Emerging Markets

Highlights We continue to recommend overweighting Mexican local fixed-income markets, the peso and sovereign credit relative to their respective EM benchmarks. A new trade: Sell Mexican CDS / buy Brazilian and South African CDS. Continue holding the long MXN / short ZAR position. We have a lower conviction view that Mexican equities will outperform the EM benchmark. Feature Since the election of Andrés Manuel López Obrador – or AMLO, as he is commonly known – as President, investors have been worrying about Mexico’s fiscal policy and public debt sustainability. Specifically, investors have expressed concern over the debt dynamics of state-owned petroleum company Pemex and its impact on the country’s public debt. While these concerns are not groundless, on balance we find the risk-reward profile of Mexico’s sovereign credit and local currency bonds superior relative to their respective EM peers. Fiscal Sustainability: A Comparative Analysis We discussed debt sustainability in Brazil and South Africa in two of our recent reports, and concluded that their public debt dynamics are unsustainable without drastic fiscal reforms. However, a closer look at debt sustainability in Mexico reveals a different picture. Chart 1Public Debt Burden Including SOE Debt Public Debt Burden Including SOE Debt Public Debt Burden Including SOE Debt Mexico’s public debt level including the debt of state-owned enterprises is lower than those in Brazil and South Africa (Chart 1). Notably, Mexico’s public debt-to-GDP ratio has been flat over the past three years. Importantly, as detailed below, the two primary conditions for public debt sustainability – the level of government borrowing costs and the primary fiscal balance - are far superior in Mexico relative to Brazil and South Africa.   Government borrowing costs in local currency terms are only slightly above nominal GDP in Mexico. Brazil and South Africa score much worse on this measure (Chart 2). The primary fiscal balance in Mexico is much better than in Brazil and South Africa (Chart 3). In fact, Mexico is targeting a primary surplus of 1% for 2019. Chart 2Local Borrowing Costs Versus Nominal GDP Local Borrowing Costs Versus Nominal GDP Local Borrowing Costs Versus Nominal GDP Chart 3Primary Fiscal Balances Primary Fiscal Balances Primary Fiscal Balances Even with potential pension reforms, Brazil will continue to run primary deficits for the next few years. As we discussed in our recent report on Brazil, the government’s submitted draft on social security reforms will save only BRL190 billion over the next four years, or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP. Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated in the next four years. Unlike Brazil and South Africa, the growth of public sector debt in Mexico is not outpacing nominal GDP growth (Chart 4). Critically, the latter point is also true in Mexico if one includes state-owned enterprises’ debt. Brazil and South Africa sovereign spreads are currently only 40 and 85 basis points above those in Mexico, respectively. The spread will widen further in favor of Mexico, given the latter’s superior fundamentals (Chart 5). In terms of local currency bonds, real yields in Mexico are also on par with Brazil but are well above those in South Africa (Chart 6). Hence, Mexican local bonds offer relative value versus many of their EM peers. Chart 4Public Debt and GDP Growth Public Debt and GDP Growth Public Debt and GDP Growth Chart 5Sell Mexican CDS / Long South African and Brazilian CDS Sell Mexican CDS / Long South African and Brazilian CDS Sell Mexican CDS / Long South African and Brazilian CDS             Nominal local currency bond yields in Mexico are about 200 basis points above the EM GBI benchmark domestic bond yield index (Chart 7). This is great value. Clearly, Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. Chart 6Real Bond Yields: Decent Value In Mexico Real Bond Yields: Decent Value In Mexico Real Bond Yields: Decent Value In Mexico Chart 7Nominal Bond Yields: Great Value In Mexico Nominal Bond Yields: Great Value In Mexico Nominal Bond Yields: Great Value In Mexico In addition, AMLO’s administration has proven to be committed to fiscal austerity. Last month, the Ministry of Finance reinforced this notion by announcing a reduction in public spending on social programs in order to balance the loss of fiscal revenue from decreasing oil revenues and lower GDP estimates. Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. We view the primary fiscal target of 1% for 2019 as aggressive and potentially unattainable due to a shortfall in revenues. However, these actions prove that AMLO’s administration is not intending to run a large fiscal deficit to finance populist spending programs, as investors had feared. Adding Pemex To Public Finances Pemex’s financial position and the government budget’s reliance on oil revenues are an Achilles’ heel for Mexico’s public finances. Therefore, we have incorporated Pemex into the budget. The resulting fiscal deterioration is not calamitous. Specifically, international credit agencies estimate that Pemex needs an additional $13 billion to $20 billion in capital expenditures per year in order to maintain current operations and replenish reserves. This is in addition to its debt service obligations in the coming years, as shown in Table 1. Table 1Pemex Debt Servicing Mexico: The Best Value In EM Fixed Income Mexico: The Best Value In EM Fixed Income We have the following considerations on this issue: First, this year the government announced $5.7 billion of financing for Pemex in the form of direct investment, tax breaks, deductions for drilling and exploration costs and revenue recovered from oil theft. In addition, the government will also do a one-time transfer of $6.8 billion from its $15.4 billion budget stabilization fund in order to finance Pemex’s debt payments due by the end of this year. While Congress must first approve the use of these funds, odds are that the bill will pass as AMLO’s party holds a majority. That would bring total capital injection into Pemex to $12.5 billion for the year, almost enough to finance the company’s capital spending this year. Second, in order to revive operations at Pemex in the medium to long term, the government must maintain this level of investment on an annual basis. Essentially, AMLO’s administration will inevitably have to sacrifice part of the $29 billion in net oil transfers it receives every year to finance the oil company and prevent further downgrades to its credit rating. How large is this required Pemex financing as a share of the public budget? We performed a simulation including into the public budget all of Pemex’s payments and all its receipts from the government. While the overall fiscal position deteriorates, it is not unsustainable. The primary and overall deficits would widen to 1.9% and 4.4% of GDP, respectively, if the government eliminates all transfers to Pemex and if the company stops all payments to the government budget, including direct transfers and indirect oil taxes1 (Table 2, Scenario 1). Table 2Mexico: Pemex And Government Budget Mexico: The Best Value In EM Fixed Income Mexico: The Best Value In EM Fixed Income In such a scenario, Pemex would gain $ 29 billion each year to invest in exploration and production. Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Chart 8Mexico's Budget Balance Adjusted For Financing To Pemex Mexico's Budget Balance Adjusted For Financing To Pemex Mexico's Budget Balance Adjusted For Financing To Pemex Third, provided Pemex’s capital spending needs could be met by half of this $29 billion, the government could provide the company just half of this amount (Table 2, Scenario 3). In this scenario, the oil company will have sufficient funds to invest. Meanwhile, the government’s primary and overall fiscal deficit will deteriorate only moderately to 0.7% and 3.2% of GDP, respectively (Chart 8 and Table 2). Finally, the importance of oil revenues – both directly from Pemex and via indirect taxation on the oil industry – have already declined as a share of total fiscal revenues – from 40% in 2012 to 18.3% currently (Chart 9). In short, Mexico’s budget is less reliant on oil revenues. If economic growth picks up, non-oil revenues will improve. Consequently, the government’s fiscal position will improve, giving it more maneuvering room to deal with Pemex. Bottom Line: Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Cyclical Economic Conditions The Mexican economy is slowing and inflationary pressures are subsiding. Narrow money (M1) and retail sales growth are decelerating (Chart 10, top panel) Capital spending is contracting and non-oil exports will be in a soft spot over the next six months, according the U.S. manufacturing ISM new orders-to-inventory ratio (Chart 10, bottom panel). Core inflation is at 3.55% and is heading south. Chart 9Dependence On Oil Revenues Has Declined A Lot Dependence On Oil Revenues Has Declined A Lot Dependence On Oil Revenues Has Declined A Lot Chart 10Mexico: Cyclical Conditions Mexico: Cyclical Conditions Mexico: Cyclical Conditions   Barring major turmoil in EM currency markets that weighs on the peso, weakening growth and disinflation will lead the domestic fixed-income market to discount rate cuts. Mexico’s central bank is very hawkish and will be slow to ease policy. Yet, such a policy stance warrants a bullish view on domestic bonds. The basis is that the longer they delay rate cuts, the more they will need to cut in the future. Investment Strategy We have been recommending an overweight position in Mexico in EM local currency and sovereign credit portfolios, and are reiterating these strategies. Relative value investors should consider this trade: Sell Mexico CDS / buy Brazilian and South African CDS. The Mexican sovereign credit market has made a major bottom versus the EM benchmark and the path of least resistance is now up (Chart 11). EM local currency bond portfolios should continue overweighting Mexico while underweighting Brazil and South Africa (Chart 12). Chart 11Sovereign Excess Returns: A Relative Bull Market In Mexico Sovereign Excess Returns: A Relative Bull Market In Mexico Sovereign Excess Returns: A Relative Bull Market In Mexico Chart 12Total Return on Local Currency Bonds in Dollar Terms Total Return on Local Currency Bonds in Dollar Terms Total Return on Local Currency Bonds in Dollar Terms Similarly, among EM currencies, we favor the Mexican peso because it is cheap (Chart 13). Specifically, we continue to hold the long MXN / short ZAR position; investors who are not yet in this trade should consider entering it now. Chart 13The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap Finally, in the EM equity universe, we are overweight Mexican stocks, but our conviction level is lower than in the case of fixed-income markets. The basis is that AMLO’s policies intend to weaken oligopolies and monopolies and undermine their pricing power. These policies are very positive for fixed-income markets and the exchange rate in the long run, as they entail lower inflation resulting from a more competitive environment. Yet, they could hurt profits of incumbent monopolies and oligopolies. This is why we recommend equity investors focus on Mexican small-caps. That said, from a macro perspective, resulting disinflation and lower local rates are also positive for equity multiples. Hence, the Mexican stock market will also likely outperform the EM benchmark in common currency terms.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com     Footnotes 1 Indirect oil taxation includes different taxes for the oil fund for stabilization and development, such as rights on drilling and exploration, import and export duties on oil and gas and financing for oil and gas research.

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chinese Credit Growth Is Rebounding... Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China ...Which Should Bode Well For Global Exports To China ...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot China Still Saving A Lot China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt From Exporting Savings To Investing Domestically And Building Up Debt From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 Image G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. Chart 5 Chart 6 In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 8 Chart 9Germany Welcomes The Upturn In Chinese Credit Growth Germany Welcomes The Upturn In Chinese Credit Growth Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Tentative Green Shoots Out Of Germany Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The Economy Italy: The Drop In Bond Yields Should Boost The Economy Italy: The Drop In Bond Yields Should Boost The Economy The ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. Image Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 14 Tactical Trades Strategic Recommendations Closed Trades

Highlights The political economy of oil will become even more complicated, following remarks by Russian Finance Minister Anton Siluanov over the weekend, which suggested policymakers there are considering another market-share war to crash prices to limit the growth of U.S. shales. The logic appears to be that by abandoning OPEC 2.0’s production-cutting deal and pushing Brent prices below $40/bbl once again for a year or so, Russia will severely reduce investment flow to the U.S. shale-oil patch, allowing it to retake global market share ceded mostly to Texas oil producers.1 The threat of a market-share war was proffered on top of stepped-up rhetoric by senior government officials – ranging from Igor Sechin, head of state-owned Rosneft Oil, to Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF) – indicating Russia will be pushing for higher production by OPEC 2.0 in 2H19 at the coalition’s upcoming June meeting. We agree with this assessment: The market will require OPEC 2.0 to lift production in 2H19, given our assessment of supply-demand balances. In our estimation, OPEC 2.0’s position has been strengthened considerably by policy-induced disruptions to the oil market.2 As such, we believe Russia’s threat of a market-share war is a feint, particularly since Russia has benefited greatly from higher prices (see below). Our balances and price forecasts this month are largely unchanged (Chart of the Week). We continue to expect Brent to average $75/bbl this year. For 2020, we expect Brent to average $80/bbl. WTI will trade $7 and $5/bbl lower (Chart 2). The balance of price risk has shifted slightly to the left side of the distribution, driven by policy risk and potential miscalculation by the dramatis personae on the international stage, chiefly leaders in the U.S., Russia and China. Chart of the WeekMarkets Continue To Track BCA Balances... Markets Continue To Track BCA Balances... Markets Continue To Track BCA Balances... Chart 2...While Prices Continue Tracking BCA Forecasts ...While Prices Continue Tracking BCA Forecasts ...While Prices Continue Tracking BCA Forecasts Highlights Energy: Overweight. Tensions in Libya could keep ~ 300k b/d of supply from reaching global markets via its Zawiya port near Tripoli. We closed our long June 2019 $70/bbl vs. short $75/bbl call spread last Thursday with a gain of 87.7%.3 Base Metals: Neutral. China’s latest credit data confirms our view the country’s credit cycle bottomed earlier this year: March Total Social Financing (TSF) increased CNY 2.8 trillion month-on-month vs. consensus expectation of CNY 1.7 trillion. This will support base metals in the coming months. We continue to expect Chinese authorities to expand credit in 2H19.Our long copper trade is up 0.7% since inception on March 7, 2019. We are closing out our tactical iron-ore trade – long 65% Fe vs. short 62% Fe at tonight’s close; it was up 22.9% at Monday’s close. Precious Metals: Neutral. Gold fell 4% from its February high on easing inflation concerns and as fears of an equity correction subsided. March U.S. PCE ex-food and -energy dropped to 1.79% yoy from 1.95% in February, while global equities rose 14% YTD. Our long gold recommendation is down 2.4% since last week, but is still up 3.6% since inception on May 4, 2017. Agriculture: Underweight. U.S. corn and wheat farmers are behind schedule in their spring planting, according to USDA data. The top four American corn-producing states had not started planting by last week, while spring and winter wheat producing states are 11% and 3% behind schedule, mostly due to weather conditions. While delays in planting are always cause for concern, we are still early in the planting season, which gives farmers time to catch up. Feature Policy uncertainty vis-à-vis global oil supply was elevated by Russian Finance Minister Anton Siluanov’s comments indicating policymakers are considering reviving an oil market-share war directed at U.S. shale-oil producers. Siluanov said prices could fall to $40/bbl or less, in the event. Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now His remarks come on the back of statements from Russian government and oil company officials lobbying for higher output. These comments suggest there is a heavyweight Russian contingent fully supporting these demands for OPEC 2.0 to increase production in 2H19 when it meets in June. Otherwise, the threat implies, Russia will seriously consider leaving OPEC 2.0, and will launch its own market-share war against U.S. shale-oil production, led by the fast-growing Permian Basin in Texas. Thus far, Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now – nicely above $70/bbl in the Brent market. He also wants to maintain cooperation with OPEC 2.0, particularly its other putative leader, KSA. We continue to believe, however, KSA and Russia become less comfortable with Brent prices moving sharply above $80/bbl.4 Nonetheless, the threat posed by the U.S. shales is non-trivial: In our latest balances estimates, we raised our 2H19 U.S. output estimates to 12.53mm b/d, and slightly decreased our 2020 estimates to 13.35mm b/d”, led by a 1.17mm b/d and 0.84mm b/d increase in shale output this year and next (Chart 3). Chart 3U.S. Oil Production Estimate Higher For Shales U.S. Oil Production Estimate Higher For Shales And GOM U.S. Oil Production Estimate Higher For Shales And GOM However, Russia – and OPEC 2.0 generally – may be overestimating the rate of growth from U.S. shales going forward: In future research, we will be exploring the extent to which capital markets will restrain growth in the U.S. shales, as investors continue to demand higher returns. The days of growing shale production at any cost may be coming to an end. Russia’s Threat Is A Feint We believe Russia’s threat of a market-share war is a feint: A market-share war would damage the Rodina’s economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or two of their production. The threat needs to be understood in the context of the deterioration of Russia’s position in Venezuela; the increasing tempo of U.S. military operations in its near abroad; and rapidly evolving global oil and gas trade flows, all of which are working against Russian interests and investments.5 The threat appears to be a not-too-subtle reminder of the havoc Russia still can create globally, should it choose to do so, as Vladimir Rouvinski noted recently re Russia’s Venezuela policy.6 Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. Russia’s GDP elasticity to oil prices is more than twice that of KSA’s, which we demonstrated last week.7 This means, from an economic standpoint, it benefits more from higher prices than the Kingdom, based on our modeling. Russia’s oil is exported to refiners and trading companies who pay whatever price is clearing the market, versus KSA, which relies more on direct investments in end-use markets to serve captive demand, and whose GDP has a higher sensitivity to EM economic growth. Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. The coalition’s production-cutting deal this year has reduced global supplies by 1.0mm b/d since the beginning of the year, lifting price from below $50/bbl to more than $70/bbl, in line with our forecast. These production cuts have been supported by strong global demand this year this, which, we expect, will persist in 2020. Of course, Russia could abandon the production-cutting deal with KSA, in the hope of severely reducing investment in U.S. shale-oil production. However, it also would accelerate the loss of foreign direct investment (FDI) in its own hydrocarbons sector, along with those of other OPEC 2.0 member states (Chart 4). Bottom Line: A Russian market-share war aimed at U.S. shale producers would run the very real risk of tanking Russia’s GDP and those of the rest of OPEC 2.0’s member states, as these economies lack the resilience and diversification of the U.S.’s GDP, particularly Texas’s. Even if its fiscal balances are in better shape now, Russia’s economy remains highly sensitive to Brent crude oil prices – moreso than KSA’s, and far moreso the U.S.’s (Chart 5).8 Chart 4Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Chart 5Russia Benefits More Than KSA From Higher Oil Prices Russia Benefits More Than KSA From Higher Oil Prices Russia Benefits More Than KSA From Higher Oil Prices BCA’s Balances Mostly Unchanged Our updated balances reflect the lower Venezuelan and Iranian output reported by OPEC’s survey of secondary sources (Table 1). As we have noted previously, we believe OPEC 2.0’s spare capacity is sufficient to cover the loss of Venezuelan output, and the limited losses on Iranian exports imposed by U.S. sanctions (Chart 6). Beyond that, however, the market will be severely stretched if an unplanned outage removes significant production from global supply. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Russia Posits Oil Market-Share War: Red Herring Or Real Threat? Russia Posits Oil Market-Share War: Red Herring Or Real Threat? On the supply side, we continue to expect OPEC and Russia to lift supply in 2H19, following the successful draining of global inventories (Chart 7). We expect OPEC ex-Iran, Libya and Venezuela, led by KSA, will lift 2H19 supply by ~ 400k b/d vs. 1H19 levels, while we expect Russia’s output to rise 200k b/d. Chart 6 Chart 7Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 We continue to expect oil demand to be supported by the renewed easing of monetary policy globally, which will redound to the benefit of EM demand, which also will benefit from the bottoming of China’s credit cycle. Indeed, the EIA added 130k b/d to its estimate of non-OECD demand for this year, on the back of stronger expected growth. We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, with EM growth accounting for 1.1mm b/d of growth this year and 1.3mm b/d next year. In levels, global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. Waivers On U.S. Iran Sanctions Will Be Extended We continue to expect waivers on U.S. sanctions of Iranian oil imports will be extended on May 2, owing to the still-tight supply conditions globally with Venezuela output collapsing and ~ 1mm b/d of Iranian oil already forced off the market. This has, as we’ve noted in our discussions of the New Political Economy of oil, strengthened OPEC 2.0’s hand. This will become apparent when the coalition meets in June to consider whether to increase production in 2H19, in line with our expectation. KSA, Russia and OPEC 2.0 member states will have sufficient data on hand to determine whether and by how much to lift output, in a manner that supports their GDPs. Indeed, on Wednesday, Russian Energy Minister Alexander Novak said, “We should do what is more expedient for us.”9 KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. We also expect U.S. President Donald Trump to try to jawbone OPEC 2.0 into increasing production again, as he did in 2H18. However, we expect those demands to fall on deaf ears, unless fundamental supply dislocations warrant such action. Bottom Line: OPEC 2.0’s strategy is working – it will have maximum flexibility re how it handles its production in 2H19, following the U.S. decision on waivers to its Iran oil-export sanctions on May 2. As we noted last month, KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      OPEC 2.0 is the name we coined for the OPEC/Non-OPEC oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It agreed in November to remove 1.2mm b/d off the market, in order to balance global supply and demand and reduce inventories.  Please see “Russia, OPEC may ditch oil deal to fight for market share: Russian minister,” published April 13, 2019, for a re-cap of Siluanov’s remarks. 2      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019; and “OPEC 2.0: Oil’s Price Fulcrum,” published March 21, 2019.  It is available at ces.bcaresearch.com. 3      Please see “Oil steadies as market focuses on supply risks,” published April 15 2019 by reuters.com 4      Please see “Putin Says No Imminent Decision on Oil Output Cuts,” published April 10, 2019, by The Moscow Times. 5      Please see for example, “Pentagon developing military options to deter Russian, Chinese influence in Venezuela,” published by cnn.com April 15, 2019; “Destroyer USS Ross Enters Black Sea, Fourth U.S. Warship Since 2019,” published by news.usni.org April 15, 2019; and “U.S. LNG exports pick up, with Europe a major buyer,” published by reuters.com March 7, 2019. 6      Please see “Russian-Venezuelan Relations at a Crossroads” by Vladimir Rouvinski, published by the Wilson Center’s Kennan Institute in its February Latin American digest. 7      Please see “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” published by BCA Research’s Commodity & Energy Strategy April 11, 2019.  It is available at ces.bcaresearch.com. 8      We discuss the impact of higher oil prices on Russia’s economy in last week’s report, which is cited in footnote 6 above.  Russia’s GDP in 2017 was ~ U.S. $1.6 trillion, according to the World Bank, while the GDP of Texas was ~ $1.7 trillion, American Enterprise Institute. 9      Please see “Russia’s Novak: early to speak about options for oil output deal,” published reuters.com April 17, 2019. 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