20 billion in monthly asset purchases is well below the prior pace of €80 billion, the central bank did say it would continue buying assets for “as long as necessary” to bring inflation up to its target. The language harkens back to Mario Draghi’s 2012 “whatever it takes” pledge, this time applied to the ECB’s inflation mandate. Not to be outdone, the People’s Bank of China cut the reserve requirement ratio by 50 basis points last week, a move that will release RMB 800 billion ($US 115 billion) of fresh liquidity into the banking system. Historically, cuts in reserve requirements have led to faster credit growth and ultimately, to stronger economic growth both in China and abroad (Chart 10). The PBOC has also instructed lenders to adopt the Loan Prime Rate (LPR) as the new benchmark lending rate. The LPR currently sits 20bps below the old benchmark rate (Chart 11). Hence, the PBOC’s order amounts to a stealth rate cut. Our China strategists expect further reductions in the LPR over the next six months. In addition, the crackdown on shadow bank lending seems to be subsiding, which bodes well for overall credit growth later this year (Chart 12). Chart 11China: Stealth Monetary Easing China: Stealth Monetary Easing China: Stealth Monetary Easing Chart 12Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing   Rising Economic Confidence Chart 13Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Chart 14The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn   At the start of 2019, nearly half of US CFOs thought the economy would be in a recession by the end of the year. Similarly, two-thirds of European CFOs and four-fifths of Canadian CFOs expected their respective economies to succumb to recession. Professional economists were equally dire (Chart 13). Households also became increasingly worried about a downturn. Google searches for “recession” spiked to near 2009-highs last summer (Chart 14). The mood has certainly improved since then. According to the latest Duke CFO survey, optimism about the economic outlook has increased. More importantly, CFO optimism about the prospects for their own firms has risen to the highest level in the 18-year history of the survey (Chart 15). Chart 15CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late Show Me The Money Going forward, global growth needs to accelerate in order to validate the improved confidence of CFOs and investors alike. We think that it will, thanks to the lagged effects from the easing in financial conditions in 2019, a turn in the global inventory cycle, a de-escalation in the trade war, easier fiscal policy in the UK and euro area, and re-upped fiscal/credit stimulus in China. For now, however, the economic data remains mixed. On the positive side, household spending is still robust across most of the world, a fact that has been reflected in the resilience of service-sector PMIs (Chart 16). Chart 16AThe Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) Chart 16BThe Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) Chart 17US Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Time For A Breather Time For A Breather Chart 18US Housing Backdrop Is Solid US Housing Backdrop Is Solid US Housing Backdrop Is Solid The US consumer, in particular, is showing little signs of fatigue. The Atlanta Fed GDPNow estimates that real personal consumption grew by 2.4% in the fourth quarter, having increased at an average annualized pace of 3% in the first three quarters of 2019. Both a strong labor market and housing market have buoyed US consumption. Payrolls have risen by an average of 200K per month for the past six months, double what is necessary to keep up with labor force growth. This week’s strong ADP release – which featured a 29K jump in jobs in goods-producing industries in December, the best since April – suggests that today’s jobs report will remain healthy. In addition, wage growth has picked up, particularly at the bottom of the income distribution (Chart 17). Residential construction has also been strong. Homebuilder sentiment reached the best level since June 1999 (Chart 18). Global Manufacturing: Too Early To Call The All-Clear The outlook for manufacturing remains the biggest question mark in the global economy. The US ISM manufacturing index dropped to 47.2 in December, its lowest level since June 2009. The composition of the report was poor, with the new orders-to-inventory ratio dropping close to recent lows. Chart 19Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM We would discount the ISM report to some extent. The regional Fed manufacturing indices have not been nearly as disappointing as the ISM (Chart 19). The Markit PMI, which tracks US manufacturing activity better than the ISM, clocked in at a respectable 52.4 in December, down only slightly from November’s reading of 52.6. Nevertheless, it is hard to be excited about the near-term outlook for US manufacturing, especially in light of Boeing’s decision to suspend production of the 737 Max temporarily. Most estimates suggest that the production halt will reduce real US GDP growth by 0.3%-to-0.5% in the first quarter. The euro area manufacturing PMI gave up some of its November gains, falling to 46.3 in December. While the index is still above its September low of 45.7, it has been under 50 for 11 straight months now. The UK and Japanese PMI also retreated. Chinese manufacturing has shown clearer signs of bottoming out. Despite dipping in December, the private sector Caixin manufacturing PMI remains near its 2017 highs. The official PMI published by the National Bureau of Statistics is less upbeat, but still managed to come in slightly above 50 in December. The production subcomponent reached the highest level since August 2018. Reflecting the positive trend in the Chinese economy, Korean exports to China rose by 3.3% in December, the first positive growth rate in 14 months (Chart 20). Taiwan’s exports have also rebounded. The manufacturing PMI rose above 50 in both economies in December. In Taiwan’s case, this was the first time the PMI moved into expansionary territory since September 2018. On balance, we continue to expect global manufacturing to recover in 2020. This is in line with our observation that global manufacturing cycles typically last three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 21). That said, the weakness in European and US manufacturing (at least judged by the ISM) is likely to give investors pause. Chart 20Some Positive Signs Emerging From Korea And Taiwan Time For A Breather Time For A Breather Chart 21A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle   Investment Conclusions We turned bullish on stocks in late 2018, having temporarily moved to the sidelines during the summer of that year. Global equities have gained 25% since our upgrade. We see another 10% of upside for 2020, led by European and EM bourses. Despite its recent gains, the real value of the MSCI All-Country World Index is only 3% above its prior peak in January 2018. The 12-month forward PE ratio of 16.3 is still somewhat lower than it was back then. The valuation picture is even more enticing if we compare equity earnings yields with bond yields, which is tantamount to computing a rough equity risk premium (ERP). The global ERP remains quite high by historic standards, especially outside the US where earnings yields are higher and bond yields are generally lower (Chart 22). Chart 22The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US Chart 23Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish   Nevertheless, sentiment is quite positive towards stocks at the moment (Chart 23). Elevated bullish sentiment, against the backdrop of ongoing uncertainty about the outlook for global manufacturing and an uneasy truce between the US and Iran, poses a near-term headwind to risk assets. As such, while we are maintaining our positive 12-month view on global equities and high-yield credit, we are downgrading our tactical 3-month view to neutral for the time being. We do not regard this as a major realignment of our views; we will turn tactically bullish again if stocks dip about 5% from current levels.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Ariel Edwards-Levy, “Here's What Americans Think About Trump's Iran Policy,” TheHuffingtonPost.com (January 6, 2020).   MacroQuant Model And Current Subjective Scores   Time For A Breather Time For A Breather Strategic Recommendations Closed Trades

Highlights Iran responded with missile attacks on Iraqi military bases hosting US troops in retaliation for the assassination of Gen. Qassem Soleimani, the commander of the Quds Force. The post-attack messaging from Iran and the US suggests neither side wants to escalate to a full-on war footing. Global policy uncertainty will remain elevated, which will keep a bid under safe-haven investments – particularly gold and the USD, as it did last year (Chart of the Week). With the Fed expected to remain accommodative, we expect the USD to weaken this year. However, safe-haven demand for the USD will temper that weakening, which will keep the rate of growth in EM economies below potential this year. Commodity demand growth, therefore, will be lower than it otherwise would be. Oil markets remain taut. We expect additional tightening in these markets, as global monetary stimulus revives demand and oil production remains constrained. We remain long 2H20 Brent vs. short 2H21 Brent, in anticipation these fundamentals will push global inventories lower and steepen the backwardation in forward curves. Our trade recommendations open at year-end and closed in 2019 posted an average gain of 48%. Oil recommendations open at year-end and closed in 2019 were up 64% on average. Feature Following the funeral of Quds Force Commander Gen. Qassem Soleimani, Iran’s military responded with missile attacks on Iraqi facilities housing American troops on Wednesday. The Iranian attacks were presaged by Ayatollah Ali Khamenei, who called for a “direct and proportional attack” against the US by Iranian military forces following the assassination of Soleimani ordered by US President Donald Trump. The Iranian supreme leader’s declaration was highly unusual, as his government typically uses its proxies around the Middle East to carry out military and clandestine operations.1 Oil price jumped ~ 4% in extremely heavy trading after the assassination was reported January 3. This was followed by additional gains of ~ 3%, when trading resumed Monday.  Prices have since given back these gains, as markets continue to anticipate the next iteration of this confrontation. Chart of the WeekHigher Policy Uncertainty Expected; USD, Gold Strength Will Persist Higher Policy Uncertainty Expected; USD, Gold Strength Will Persist Higher Policy Uncertainty Expected; USD, Gold Strength Will Persist Although both sides say they are trying to avoid a kinetic engagement, additional policy uncertainty is being heaped on markets as the New Year opens. This occurs just as it appeared a small respite in the Sino-US trade war was in the offing; trade negotiators from both sides are scheduled to sign “phase one” of a trade deal next week in Washington.2 Policy Uncertainty Will Remain Elevated Geopolitical and economic uncertainty worldwide will remain elevated, keeping a bid under the traditional safe havens – particularly the USD and gold. Even as political leaders work on containing conflicts – e.g., Gulf Arab states’ diplomacy aimed at reducing tensions with Iran, following the failure of the US to retaliate in the wake of attacks on Saudi Arabia’s oil facilities at Abqaiq and Khurais in September; the phase-one deal in the Sino-US trade war – many of the drivers fueling policy uncertainty remain in place.3 Popular discontent with the political status quo is a global political force. It can be seen in the increasing popularity and election of left- and right-wing populists, and in riots in societies that were considered economically and politically placid – e.g., Chile and Hong Kong. Growing discord within NATO; continued tension in Latin America, the Middle East and South China Sea; increasing civil unrest in India; rising debt levels in systematically important economies provide almost daily reminders the post-Cold War political and economic order – also referred to as the Washington Consensus favoring free trade and democracy – is eroding.4 As populists continue in their attempts to dismantle the Washington Consensus, markets will continue to signal their anxiety via gold and USD demand. The coincident rallies of the broad trade-weighted USD and gold are unusual but are emblematic of this uncertainty, as the bottom panel of the Chart of the Week illustrates – gold typically rallies when the USD and real rates weaken. Oil Markets Remain On High Alert In the immediate aftermath of the Soleimani assassination, the oil market’s attention was drawn to the ever-present threat to shipping through the Strait of Hormuz. In the immediate aftermath of the Soleimani assassination, the oil market’s attention was drawn to the ever-present threat to shipping through the Strait of Hormuz, which connects the Persian Gulf with Arabian Sea. Some 20% of global oil supply transits the strait daily, most of it bound for Asia (Chart 2). Iran has repeatedly declared it would shut down the Strait in response to threats from the US and its Gulf allies. This is a low-probability risk – even if the strait was closed, we expect traffic would quickly be restored – but it is non-trivial in our estimation.5 A closure that threatened to exceed even a week likely would spike prices through $100/bbl. Chart 2Asia Is Prime Destination For Gulf Crude And Condensates Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut A direct attack that shuts the Strait of Hormuz also would threaten a large share of OPEC’s spare capacity of ~ 2.3mm b/d (Chart 3). Most of this is in the Kingdom of Saudi Arabia (KSA). In order to provide export capacity in the event of a closure of the strait, last year the Kingdom accelerated its expansion of the 750-mile East-West pipeline, which terminates at the Red Sea port of Yanbu. This was expected to lift the pipeline's capacity to 7mm b/d from 6mm b/d by October 2019.6 Loading the huge number of vessels at maximum pipeline throughput at Yanbu likely would present logistical challenges of its own, given the low volumes exported from there presently. In addition, Argus notes the pipeline suffered drone attacks originating from Yemen in May of last year. Lastly, to further complicate matters, the Bab el-Mandeb Strait connecting the Red Sea with the Gulf of Aden Indian Ocean also is quite narrow in places, which presents a natural point of disruption. Chart 3OPEC Spare Capacity Threatened If Straits Of Hormuz Are Shut Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut In addition to OPEC’s spare capacity and KSA’s Red Sea outlet, the US can mobilize its 640mm-barrel Strategic Petroleum Reserve (SPR) to supply the market with ~ 2mm b/d of crude.7 In addition, member states of the Organization for Economic Development (OECD) maintain close to 3 billion barrels of crude and product inventories that could be drawn down in the event of an emergency (Chart 4). China’s SPR is estimated at ~ 800mm b/d – covering ~ 80 days of consumption – but the rate at which it can be delivered to the market is unknown.8 Chart 4OECD Inventories Remain Elevated, But We Expect Them To Move Lower OECD Inventories Remain Elevated, But We Expect Them To Move Lower OECD Inventories Remain Elevated, But We Expect Them To Move Lower Investment Implications Of Unknown Unknowns At present, the known unknowns – i.e., risks – do not appear to be galloping higher, based on the recent performance of crude oil and gold options’ implied volatilities. At present, the known unknowns – i.e., risks – do not appear to be galloping higher, based on the recent performance of crude oil and gold options’ implied volatilities (Chart 5). But uncertainty – i.e., the unknown unknowns, which are impossible to model – are expanding, in our estimation. In this environment, we are inclined to remain long 2H20 Brent futures vs short 2H21 in expectation that any event affecting shipments of crude through the Strait of Hormuz or the Bab el-Mandeb will quickly result in inventory drawdowns, which will be reflected in a steeper backwardation – i.e., the 2H20 Brent futures will trade at a higher premium to 2H21 futures (Chart 6). We recommended this position December 12, 2019, and it was up 78.9% as of Tuesday’s close. Chart 5Known Unknowns - Risk -Under Control Known Unknowns - Risk -Under Control Known Unknowns - Risk -Under Control Chart 6Expect Backwardation To Steepen Expect Backwardation To Steepen Expect Backwardation To Steepen Recap Of 2019 Recommendations Our commodity recommendations – across all markets – returned 48% on average last year. Oil positions still open at year-end and closed during 2019 led the performance, averaging a 64% gain (Tables 1 and 2). By comparison, the S&P GSCI commodity index was up 17.63% last year. Table 1Overall Recommendations Returned 47.5% Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut Table 2Oil Recommendations Led Performance Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut We are leaving the positions we ended the year with open. We are leaving the positions we ended the year with open (Table 3). Absent a war – or even a skirmish – we continue to expect OPEC 2.0’s production restraint will tighten physical markets and force inventories lower resulting in steeper Brent forward curves – i.e., Brent backwardation increasing meaningfully. We remain long the S&P GSCI, given its heavy energy weighting and expected outperformance as the backwardation of crude oil forward curves continues. In addition, we remain long gold, silver and platinum as portfolio hedges. We still also remain long December 2020 high-grade iron ore (65% Fe) vs. short December benchmark iron ore (62% Fe), expecting a revival of industrial commodity demand in China and EM this year. Table 3Year-End 2019 Positions Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1     Please see Khamenei Wants to Put Iran’s Stamp on Reprisal for U.S. Killing of Top General published by the New York Times January 6 and updated on January 7, 2020. 2     Unlike risk – the known unknowns that can be gauged using probability measures – uncertainty (unknown unknowns) defies measurement.  However, discussions and mentions of it can be tracked in newspapers as journalists and pundits hold forth on “uncertainty.”  We track uncertainty using the monthly Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index, which is constructed by tracking references to economic uncertainty in newspapers published in 20 economies representing 80% of global GDP on an FX-weighted basis.  See also The Stock Market: Beyond Risk Lies Uncertainty published by the Federal Reserve Bank of St. Louis July 1, 2002. 3    Please see Saudi envoy arrives in Washington amid fear of U.S.-Iran war published by axios.com January 6, 2020. 4     Robert Kagan at the Brookings Institution draws attention to this transformation in The Jungle Grows Back, an extended essay published in 2018 by Alfred A. Knopf arguing in favor of the Washington Consensus.  See also the photo essay Photos: The Year in Protests published by the Council on Foreign Relations in New York on December 17, 2019. 5     A non-trivial risk, in our estimation, is one in which the odds of a highly unfavorable outcome are approximately 1 in 6, the same odds as Russian roulette, with all of its dire connotations. 6     Please see Saudi Aramco fast-tracks East-West pipeline expansion published by Argus Media August 5, 2019. 7     Please see US SPR release in response to Abqaiq, Khurais attacks likely not imminent: analysts published by S+P Global Platts September 15, 2019, following the attacks on KSA’s facilities. 8     Please see RPT-COLUMN-Bearish signal for crude as China closes in on filling oil storage: Russell published by reuters.com September 23, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Iran Responds To US Strike; Oil Markets Remain Taut Iran Responds To US Strike; Oil Markets Remain Taut