Emerging Markets

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights Odds are that the recently improved access to financing will allow property developers to boost construction volumes modestly in the coming months. Yet, the outlook for new credit origination and government tolerance of another credit binge is highly uncertain. For now, the completion of previously launched projects will help construction-adjacent industries in the short run. However, these activities will consume real estate developers’ cash augmenting both their liquidity needs and financial vulnerability. That is a basis to underweight the Chinese real estate sectors within both the Chinese MSCI investable universe and the onshore A-share indexes. Feature The emergent divergence among Chinese property sales, starts and completions constitutes an exceptionally bizarre phenomenon. The gaps between these three indicators are currently unprecedented (Chart I-1). Understanding these divergences is critical to correctly gauging the outlook for the Chinese real estate market. This report aims to assess the growth outlook of these three variables. Odds are that these gaps will narrow going forward. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions (Chart I-2). Chart I-1An Unprecedented Divergence… The Unprecedented Divergence The Unprecedented Divergence Chart I-2…But A Convergence Looms Convergence Ahead Convergence Ahead   In terms of the strength of construction activity in the Chinese property market, the real estate developers’ access to funding has been and remains the key. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions. For now, we reckon the improved access to financing in recent months should help property developers to boost construction volumes modestly in the coming months (Chart I-3). Chart I-3Construction Activity Will Modestly Improve In The Coming Few Months Further Credit Easing Will Likely Lead To Rising Construction Activity Further Credit Easing Will Likely Lead To Rising Construction Activity That said, the current round of credit stimulus has probably been front-loaded in the first quarter, and property developers’ access to funding will begin to deteriorate again going forward. This will weigh on their ability to raise construction volumes materially. Understanding The Construction Cycle In China Floor space sold, starts and completions generally move in tandem. Specifically, strong sales lead rising starts, which then with a time lag result in increased completions. However, over the past 15 months, the growth rate of property starts has accelerated to over 20%, while sales have mildly contracted and floor space completions have been shrinking dramatically (Chart I-2). The key reason for these divergences has been the considerable financing difficulties facing property developers. Tighter monetary policy and credit beginning in late 2016 severely impaired developers’ ability to raise funds. This made Chinese real estate developers desperate for any source of possible revenue or financing. Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell and get cash at a time when credit was tight.  Property developers were also aiming to conserve cash flow amid tight credit. After investing 25% of the total investment required for a property project (excluding the value of the land), they received a presale permit from the authorities. The permits allowed them to sell housing units in advance. Home-buyers had to pay at least 30% of the total property value at the time they signed the presale contract. This way, developers were able to obtain both deposits and advance payments1 (Chart I-4). This was a welcome addition to scarce financing last year. After this phase, property developers then slowed their investment in construction, installation and equipment purchases – because these would consume precious, limited cash. This depressed construction activity has resulted in a material contraction in floor space completed (Chart I-5). Chart I-4Developers’ Funding Has Improved Due To Deposits & Advanced Payments Rising Funding From Deposits And Advance Payments Rising Funding From Deposits And Advance Payments Chart I-5   Bottom Line: Launching new projects and pre-selling housing units while shrinking construction enabled Chinese real estate developers to stay afloat last year amid tight access to credit. What Does This Mean? There are two important implications related to this unprecedented divergence among property sales, starts and completions. The first is that raising funds via launching property starts along with shrinking completions has resulted in a significant increase in Chinese property developers’ liabilities. This is a form of borrowing money for property developers, and it has been occurring on top of very poor financial health. Specifically, Chinese real estate developers’ debt-to-equity ratio is currently above 4, and continues to surge (Chart I-6). Further, in 2018, 54 out of 131 Chinese property developers had negative free cash flow. This scheme of raising funding via new launches along with postponing building and completions is becoming unsustainable. The divergence between surging property starts and contracting completions suggests that real estate developers have raised funds through selling more uncompleted buildings instead of completed properties (Chart I-7, top panel). Chart I-6Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chart I-7A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings   Specifically, some 87% of total residential floor space sold in the past 12 months has been sold in advance, much higher than the approximate 77% total recorded in the years prior to 2018 (Chart I-7, bottom panel). The second important implication is that property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. Chinese real estate developers are facing massive funding requirements this year. Developers need considerable amounts of funding this year to speed up their construction activities on delayed projects (launched but not completed ones). It generally takes about two years for real estate developers to complete a construction project and deliver the presold properties. Developers had already slowed their construction progress last year. They must accelerate the pace this year to ensure deliveries are made on time. Developers also need to roll over or repay significant amounts of debt coming due in 2019. On the whole, they have issued nearly RMB3.9 trillion of bonds so far, with most in the three- to five-year duration. Chart I-3 on page 2 shows that further improvements in credit flows in the economy will likely lead to ameliorating construction activity. Credit easing has allowed developers to raise funds through bank loans, bond issuances (both domestic and overseas) and other forms of borrowing (Chart I-8). Property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. As a result, real estate investment in construction, installation and equipment purchases have all ameliorated in recent months (Chart I-9). This reflects a true pickup in real estate construction activities since the beginning of this year. Chart I-8Marginal Credit ##br##Easing Marginal Credit Easing Marginal Credit Easing Chart I-9   However, whether or not this latest improvement develops into full-fledged recovery is contingent on credit flows in the economy in general, and property developers’ access to financing in particular. If the overflow of credit decelerates after the massive binge that took place in the first quarter, it will weigh on construction activity. If the first-quarter credit binge persists, Chinese property developers will likely be able to raise sufficient funds to speed up property completions and roll over their maturing debt this year. In this scenario, construction activity will gather speed, facilitating a recovery in the overall economy.  At the current juncture, it is impossible to make a definite conclusion. The outlook for new credit flows and government tolerance of another credit binge is highly uncertain. On the one hand, the Politburo last month reiterated that China will push forward structural deleveraging and prevent speculation in the property market. Preliminary credit flow numbers for April appear to be very weak, not confirming blockbuster credit in the first quarter. Besides, the banking regulator has renewed pressure on banks to recognize non-performing loans and provision for them.2 This will curb banks’ ability to originate new loans and buy corporate bonds. On the other hand, an escalation of tensions between China and the U.S. and the uncertainty it is instilling in the economy and financial markets could lead the authorities to keep the credit taps open for longer, allowing credit to flow into the broader economy. Bottom Line: Real estate developers are extremely leveraged and lack cash to complete launched projects. Hence, property developers’ ability to raise financing holds the key in terms of the strength of property construction activities in China. Further easing in credit will likely lead to rebounding property completions and rising construction activity, and vice versa. What About Chinese Property Demand? Easy credit may alleviate the financing stress facing Chinese real estate developers and lift construction activity temporarily. However, the most important and sustainable source of funding for real estate developers is property sales. Chart I-10 shows that funding from property sales, including deposits, advance payments and mortgages assumed by property buyers, contributes nearly half of the sources of funds raised in that year. Chart I-10 Self-raised funds are the second-largest component of the source of funds, with a share of 34%. One major component of self-raised funds – retained earnings – are also closely related to property sales. The other major component is equity and bond issuance. Bank loans and foreign investment (including direct equity injections, sales of bonds and equity, and borrowing from foreign banks) together account for only about 15%. Even though there has been some credit easing for Chinese real estate developers, the bad news is that property sales are still in a structural downtrend. Chart I-11Slower PSL Injections Will Negatively Impact Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand As discussed in our previous reports,3 China’s property market is currently facing structural impediments. Low affordability, slowing rural-to-urban migration, demographic changes, the promotion of the housing rental market and the government’s continuing emphasis on clamping down speculation are together generating strong structural headwinds for property demand in China. Importantly, surging property demand between late 2015 and 2017 was mainly driven by the Chinese central bank’s direct lending to the real estate sector, which is not sustainable. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Summary Lending (PSL) facility designed for slum area reconstruction.4 Indeed, the central bank’s PSL injections have already decelerated considerably since last year (Chart I-11). This has resulted in contracting overall property sales. Late last month, the authorities significantly cut their slum-area reconstruction target by more than one-half – from 6.4 million units last year to 2.85 million units this year. This suggests the amount of PSL injections will decline correspondingly (Chart I-12). Chart I-12 Besides the diminishing PSL scheme, some other factors are also signaling a dismal outlook for Chinese property demand. A deep and long contraction in property demand in rich provinces indicates demand saturation (Chart I-13). Sales outside eastern provinces track PSL injections very closely, as per Chart I-11, and are facing headwinds. Chinese households are more leveraged than U.S. ones, with the former’s debt-to-disposable income ratio having surpassed that of the latter (Chart I-14). Chart I-13Demand Is Saturated In China’s (Richer) Eastern Provinces Demand Saturation In Rich Eastern Provinces Demand Saturation In Rich Eastern Provinces Chart I-14China’s Household Debt Burden Is Very Elevated Escalated Household Debt In China Escalated Household Debt In China   Chart I- In addition, mortgage rates in China have not dropped much, despite monetary policy easing in the past 12 months. Recent data shows the average mortgage rate paid by first-time homebuyers has fallen from 5.71% last November to 5.56% this March, a still-high number. With respect to the ability to service mortgage payments, on a 90-square-meter house with a 30% down payment, our calculations show that annual interest costs account for about 27% of average household disposable income levels (Table I-1). Overall, poor affordability for Chinese homebuyers will constrain property demand in the coming years. Finally, the government is quite determined to implement its property tax in a few years. Local governments’ financing needs will become more acute as revenue from land sales decline substantially. China’s property market is on the way to becoming the market dominated by second-hand properties instead of new buildings – similar to many developed countries. Critically, the progress in establishing property tax laws in China seems to be accelerating. There have been more high-level meetings and discussions about the property tax law, and these meetings/discussions are becoming more detailed and concrete. Bottom Line: Chinese housing demand will be in a structural downtrend, weighing on construction activity beyond any near-term rebound. Investment Implications Based on the above findings, we draw the following investment strategy conclusions: It is reasonable to expect a slight pickup in real estate construction activity in China over the next few months. This will be marginally positive for construction-related commodities demand. Consequently, construction-related commodities markets (steel, cement, and glass) may be supported in the near term (Chart I-15). However, over the longer term, we remain fundamentally negative on construction activity within China’s property markets, as property sales will be in a structural downtrend. BCA’s Emerging Market Strategy service recommends equity investors underweight Chinese property developers within the Chinese equity indexes (Chart I-16). Chart I-15Construction-Related Commodities May Marginally Benefit From A Pickup In Activity Contraction Commodities Prices May Marginally Benefit Contraction Commodities Prices May Marginally Benefit Chart I-16Underweight Real Estate Stocks Relative To The Domestic And Investable Benchmarks Underweight Real Estate Stocks Within Respective Chinese Investable Universes Underweight Real Estate Stocks Within Respective Chinese Investable Universes   The completion of previously launched projects will help construction-related industries. Yet, these activities will consume real estate developers’ cash augmenting their liquidity needs and amplifying their financial vulnerability. This is a basis for our recommendation to underweight property stocks, especially following their significant outperformance in the past six months.  Further, property stocks respond to marginal changes in financing conditions rather than housing sales or construction activities. The basis is that they are extremely leveraged, and access to funding is key. In the coming months, if credit conditions tighten at a time when real estate developers must commit cash to complete previously launched projects, their cash flow will deteriorate. This will be reflected in their share prices, which will underperform the Chinese broader onshore and offshore indexes. This is likely to occur regardless of the absolute performance of Chinese stocks. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Chinese real estate developers could also slow the construction activity after completing 50% of a property project, which allows them to receive at least 60% of the presold property value from house buyers. 2      https://www.bloomberg.com/news/articles/2019-05-06/china-is-said-to-imp… 3      Please see Emerging Markets Strategy Special Report “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018 and China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 4      Please see China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese housing market with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Ellen’s previous housing report was extremely well received,1 and clients should look forward to tomorrow’s update. Chart 1A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook Turning to the financial markets, investors have been squarely focused this week on the sudden escalation in tension between the U.S. and China, caused by President Trump’s renewed threat on May 5 to heighten tariffs on Chinese imports at the end of this week. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. The financial market reaction was swift: Chinese A shares fell nearly 6% on Monday, and USD-CNY surged nearly half a percent (Chart 1). Chinese stocks fared better on Tuesday, but may come under pressure again later in the week as China’s trade delegation returns to the U.S. for talks on Thursday & Friday. Despite this week’s volatility, we would not yet recommend any portfolio strategy changes to investors who are positioned in favor of Chinese stocks or China-related assets more generally. First, we still see the combined odds of a deal or a further extension in talks as being as high as 60%, and investors would view an agreement to extend the negotiations in a positive light after this week’s selloff. At a minimum, investors are likely to get a better chance to sell in such a scenario. Second, over that past year we have steadfastly maintained that China’s economy and its earnings cycle are driven by monetary conditions, money, and credit growth, and two of these three drivers are clearly now pointing to improving economic activity over the coming year. Certainly, the imposition of a 25% import tariff on all Chinese goods would represent a new, negative shock to the Chinese economy, but in this scenario Chinese policymakers would also substantially dial up their reflationary response. As such, while the near-term response in the equity market is likely to be very negative if President Trump follows through with his threat, the cyclical (i.e. 6-12 month outlook) for Chinese relative equity performance is not yet clear. This is only true in local currency (i.e. hedged) terms, however, as we agree that there is meaningful downside potential for the RMB in a full tariff scenario. So while we are likely to advise investors to wait and assess the likely reflationary response if a 25% “second round” tariff rate is imposed this week before changing their equity stance, we would recommend a long USD-CNY/CNH position in the interim as a hedge against a potentially substantial decline in the RMB. Stay tuned.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1      Please see BCA Research’s China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?,” published September 13, 2018. Available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Highlights So What? The Trump administration’s decision to apply maximum pressure to Iran fundamentally changes the investment landscape in 2019-20. Why? The impact of the Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity. However, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. Policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Feature What are the Trump administration’s foreign policy objectives? First, to confront the U.S.’s greatest long-term competitor, China, by demanding economic reforms and greater market access. Second, to force a decision-point upon rogue regimes with significant ballistic missile programs and nuclear-weapon aspirations: North Korea and Iran. Third, to maintain credible deterrence in Russia’s periphery. Fourth, to reassert the Monroe Doctrine through regime change in Venezuela. The common thread, even with Russia, is confrontation. It is not necessary for President Trump to pursue all of these objectives at once. So his decision last November to issue waivers for eight importers of Iranian oil suggested to us that he was prioritizing – and becoming more risk averse ahead of the 2020 election. Full enforcement of the oil sanctions at that time threatened to push oil prices up at the same time as the Fed was raising rates, a pernicious combination late in the cycle (Chart 1). Thus, after walking away from the 2015 nuclear accord with Iran, it made sense for Trump to delay any confrontation with Iran until his hoped-for second term in office. He could focus on building the border wall, resolving trade tensions with China, and making peace with North Korea instead. Chart 1Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Chart 2Sanctions Will Raise Risk Sanctions Will Raise Risk Sanctions Will Raise Risk   This view has now been proved wrong. The oil waivers apparently represented only a temporary delay in the administration’s hawkish Iran policy. Now that financial conditions have eased and growth has stabilized, Trump has declared the Iranian Revolutionary Guard Corps a foreign terrorist organization and announced that he will discontinue the waivers, demanding full compliance on energy sanctions from all states by the end of May. Volatility will move higher (Chart 2). Trump is emboldened by America’s newfound energy independence (Chart 3). While the shale boom can be used to reduce U.S. strategic commitments in the Middle East, it can also encourage Washington to believe it is invulnerable to traditional Middle Eastern risks. Trump’s advisers, Secretary of State Mike Pompeo and National Security Adviser John Bolton, apparently have won the Iran policy debate on this basis. Since Trump’s reelection is far from guaranteed, it would appear his advisers view re-imposing sanctions against Iran as a rare opportunity to achieve long-term strategic objectives. They may not have the chance in 2021. Chart 3The U.S. Is Energy Independent The U.S. Is Energy Independent The U.S. Is Energy Independent Chart 4Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes All the same, the problem for Trump is that, while the U.S. will survive any chaos ensuing from an Iran confrontation, his presidency may not. Full enforcement of the sanctions could spiral out of control and, through the oil price channel, come back to hurt Trump’s economy – and hence his re-election odds (Chart 4). The implication is that Trump has either been misled about the risks of his Iran policy, or he does not care as much about his re-election odds as we believed. Either way, the result is aggressive policy, which increases the geopolitical risk premium in oil prices. We can see this in our simulations (below), which are based entirely on spare capacity and compliance by consumers to the sanctions. We did not include an Iran-retaliation scenario in this modeling. Therefore, any threat to Iraqi supplies, or talks of disrupting the Strait of Hormuz will add to our prices forecasts. U.S. Administration Sailing Close To The Wind From their public comments, it would appear the U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of production in Iran and Venezuela. For the Trump administration, this view is supported by growing U.S. shale-oil supplies, and the administration’s belief the Kingdom of Saudi Arabia (KSA) and its Gulf allies stand ready to increase production to cover any losses arising from the re-imposition of Iranian oil-export sanctions by the U.S. This belief supports the administration’s end-game, which appears to be regime change in Iran, a position long favored by Trump’s national security advisor John Bolton. Frank Fannon, U.S. Assistant Secretary of State for Energy Resources, succinctly captured the administration’s view when he declared, “We are doing this ... in a favorable market condition with full commitment from producing countries.” He further stated, “We think this is the right time.”1 We believe the Trump administration is sailing close to the wind here. The U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of oil production in Iran and Venezuela. While increasing U.S. shale output does provide something of a cushion to global oil markets, it is not a substitute for the heavy-sour crude produced by Iran and Venezuela (and others), which is favored by refiners with complex units. The loss of Iranian exports hits these refiners harder than those able to process lighter, sweeter crude of the sort exported by the U.S. (Chart 5).2 As Iranian and Venezuelan barrels are lost to the market, these heavier crudes are getting more scarce relative to the crude produced in U.S. shales – typically classified as West Texas Intermediate (WTI) crude oil. This can be seen in tighter light-versus-heavy crude oil spreads, and the wider Brent-WTI spreads, which indicate WTI is relatively more plentiful (Charts 6A & 6B). Chart 5 Chart 6AWTI Relatively More Plentiful… WTI Relatively More Plentiful... WTI Relatively More Plentiful... Chart 6B…As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce It is true U.S. production continues to grow, which is causing crude oil inventories to increase as sanctions on Iran are being re-imposed. We expect U.S. shale-oil output to grow 1.2mm b/d this year – taking it to a record 8.4mm b/d on average – and 800k b/d next year. Caution is required regarding inventories, however: U.S. refiners are in the thick of their plant maintenance – known as turn-around season – and have loaded a lot of the maintenance they would normally have done in the Fall into Spring. As a result, U.S. refiners are running at reduced rates preparing for the Northern Hemisphere’s summer driving season and the January 1, 2020, implementation of the U.N. IMO 2020 regulations, which will require shippers to use lower-sulfur fuel to power their vessels worldwide.3 OPEC 2.0 Gains Control Of Brent Forward Curve Growing U.S. production and inventories might give the Trump administration comfort the market can absorb the loss of Iran’s exports – some 1.3mm b/d at present. However, our base case holds that Iran’s exports will stabilize at ~ 600k b/d after sanctions fully kick in. In most of the scenarios we run (Table 1), the impact of Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity (Chart 7).4 Indeed, many of the low-probability scenarios we run – including the “maximum pressure” scenario, in which the Trump administration succeeds in removing all of Iran’s exports – can be accommodated by current supply and spare capacity without sending Brent prices through $100/bbl (Chart 8). OPEC 2.0 holds ~ 1.5mm b/d of what we would describe as readily available spare capacity – mostly in KSA – that can be brought to market fairly quickly, as the ramp-up last year ahead of the first round of sanctions in November amply demonstrated. Another 1.5mm b/d or so is held by the Kingdom and its GCC allies, but it would take longer to bring on line. Table 1BCA Oil Market Scenarios U.S.-Iran: This Means War? U.S.-Iran: This Means War? Chart 7OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses Chart 8Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 In reality, once refiners are up and running at max capacity in the U.S. in a few weeks, U.S. inventories will begin to draw hard. This will support what we believe to be OPEC 2.0’s goal of backwardating the Brent curve – perhaps sharply. This will allow it some breathing space to gradually add barrels to the market in 2H19 as needed, as our balances and forecasts assume. It is important to remember OPEC 2.0 was formed to drain the massive storage overhang that resulted from the 2014-16 market-share war launched by KSA. The Kingdom’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. Throughout the ramp to renewed sanctions, he has steadfastly maintained the Kingdom will provide oil as Aramco’s customers need it, following the blind-side hit KSA took from the Trump administration in November when it granted Iran’s largest customers waivers on its export sanctions. U.S. Pressure On OPEC To Raise Output Will Grow We expect the Trump administration to continue to pressure OPEC – the old cartel, not OPEC 2.0 – to boost production post-sanctions. However, it is not entirely clear that this time OPEC’s – particularly KSA’s – interests are 100% aligned with President Trump’s. KSA and other producers were shocked by the administration’s decision to grant waivers after lifting supply sharply in response to Trump’s demands. This time around, we believe OPEC – KSA in particular – will be more cautious lifting output, even as the U.S. Navy very publicly displays its ability to project and sustain force in the Mediterranean and Persian Gulf regions (Map 1). With good reason: The U.S. holds ~ 650mm barrels of oil in its Strategic Petroleum Reserve (SPR), which can be released at a rate of 1mm to 1.3mm b/d for a year or so. Realistically, it is probably more like six to nine months, since, by the time much of the oil has been released to the market the reserves that are left likely will have higher concentrations of contaminants (e.g., metals and solids that migrated to the bottom of the storage while it was sitting idle), making buyers way more leery of using it. Chart After the shock of the waivers, KSA likely will minimize its exposure to another surprise from the U.S. as sanctions take hold. The risk to OPEC – KSA in particular – is that Trump again will pull a fast one as the U.S. general election approaches. Given Trump’s demonstrated sensitivity to U.S. gasoline prices approaching elections, it is not unlikely that he would hold on to the SPR barrels until mid to late summer 2020, then release them in time to reduce prices further. If, in the run-up to U.S. elections, OPEC has steadily increased production to build precautionary inventories then it runs a non-trivial risk the crude oil price would once again crash as SPR barrels are released. The Kingdom of Saudi Arabia’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. In this iteration of Iranian export sanctions, we expect KSA to adopt a just-in-time inventory management strategy, so that it is not caught out once again over-supplying the market ahead of a U.S. surprise. U.S. Shales Will Figure Into OPEC 2.0’s Calculus Chart 9U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained The other big fundamental OPEC 2.0 will be considering is the rate at which U.S. shale oil can be exported. Export capacity still is constrained by the shortage of deep-water harbor facilities in the U.S. Gulf. This is being addressed, but it has been slowed by additional requests for environmental impact statements from the federal and state governments. If prices start moving higher because KSA and OPEC 2.0 are responding to tightening markets with caution (and slowly), we’d likely see WTI production increase – it’ll have 2mm b/d of new pipe in the Permian to fill by end-2019 – but that crude could start backing up as storage in the U.S. Gulf fills. This would again widen the Brent vs. WTI - Houston spread, which will benefit refiners in the U.S. Gulf, but will lower prices received by U.S. shale producers (again) (Chart 9). Bottom Line: Trump’s decision not to extend the Iranian oil waivers suggests that he has plenty of risk appetite ahead of the 2020 election. His Iran policy is now the biggest geopolitical risk to the late-cycle bull market. It also risks tightening the oil market considerably as the election approaches. Can Iran’s Regime Withstand The Sanctions? Iran’s economic weakness was an added inducement for the Trump administration to take an aggressive turn. The sanctions against Iran’s crude oil exports have not yet been implemented in full force, but the economy is already showing signs of distress. For one, inflation is back near 40% – levels only reached during the previous round of sanctions (Chart 10). Given that food, beverages, and transportation are among the sectors experiencing the fastest growing prices, lower income groups – which the World Bank estimates spend almost half their income on food alone – will suffer disproportionately. Economic dissatisfaction has catalyzed protests in Iran in the past, and the squeeze from the U.S. sanctions could propel further unrest. Chart 10Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Chart 11 Moreover, soaring prices are coinciding with a slowdown in activity and consumption. On the surface Iran appears relatively well protected given that its economy is not as directly correlated with oil exports as some of its peers (Chart 11). However, Iran’s oil and non-oil sectors are actually closely intertwined. This is evident from weakness in the non-oil sector during the previous round of sanctions (Chart 12). The IMF expects the economy to contract by 6% this year – faster than its 3.9% estimate for last year – leaving Iranians to face a period of deepening stagflation. Chart 12 The jump in consumer prices is a reflection of the ongoing collapse of the currency. Despite the government’s best efforts to stabilize the foreign exchange market, heightened demand for foreign currencies caused a nearly 30% depreciation in the unofficial exchange rate vis-à-vis the U.S. dollar since the beginning of the year (Chart 13). Chart 13Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Chart 14Debt Burden Is Manageable Debt Burden Is Manageable Debt Burden Is Manageable To soften the impact of the weaker currency and the potential shortage of essential goods, authorities have introduced a three-tier exchange rate system, and banned the export of several products including grains and seeds, powdered milk, butter, and tea. Since the level of external debt remains manageable (Chart 14) the weak currency will pressure the economy through its impact on prices (highlighted above), with imported inflation eroding purchasing power. Furthermore, Iran will not benefit from any additional export competitiveness due to currency depreciation. The current account surplus is expected to deteriorate and eventually flip to a deficit amidst weak exports, and despite declining imports (Chart 15). The fact that Iran runs a non-energy trade deficit does not help. Chart 15Trade Surplus At Risk Trade Surplus At Risk Trade Surplus At Risk Chart 16Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint In terms of the fiscal purse, under normal circumstances, a weaker rial would raise government revenue from oil exports. However, given the restrictions on oil exports, the fiscal budget will not benefit from this relationship. Instead, the dominant impact will be greater government spending. Historically, expenditures tend to be countercyclical, aiming to mitigate the impact of the deteriorating economic environment on Iranian households (Chart 16). In the past, the Iranian government’s healthy fiscal balance allowed policymakers to implement social protection schemes to combat poverty and revitalize the economy. Now, however, the fiscal coffers are no longer so well-cushioned and the deficit will constrain this option. Stimulative fiscal policy in this environment would only raise inflation further. Furthermore, given that the lion’s share of Iran’s imports are capital and intermediate goods, the currency depreciation will spill over into the domestic industry and weaken demand, even for domestically produced goods. Investments have been lacking in many of the most essential services. The electricity sector is a prime example: while demand is rising, spare capacity is dwindling and causing recurring outages. Similarly, foreign direct investment will likely fall in this uncertain political environment. With the economy on the brink, Iran is not in a position to confront the United States directly. It must take total sanctions enforcement as a very grave risk and seek delaying actions and negotiations. However, this vulnerability will turn into desperation if the Trump administration proceeds with a full embargo without any “off ramp” for negotiations. Bottom Line: Full enforcement of sanctions threatens to destabilize Iran’s already vulnerable economy. Inflation is soaring, the currency is plunging, and the economy will likely be plagued by a twin deficit going forward. The implication is that Iran will eschew direct confrontation unless forced. Will Iran Retaliate In Iraq? Iran is also at risk of losing one of its great sources of leverage: Iraqi stability. Given its gloomy economic outlook, Iran is looking to expand ties with its neighbors in an attempt to soften the blow from the sanctions. Earlier this year president Hassan Rouhani and Iraqi prime minister Adel Abdul Mahdi signed several preliminary trade deals, with the ultimate aim to boost bilateral trade to $20 billion from its current ~$12 billion. However, natural gas exports to Iraq – a major traded good – are covered by the sanctions, so this target is probably unattainable. Although Iran is currently the only foreign supplier of natural gas and electricity to Iraq, the temporary halt in electricity supplies last summer coincided with violent protests in Southern Iraq.5 Growing anger over Iran’s inability to satisfy its commitments to Iraq highlights the tensions in the Iraq-Iran relationship. What’s more, the U.S. is pressuring Iraq to turn to other neighbors such as Saudi Arabia, Jordan, and Kuwait for its electricity needs.6 In March, it renewed a three-month waiver allowing Iraq to import Iranian gas. Then Saudi Arabia promised to connect Iraq to the Saudi electricity grid during a visit by its economic delegation to Baghdad on April 4.7 At that meeting, the Saudi delegation also agreed to provide Iraq with $1 billion in loans, $500 million to boost exports, and a sporting complex as a gift. Additionally, the Saudi consulate in Baghdad – which had been closed for almost 3 decades – reopened last month. Saudi Arabia and Iraq are starting to cooperate. Iraq’s new government is clearly taking a pragmatic approach to its regional relationships. This is also largely in line with growing domestic opposition to Iranian interference within Iraq. Influential Shia leaders such as Muqtada al-Sadr and Ayatollah Ali al-Sistani have been voicing concerns about Iran’s influence in Iraqi politics. As such, the new Iraqi government is attempting to walk a tight rope between placating Iran and taking advantage of new opportunities with its Arab neighbors to rebuild its economy. This trend raises the risk that Iran will strike rapidly in Iraq if it believes Trump’s maximum pressure strategy is succeeding in bringing oil exports to zero. Iraq is the logical target as Iran has great political and sectarian influence there, it is the geographic buffer with Saudi Arabia, and it is the necessary launchpad for Iran’s strategic opponents to undermine or attack the Iranian regime (Map 2). Chart Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a fullfledged conflict. Chart 17 Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. About 85% of Iraq’s crude exports flow through the southern port city of Basra (Chart 17). It is already home to recurrent protests and any disruptions there threaten around 3.5mm bbl shipping to international markets daily. Bottom Line: Iraq is caught in the strategic tug-of-war between Iran and Saudi Arabia, with the latter gaining influence at present. Sanctions could compel Iran to retaliate in Iraq, jeopardizing up to 3.5mm b/d of supply. What Comes Next? The latest data suggest that Japan is in full compliance with the U.S. sanctions against Iran as of April and that China has been front-running the sanctions and is now reducing imports, as it was at the time the waivers were first introduced. China may not go to zero, but it is apparently complying. This is important given that the Trump administration has essentially introduced a bold new demand – cut off all energy imports from Iran – at the eleventh hour of the U.S.-China trade negotiations. Our projections of spare capacity suggest that the Trump administration will believe it has room to enforce the sanctions fully (Chart 18). This is a risky approach, as a fairly standard unplanned outage anywhere else in the world could bring spare capacity much lower, but the data suggest that Trump’s team will not see it as a hard constraint. If necessary, the administration can later choose to soft-pedal enforcement on black market activity so as to calibrate the global impact. Chart 18 The Iranians, for their part, are unlikely to leap to the most aggressive forms of retaliation immediately – such as fomenting unrest in Iraq – because of their economic vulnerability. Small acts of sabotage or subversion are a way to send the U.S. a warning signal, but generally Iran will want to signal defiance while shifting the emphasis to negotiations. Hence it will primarily retaliate through diplomatic actions and calculated displays of force. A limited response enables Iran to appear innocent, divide the U.S. and EU, and thus isolate the U.S. over its belligerent policies. Previously, Trump has sought to negotiate with Iranian President Hassan Rouhani. The Iranians have so far rebuffed him, but Foreign Minister Mohammad Zarif’s initial response to the waiver announcement was to blame Trump’s advisers, instead of Trump himself, and offer an exchange of prisoners (And release of detained Americans happen to be one of the Trump administration’s key demands – see Table 2.) Negotiations could begin through back channels and an uneasy period of tensions could thus ensue without a full-blown war. Table 2Trump Administration’s 12 Demands On Iran U.S.-Iran: This Means War? U.S.-Iran: This Means War? The problem is that negotiations cannot work if Trump fully and immediately enforces the sanctions without offering Iran an “off ramp.” If the administration backs Iran into a corner it will have no option but to strike out forcefully. Negotiations also cannot work if Iran joins the U.S. in withdrawing from the 2015 deal and reactivating its nuclear program, specifically the suspected military dimensions of that program. This would force Trump to respond (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree U.S.-Iran: This Means War? U.S.-Iran: This Means War? In short, a period of “fire and fury” is about to ensue between Trump and Rouhani. It will be even more uncertain and disruptive than the summer 2017 showdown between Trump and Kim Jong Un of North Korea (Chart 19), which drove a 35 bps decline in the 10-year Treasury yield. Chart 19Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Kim Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown There is a pathway for Trump’s pressure tactics to succeed: Iran is vulnerable and the United States and its allies are in a position of relative strength in terms of global oil supply. Therefore, it is possible that Trump could fully enforce the sanctions and yet avoid any uncontrollable crisis or oil shock. However, this pathway, at a subjective 26% probability, is less likely than the combined 48% probability of the alternatives: either escalation short of war, or ultimatums leading to Middle Eastern instability and much higher odds of war. Bottom Line: The geopolitical risk of U.S.-Iran confrontation is not contained. But we do not expect Iran to overreact unless Trump plows forward with full and immediate sanctions enforcement and offers no realistic “off ramp” for negotiations. At that point Iranian retaliation will be concrete and escalation could spiral out of control. Investors should keep in mind that Iran is not North Korea. Unlike the hermit kingdom, Iran has the ability to retaliate with a number of different levers. Indeed, it has threatened to shut the Strait of Hormuz in the past, and could, at the limit, be backed into that corner. While the risk of this is extremely low, should it occur the consequences would be huge – close to 20% of the world’s daily oil supply passes through the Strait daily. Indeed, just this week Iran’s Oil Minister Bijan Zanganeh again threatened to take action against any OPEC member working against its interests. Following a meeting with the Cartel’s president, he is reported to have said, “Iran is a member of OPEC because of its interests, and if other members of OPEC seek to threaten Iran or endanger its interests, Iran will not remain silent.”8 Investment Conclusions The Trump administration’s decision to apply maximum pressure to Iran is a significant and unexpected injection of geopolitical risk that we believe fundamentally changes the investment landscape in 2019-20. While our base case is that the U.S. will enforce the oil sanctions gradually and in such a way as to avoid causing an oil shock, policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1 Please see Humeyra Pamuk and Timothy Gardner, “How Trump’s hawkish advisors won debate on Iran oil sanctions,” Reuters, May 1, 2019, available at reuters.com. 2 Heavy-sour crudes are those with low API gravity (a measure of how easily a crude flows) and higher sulfur content. Light-sweet crudes have higher API gravity and lower sulfur content. 3 Please see BCA Commodity & Energy Strategy Weekly Report, “IMO 2020: The Greening Of The Ship-Fuel Market,” February 28, 2019, available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition led by KSA and Russia, which was formed in 2016 to manage global crude oil output. Its goal is to drain the massive storage overhang caused by the market-share war launched by KSA in 2014. 5 Iran cited dissatisfaction with Iraq over the accumulation of unpaid bills as the cause of the halt in electricity exports to Iraq. This prompted Iraqi authorities – under pressure from domestic unrest – to send a delegation to Saudi Arabia in attempt to negotiate an electricity agreement. 6 Please see Edward Wong, “Trump Pushes Iraq to Stop Buying Energy From Iran,” The New York Times, February 11, 2019, available at nytimes.com. 7 Please see Geneive Abdo and Firas Maksad, “Iraq’s Place in the Saudi Arabian-Iranian Rivalry,” The National Interest, April 15, 2019, available at nationalinterest.org. 8 Please see Babk Dehghanpisheh, “Iran will respond if OPEC members threaten its interests: oil minister,” Reuters, May 2, 2019, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image