Energy

Highlights So What? A collapse in Venezuelan oil production could cause Brent prices to average $92/bbl next year. Why? Venezuelan oil output is in freefall. Years of mismanagement constrain its production potential, severely denting government revenues. External debt is sky-high. Venezuela faces challenges in repaying its obligations. China and Russia are unlikely to provide the large-scale subsidies necessary to stabilize the regime over a long period. The United States is unlikely to lift sanctions anytime soon. Rather they may expand them. Feature "PDVSA is red, red from top to bottom." - Former Energy Minister Rafael Ramí­rez "It has been an interesting activity, working without payment." - Sergio Requensa, President of the Corporation of Intermediary Industries, on volunteer groups trying to boost oil output. Global oil prices have fallen by 28.5% since their peak on October 4. While the world awaits OPEC 2.0's meeting on December 6 in Vienna, it is important to remember that global spare capacity is low while serious supply risks loom in many corners of the world. One such risk is the deterioration of Venezuela's economic, political and social situation, which has already precipitated steady declines in oil production (Chart 1). The odds of halting or reversing this trend are razor thin. The Nicolás Maduro government has managed to hobble along, but there is no firm basis for projecting a stabilization either of the regime or oil output. Although it is possible that Venezuela will secure enough ad hoc funding to survive another year, we have no solid grounds for arguing that it will. Chart 1On A Downward Spiral On A Downward Spiral On A Downward Spiral In our dominant scenario of steadily declining Venezuelan output, we forecast Brent to average $82/bbl in 2019. The event of a complete collapse could push Brent prices as high as $92/bbl next year (Chart 2). Chart 2A Production Collapse Would Trigger A Price Spike A Production Collapse Would Trigger A Price Spike A Production Collapse Would Trigger A Price Spike Venezuelan Production In Freefall While Venezuelan authorities have stopped reporting official economic data, declining oil production offers clear evidence of a deepening crisis. Venezuela is a founding member of OPEC and was once one of the most prosperous Latin American countries. Decades of gross mismanagement have pushed the country into crisis. Estimated to hold the world's largest crude oil reserves (Chart 3), Venezuela's potential role in global oil markets is massive. Its oilfields have, in the past, accounted for 4% of global oil supply, but have dwindled down to 1% so far this year (Chart 4). Nevertheless, Venezuela's role should not be underestimated. Price risks could be to the upside - on the back of a collapse in output - or to the downside in the unlikely event of production restoration. For now, we project monthly declines will average 35k b/d over the coming year, ending at 681k b/d by the end of 2019. Chart 3Venezuala's Potential Is Unrivaled... Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Chart 4...But Not Captured By Its Dwindling Production Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Continued deterioration in supply comes on the back of decades of economic mismanagement at the hands of former President Hugo Chávez and his United Socialist Party of Venezuela. The failed 2002 coup attempt and related labor strikes at Petróleos de Venezuela, S.A. (PDVSA) - the state-owned oil and gas company - led to the firing of thousands of employees and their replacement with Chávez loyalists, Chavistas. This event politicized the country's economic engine, catalyzing a steady loss in capital and technical expertise. Furthermore, regulations imposed on the energy sector are unfavorable to international investors. For example, the 2001 Hydrocarbons Law stipulated a massive rise in royalties paid by foreign companies - increasing from a range of 1%-17% to 20%-30%. Today, taxes per barrel in Venezuela are the highest among the major producers and form the largest cost component per barrel of oil and gas (Chart 5). Chart 5High Tax Rate Is Unattractive Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Other damaging state actions include: A law requiring PDVSA to hold at least 60% equity in joint ventures with foreign firms investing in the Venezuelan oil sector; The nationalization of the Orinoco Belt - a highly fertile region home to the world's largest petroleum deposits; Government expropriation of foreign assets; Payment failures to international oil service companies. These events ultimately culminated in today's production freefall, which has continued despite the rebound in oil prices after 2015. Needless to say, falling revenues are deadly for petro states. Caracas relies on oil sales for 95% of the government's revenue. Falling rig counts are an ominous sign (Chart 6). Chart 6An Ominous Sign An Ominous Sign An Ominous Sign To make matters worse, export figures actually understate the dire economic situation. The U.S. EIA estimates that roughly half of Venezuela's oil exports are not generating cash! The Venezuelan government has mortgaged much of its production in exchange for loans from China and Russia in recent years. Under these loans-for-oil schemes, the government secured emergency funding to keep its ailing economy afloat, but sacrificed the long-term ability to ensure its own liquidity. This arrangement also includes shipments to the Vadinar refinery in India, which is owned by Russia's Rosneft (Chart 7). Chart 7U.S. Exports Are Main Source Of Revenue U.S. Exports Are Main Source Of Revenue U.S. Exports Are Main Source Of Revenue This leaves exports to the U.S. as the main source of revenue for the Venezuelan government. The result is a Catch-22: With fewer oil barrels to go around, Venezuela can either satisfy its foreign creditors to keep open the possibility of future lines of credit, or it can sell to the U.S. in return for badly needed cash. For the moment, Venezuela is opting for cash. Despite having been cut by ~20% since last year, exports to the U.S. appear to have hit a floor. According to EIA data, after coming in at 13.21mm bbl in February, they have rebounded slightly averaging 19mm bbl/month since June. This is occurring despite ongoing production declines. This is ultimately unsustainable, as the evidence of mismanagement goes beyond production facilities: A breakdown in domestic refining facilities has necessitated an increase in Venezuela's imports of U.S. crude. The lighter oil is needed as a diluent - to blend with Venezuela's heavy crude, facilitating transportation. This is forcing Venezuela's economy to divert scarce hard currency to these imports. In fact, imports have picked up even amid declining oil production and the deepening economic crisis. Earlier this year, PDVSA's Caribbean assets fell under risk of being handed over to ConocoPhillips as compensation for Chavez's 2007 nationalization of Conoco's facilities. These Caribbean assets include storage facilities, refineries, and export terminals on the islands of Bonaire, Curacao, St. Eustatius, and Aruba. Terminals there account for 17% of the company's exports - mainly destined for Asia (Table 1). To prevent this transfer, Venezuela has agreed to pay the American company $2 billion in compensation, $345 million of which has been paid. If these payments cannot be met, the Caribbean assets will be in jeopardy once again - and Conoco is by no means the only company preparing lawsuits to claim assets in the event of further defaults. Table 1Caribbean Assets At Risk Of Seizure Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Similarly, CITGO - PDVSA's U.S. refiner and crown jewel - is at risk to being handed over to creditors. A loss of control of CITGO would disrupt one of the most reliable sources of cash for Venezuela. While U.S. sanctions prevent CITGO from sending dividends to Venezuela, it is so far still allowed to purchase Venezuelan crude. CITGO's assets include three U.S. refineries with a total capacity of 750k b/d. To complicate matters, several creditors are claiming stakes in the refiner: Crystallex International, a Canadian mining company whose Venezuelan assets were nationalized in 2011, is making claims on CITGO. In August, a U.S. federal judge ruled in favor of Crystallex, giving it permission to seize shares of PDV Holding Inc., which owns CITGO. However, the judge also issued a temporary stay on Crystallex - which is planning to auction the shares - until an appeal is decided. If the appeal is in favor of Crystallex it will encourage additional asset grabs by aggrieved foreign companies. PDVSA has offered bond investors a 51% claim on CITGO to push back maturing payments to 2020. The remaining 49% of CITGO was put up as collateral for a $1.5 billion loan from Rosneft. The risk - which intensifies with each missed payment - is that as Venezuela defaults on its debts, more of its facilities will be seized, further reducing its production, refining, and export potential. This would ultimately accelerate the total collapse of Venezuelan output. Bottom Line: Venezuelan oil production is steadily crumbling. Almost two decades of mismanagement have preceded this outcome and, as such, it cannot be reversed easily. We expect monthly declines to average 35k b/d, with the probability of a complete collapse in output rising with each passing day. A Macroeconomic Mess Venezuelans today are paying the price for the unsustainable external debt amassed over the past decade (Chart 8). Estimates of external debt place it around a staggering $150-$200 billion! Sovereign and PDVSA bonds due next year are estimated to be about $9 billion (Chart 9). This does not even account for payments due from other forms of debt (Table 2). Chart 8Debt Levels Are Unsustainable Debt Levels Are Unsustainable Debt Levels Are Unsustainable Chart 9It's Payback Time Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Table 2Yikes! Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Total reserves leave little room for optimism (Chart 10). They now stand at less than $10 billion, down from $43 billion less than a decade ago. Chart 10Reserves Cannot Lend Support Reserves Cannot Lend Support Reserves Cannot Lend Support In projecting the country's ability to make payments in 2019, we looked at several oil-price and production scenarios. All scenarios point to default, as shown in Table 3. Even in the optimistic scenario in which production is flat (which is highly unlikely given that it has been declining at an average monthly rate of 47k b/d so far this year), the country needs $14.8 billion in foreign exchange reserves to cover rising PDVSA expenses plus debt-service costs and its total import bill. This will put Venezuela $6 billion in the red. Table 3All Roads Lead To Default Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop This forecast would become even more somber if we were to include payments due on other forms of debt (e.g. private bonds, loans, etc), for which there is no published repayment schedule. Stability is entirely out of reach for the Venezuelan government alone. Maduro's recovery plan announced earlier this year will do nothing to combat the root of the crisis. For instance, the launch of a cryptocurrency - the "petro" - that is backed by five billion barrels of oil reserves, to which the bolivar will be pegged, is not a viable solution.1 In fact, Venezuela's policy options are extremely limited. Only a massive show of support from China and Russia can realistically bring about a substantial improvement. This would require a commitment to pay: (1) debt servicing and import costs; (2) the operating costs of PDVSA and the funds needed to preserve CITGO and other critical assets; (3) the funding of new investment required to revive the oil sector. Over the past decade, China and Russia have provided loans worth ~ $60 billion and ~ $20 billion, respectively. Of these loans, an estimated $28.1 billion and $9.1 billion remain outstanding for China and Russia, respectively.2 Venezuela has paid off not quite half of its debts to these powerful patrons. The last Chinese loan was in 2016. China stopped the credit tap throughout 2017 and most of 2018 amid Venezuelan instability. While China expressed its intention to extend a $5 billion loan in September, this amount is small by comparison with the double-digit billions of loans and direct investment that China provided annually from 2009-15. It would not cover Venezuela's shortfall of funding in our three scenarios even if it were devoted entirely to paying immediate obligations. Moreover, the Chinese loan has not been finalized.3 Thus, China's diplomatic "return" to Venezuela suggests that Beijing is not willing to provide the large-scale subsidies necessary to stabilize the regime over a long period. Indeed, China's state oil firm Sinopec has joined other foreign companies in suing Venezuela for unpaid debts!4 Moreover, Chinese and Russian funds are hardly likely to exceed the large amount invested over the past decade - and those amounts did not prevent Venezuela from falling into its current crisis. Russia is no longer capable of fully financing a satellite state in the way the Soviet Union financed Cuba in the twentieth century. It is hoping that China will foot most of the bill. While China is probably able to do so in cash terms, it is so far unwilling to pay the strategic price of setting up a Soviet-style power struggle with the United States in violation of the Monroe Doctrine.5 Indeed, plowing tens of billions of additional dollars into Venezuela may be unwise if the U.S. reverts back to its tried and tested strategy of directly intervening in the domestic affairs of Latin American countries. Venezuela, being in South America and on the Atlantic coast, is too far away for China to secure in the event of a showdown with the United States. As such, Beijing must understand that any investment in Venezuela could one day become stranded capital in a traditionally American sphere of influence. In fact, China is concentrated on building its own sphere of influence in Asia. While Venezuela is nominally part of the expansive Belt and Road Initiative, the latter is ultimately directed at making China's outward investment more coherent and expanding influence on the Eurasian continent. Neither of these aims is all that favorable for Venezuela. While China certainly wants privileged access to Venezuelan oil, it does not "need" Venezuelan crude for supply security in the way that is often implied. It frequently re-sells the oil on global markets. Nevertheless, Russia and China can offer debt restructuring and relief. Out of the $9 billion outstanding that is owed to Russia, Moscow has agreed to restructure $3.15 billion to be paid over ten years. Other such restructuring deals could be forthcoming (although, notably, China did not agree to a restructuring when Maduro visited in September). Restructuring will not work with U.S. bondholders. The U.S. imposed sanctions on August 24, 2017 seem to prevent U.S. holders of Venezuelan bonds from participating in such arrangements. The U.S. Office of Foreign Assets Control is unlikely to lift sanctions anytime soon.6 More likely, the United States will expand sanctions, as U.S. National Security Advisor John Bolton indicated in a speech in Miami on November 2. There he dubbed Venezuela, Cuba, and Nicaragua the "troika of tyranny" in the western hemisphere. Possible sanctions include: First, the Trump administration has moved to restrict purchases of Venezuelan gold, as the government has been increasing exports to Turkey (and likely China).7 Trump is considering putting Venezuela on the list of state sponsors of terrorism, which will cut off aid and loans. Second, the financial sanctions announced in 2017 could be expanded to cover existing debts, the trading of government and PDVSA bonds on secondary markets, and CITGO's newly issued debt - all areas that the Department of Treasury has so far exempted. Third, sanctions on tanker insurance could impede Venezuela's ability to transport its oil to international destinations. Venezuela does not have the tanker capacity to ship its own oil. Fourth, in the most extreme case, restrictions on U.S. imports of crude oil could punish the Maduro administration. The U.S. is reluctant to exacerbate the humanitarian crisis and deal with its second-round effects. But it could ultimately use its leverage as importer to insist that its companies are compensated, one way or another, for Venezuelan defaults. Technically alternative buyers could absorb Venezuela's heavy crude, but the loss of the U.S.'s cash-generating imports would pile more pressure onto an already wobbling regime. Bottom Line: Venezuela has been relying on ad hoc funding to survive thus far. Loans in exchange for oil are now eating up its revenues. President Maduro's recovery plan does not address the root causes of the ongoing macroeconomic mess. All scenarios point to insolvency. A Regime Change Is In Order Hyperinflation and the absence of basic necessities have left Venezuelans pessimistic about their country's future (Chart 11). This is not surprising: A staggering 87% of households are estimated to be below the national poverty line, most of whom are in extreme poverty. GDP per capita is half the level it was only a decade ago (Chart 12). These are the ingredients of a revolutionary brew. Chart 11The Outlook Isn't Rosy The Outlook Isn't Rosy The Outlook Isn't Rosy Chart 12Purchasing Power Has Been Slashed By Half Purchasing Power Has Been Slashed By Half Purchasing Power Has Been Slashed By Half The deepening humanitarian and economic crisis is causing one of the largest outflows of emigrants in recent years. According to the United Nations, 2.6 million Venezuelans live abroad and 1.9 million of them have left since 2015 (Chart 13). Chart 13Venezuelans Are Fleeing Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop The crisis has naturally translated into a massive shift in public opinion against the regime (Chart 14). Maduro's reelection for a second term in May occurred in an environment in which the opposition boycotted the elections and voter turnout was reported at just 46.1%, hardly half of the 80% rate in 2013. Venezuelans have also lost faith in the armed forces and police, which have buttressed the current regime (Chart 15). Chart 14Maduro Lacks Support Maduro Lacks Support Maduro Lacks Support Chart 15Loss Of Faith In Security Institutions Loss Of Faith In Security Institutions Loss Of Faith In Security Institutions Opposition parties do not have the power to force a transition to a new government, but under today's extreme circumstances they are not as divided as they were in the past. They all support regime change, domestic resistance, and international pressure. All have refused to participate in any dialogue unless it is to discuss the terms of Maduro's resignation. This means that a fracture within the regime, or an external factor like U.S. action, could tip the balance. Could a military coup provide the way out of the current morass? Ultimately, yes, in the sense that the military is the ultimate arbiter of Venezuelan society over the course of history. But short-term investors should not hold their breath. The Maduro regime has managed to survive as long as it has by ceding ever more power to the army, meaning that, in a sense, the coup has already occurred. Food distribution and oil production are now directly under the control of the military. Once the regime becomes completely fiscally defunct, military leaders may pin the blame on Maduro and reshape or expunge the Socialist Party. The timing, however, is nearly impossible to predict other than to emphasize that the current situation is unsustainable and we do not believe that Beijing will ride to the rescue. One foreboding sign is that Maduro has authorized hikes to domestic gasoline prices, which are heavily subsidized. A hike of this nature prompted the Caracazo social unrest in 1989, which helped motivate the attempted coups of 1992. Another option may be direct U.S. action. While the U.S. has been reluctant to intervene in Latin America since the short-lived, albeit successful, 1989 intervention in Panama, President Trump did raise the idea of a "military option" in August 2017.8 While Trump's comments were largely ignored, and subsequently opposed by the Pentagon itself, the reorientation of U.S. policy towards confronting China may convince the U.S. defense and intelligence establishment to view Venezuela through the prism of a new Cold War. As such, and especially if the humanitarian crisis grows, investors should not completely dismiss the possibility of a U.S. military-backed coup in Venezuela.9 Bottom Line: Opposition parties are not as divided as they were in the past, in a sign that the current regime is failing to maintain control. Given the unsustainability of the economic situation and the military's ever-growing role, odds are in favor of an army takeover at some point. The relevant takeaway for investors is that things will have to get worse before that occurs - adding pressure on global oil supply and leading to additional debt defaults. Investment Implications Declining Venezuelan oil production will continue weighing on global supply. We model monthly production declines of 35kb/d as the dominant scenario in our supply-demand balances. On this basis, we expect Brent to average $82/bbl in 2019 and WTI to trade $6/bbl below that. A complete collapse in Venezuelan production next year could push prices much higher - up to $92/bbl and $86/bbl for Brent and WTI, respectively. While an eventual production collapse is inevitable, Venezuela may be able to hobble along for another year through ad hoc funding. Thus, a premium will be priced into global oil markets in 2019 on the back of falling Venezuelan production - and the risk of its collapse. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Pavel Bilyk, Research Associate pavelb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1 The U.S. is already considering sanctions targeting the cryptocurrency. Please see Franco Ordonez, "Top lawmakers in Congress push tough new measures against Venezuela," September 24, 2018, available at www.mcclatchydc.com. For the text of an earlier proposal please see "Venezuela Humanitarian Relief, Reconstruction, and Rule of Law Act of 2018," introduced into the Senate by Senator Robert Menendez (D, NJ) on the foreign relations committee, S. 3486 at www.congress.gov. 2 Please see "Venezuela: Deuda externa per capita del sector público," Prodavinci, available at especiales.prodavinci.com. 3 Please see "China y Rusia desconfían del régimen chavista y aumentan la supervisión de sus inversiones en Caracas," PD América, October 31, 2018, available at www.periodistadigital.com. 4 Please see Jonathan Wheatley, "Sinopec settles with Venezuela's PDVSA, ending 5-year dispute," Financial Times, December 12, 2017, available at www.ft.com. 5 The Monroe Doctrine was reinforced specifically in relation to Venezuela by the "Roosevelt Corollary" in 1902-03. Recently the United States has reasserted the Monroe Doctrine in the face of a widespread perception that China has gained strategic ground on the continent, namely in Venezuela. Please see Vice President Mike Pence, "Remarks by Vice President Pence on the Administration's Policy Toward China," the White House, October 4, 2018, available at www.whitehouse.gov. 6 On the contrary, sanctions are expanding. Please see U.S. Treasury Department, "Treasury Targets Venezuelan President Maduro's Inner Circle and Proceeds of Corruption in the United States," September 25, 2018, available at home.treasury.gov. 7 Please see the White House, "Executive Order Blocking Property of Additional Persons Contributing to the Situation in Venezuela," November 1, 2018, available at www.whitehouse.gov. 8 Please see Jeremy Diamond, "Trump asked advisers about invading Venezuela in 2017," CNN, July 5, 2018; and Dan Merica, "Trump says he won't rule out military option in Venezuela," CNN, August 11, 2017, both available at www.cnn.com. 9 Even the Secretary General of the Organization of American States, Luis Almagro, has refused to rule out any options, including military intervention. Pro-Maduro commentators have claimed that the U.S., along with Colombia and other enemies of the regime, supported the apparent attempt to assassinate Maduro by drones in August this year. Please see "Venezuela President Maduro survives 'drone assassination attempt,'" BBC, August 5, 2018, available at www.bbc.com. The New York Times has also reported that the Trump administration sent officials to "listen" to rebel Venezuelan military officers proposing a coup attempt. Please see Ernesto Londono and Nicholas Casey, "Trump Administration Discussed Coup Plans With Rebel Venezuelan Officers," NYT, September 8, 2018, available at www.nytimes.com. We Read (And Liked)... The Great Leveler: Violence And The History Of Inequality From The Stone Age To The Twenty-First Century Professor Walter Scheidel's opus - The Great Leveler - introduces the "Four Horsemen" of equality: warfare, revolution, state collapse, and pandemics.10 These four factors, he argues, explain all significant levelling of wealth and income throughout history. And by history, Scheidel really means all of human history. The thesis behind The Great Leveler is that only through the "aid" of the Four Horsemen has wealth ever been distributed more evenly in human societies. In every grand passage in history, one of the four terrible afflictions has tipped the scales away from capital and landholders and in favor of laborers. Otherwise, when there is not war, revolution, state collapse, or pandemics, capital and landholders acquire sufficient wealth and political capital to stave off any attempts at leveling. Scheidel's focus on World War I and II is particularly interesting. He controversially argues that the prosperity and equality that prevailed in the western world after these wars was to a great extent the product of government measures imposed in order to win the conflict. These included nationalization, direct intervention in production, fiscal policy, and inflationary monetary policy. Mass mobilization necessary to wage and win a total war left western societies, and Japan, "levelled" by the time the wars ended. BCA Research was honored to have Professor Scheidel attend our annual Investment Conference in Toronto this September. In the talk, he warned the room full of investors to "be careful what you wish for," since the suppression of inequality has "only ever brought forth sorrow." Furthermore, Scheidel rejected the hypothesis that wealth and income inequality bring about their own demise. They usually grow unchecked until one of the Four Horsemen appears exogenously. The takeaway from Scheidel's work is that income and wealth inequality are, according to the scales of human history, essentially part of human existence. As such, one should neither fret too much about them nor worry that they will lead to serious efforts to curb them. There are two weaknesses in this argument. First, the book is primarily a treatise on medieval history. The vast amount of empirical evidence that Scheidel has carefully collected occurred before societies became democratic, and specifically before universal suffrage. While Scheidel focuses on the effects of the world wars in the twentieth century as the causes of modern leveling, he barely mentions the role played by the spread of the electoral franchise during and after the conflicts. And it is true that democracy has not prevented the rise of income inequality in much of the developed world since the 1980s - that is, since the laissez-faire revolution. However, the end to that story is yet to be written. Which brings us to the second weakness: Scheidel dismisses GINI coefficient data on income inequality. It does not support his thesis. For example, his tables show that the "market GINI" of many western European countries is as high as that in the United States. However, after accounting for redistributive effects, it is in many cases significantly lower. Instead, Scheidel focuses on the wealth accruing to the top 1%. But again, continental European countries have experienced much lower concentration of wealth than the laissez-faire economies of the U.K. and the United States. Yes, there is growth in concentration even in the social democracies of Europe, but it is at a much slower pace than in the countries that have been the most committed adherents of the Reagan-Thatcher revolution. The greatest failing of Scheidel's thesis is that it lacks nuance when it comes to the modern era. Its parsimony over the course of human history is astounding and commendable - it is what makes this a true magnum opus of social science. However, the real world is rarely as parsimonious. The facts are quite different from the theory. Chart 1 shows that the wealth accruing to the top 10% of income distribution in France was higher in the 1950-1970 era than in the U.S., and much higher than in the United Kingdom. Then, the supply-side revolution took hold in the Anglo-Saxon world, while France pursued policies that sought to reverse the causes of the May 1968 social angst. The shift in wealth distribution was jarring. Chart 1No Horsemen Here, Just Social Democracy No Horsemen Here, Just Social Democracy No Horsemen Here, Just Social Democracy From this one example we can draw two conclusions. First, Scheidel is wrong when he says that the march of income inequality is inevitable. It clearly has not been in western Europe in recent memory. Second, Scheidel is also wrong when he argues that the march of income inequality is irreversible. France was once a right-of-center country ruled by elites who saw revenues accrue to their capital and wealth holdings. Then, all hell broke loose in the country, with teenage Baby Boomers joining up with common workers in a (relatively) bloodless socialist revolution. Rather than adopt laissez-faire capitalism with vigor, French policymakers adopted wealth and income taxes that reversed the rising share of income accruing to the top 10%. Only today, after decades of a deliberately orchestrated and significant leveling, are policymakers in France looking in a different direction. Scheidel claims that his book is pessimistic, but that of course depends on the audience. Our audiences tend to be made up of investors, i.e. of savers. As such, Scheidel's thesis is in fact joyous! A historical opus that proves, without a doubt, that income inequality is irreversible short of apocalypse!? Sounds too good to be true! It is. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 10 Princeton: Princeton University Press, 2017, 504 pages.

Highlights When we flagged the increasing likelihood of higher volatility a few weeks ago, we did not expect the Trump Administration's granting of waivers on sanctions against Iranian oil exports, which ultimately led to the oil-price meltdown.1 Neither, it seems, did the market, as the surge in Brent and WTI implied volatilities attests (Chart of the Week). Chart of the WeekOil-Price Volatility Surges As Markets Process Conflicting News Oil-Price Volatility Surges As Markets Process Conflicting News Oil-Price Volatility Surges As Markets Process Conflicting News In one fell swoop, the Trump Administration's volte-face on Iran oil-export sanctions transformed the threat of an oil-price spike to $100/bbl in 1Q19 into a price rout. Whether that persists depends on how OPEC 2.0 responds to sharply higher short-term supply. Our updated supply - demand balances and price forecast are highly conditional on our expectation OPEC 2.0 will reduce output in response to the 1mm+ b/d or so of oil put back into the market early next year because of waivers. Inventories globally are at risk of swelling once again, if OPEC 2.0 does not cut output. OPEC 2.0's interests will conflict with the Trump Administration's agenda. Going into OPEC 2.0's December 6 meeting in Vienna, we lowered our 2019 Brent expectation $82/bbl, and continue to expect WTI to trade $6/bbl below that. We expect volatility to persist. Energy: Overweight. Natgas futures raced above $4.00/MMBtu on the NYMEX as the U.S. heating season kicked off with inventories of 3.2 TCF - 16% below their five-year average, and the lowest since 2005, according to EIA data. Base Metals: Neutral. China's benchmark copper treatment and refining charges are expected to remain on either side of $82.25/MT next year, as concentrate supply tightens slightly, Metal Bulletin's Fastmarkets reported. Precious Metals: Neutral. The Fed is on course to lift the fed funds range 25bp to 2.25% - 2.50% at its December meeting, which will keep gold under pressure. Ags/Softs: Underweight. The USDA's latest ending stocks estimates for the 2018/19 crop year came in below trade expectations for corn and wheat - at 1.74 billion and 949mm bushels, respectively, vs. expectations of 1.78 billion and 969mm, according to agriculture.com. Soybean estimates came in at 955mm vs. an expected 906mm bushels. Feature Brent and WTI crude oil prices air-dropped from a high of $86.10/bbl in early October to a Wednesday low of $65.01/bbl as we went to press. This was a 24% drop in a little more than a month, reflecting the difficulty markets experienced recalibrating supply - demand balances in the wake of the Trump Administration's volte-face on Iranian export sanctions, which took effect last week. Over the past weeks, markets appear to be pricing the return of more than 1mm b/d of Iranian exports in 1Q19, on the back of these waivers for importers of Iranian crude. The full extent of the additional volumes that will be allowed back on the market still is unknown. Lacking certain information, market participants have to assume the waivers will dramatically expand short-term supplies, which already had been boosted by OPEC 2.0 and U.S. producers, in the lead-up to sanctions (Table 1).2 The sell-off on the back of the waivers did, however, dissipate some of the risk premium we identified in prices in October, and brought price more in line with actual balances (Chart 2).3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl Chart 2Oil Risk Premium Dissipates All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl Prior to the granting of waivers, markets were girding for sanctions-induced losses of as much as 1.7mm b/d. Now markets could see a far lower supply loss of 500k b/d in Iranian exports. This lower loss of exports from Iran reduced expected prices by $10/bbl in 1H19, vs. our previous expectation of $85/bbl for 1H19 using our ensemble forecast (Chart 3). For market participants hedging or trading based on the expectation of higher losses of Iranian exports, the granting of waivers creates even more "new-found" and unanticipated supply. In a simulation with the waivers extended to end-2019, average 2019 Brent prices fall to $75/bbl vs. $82/bbl using our current assumptions. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 In our estimation, "finding" this much supply via waivers amounts to a supply shock. This was compounded by surging U.S. crude and liquids production, which is boosting oil and product exports from America. Uncertain Balances, Volatile Prices Waivers are not the only factor contributing to price volatility. Fears of weaker global demand come up repeatedly - particularly as regards Asia in general, and China in particular.4 Those fears are not showing up in actual demand. In our balances estimates, we expect demand growth of 1.46mm b/d next year, down slightly from our previous estimate, given realized oil consumption remains strong (Chart 4 and Table 1). Supporting data - e.g., EM import volumes - continue to indicate incomes are holding up. Chart 4Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 On the supply side, references to an apparent disagreement between the Kingdom of Saudi Arabia (KSA) and Russia - the leaders of OPEC 2.0 - over the need to cut 1mm b/d of production next year, to keep inventories from once again swelling as they did in 2014 - 2016, compounding risks.5 While it appears KSA has carried the day on the need to cut production, that could change at OPEC 2.0's December meeting in Vienna. Output from OPEC 2.0's weakest member states - i.e., Libya and Nigeria - remains strong. Even Venezuela's rate of decline slowed some. Therefore, even without the waivers, KSA and its Gulf Arab allies would have had to reduce output to make room for these states, which are desperately trying to rebuild war-torn infrastructure. In addition to the OPEC 2.0 output surge, U.S. production has been unexpectedly strong, as have U.S. crude and refined product exports (Chart 5). The EIA - in an adjustment that surprised its analysts - revised its U.S. production estimate for October by 400k b/d vs. September's estimate to 11.4mm b/d. Production in the Big 4 shale plays - Permian, Eagle Ford, Bakken, Niobrara - is proving to be even stronger as well (Chart 6). U.S. shale output will be just under 8mm b/d by December, months ahead of schedule. The infrastructure buildout in the Permian will no doubt absorb this production and the subsequent growth in shale output by ~1.35mm b/d next year easily. Chart 5U.S. Production, Exports Surge All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl Chart 6U.S. Shale Production Will Surge U.S. Shale Production Will Surge U.S. Shale Production Will Surge U.S. producers do not have an interest in managing their production. OPEC 2.0 does, however. We expect KSA and its Gulf Arab allies to reduce production in December and keep it low until the recently formed overhang brought on by the waivers to Iranian sanctions clears. This means OECD inventory levels will once again be a key variable for OPEC 2.0 in its production management decisions (Chart 7). Chart 7Once Again, OECD Stocks Are OPEC 2.0's Policy Variable Once Again, OECD Stocks Are OPEC 2.0's Policy Variable Once Again, OECD Stocks Are OPEC 2.0's Policy Variable We assume KSA will mobilize 800k to 1mm b/d of cuts in the coalition's production at least through 1H19. KSA already has said it will reduce exports by 500k b/d in Dec18, and that could be extended to Jun19. We also expect the rest of the Gulf Arab producers to follow suit, and cut back on the production increases they brought on line at President Trump's urging. By 2H19, the waivers will have expired, but U.S. shale output will be surging and newly built pipelines will be filling. We have been carrying lower 2H19 OPEC 2.0, particularly KSA, production estimates in anticipation of this increased production and exports from the U.S. (Table 1). OPEC 2.0 + 1? President Trump apparently wants to continue to have a say in OPEC 2.0's policy deliberations, as he obviously did in the run-up to U.S. mid-term elections earlier this year. In response to persistent messaging from President Trump, KSA, Russia and their allies surged production ~ 750k b/d in July - November over their 1H18 output, in preparation for the U.S. sanctions against Iran. In addition to pushing for higher production, the U.S. has taken a more activist approach to boosting oil production among U.S. allies, possibly ahead of another attempt to impose sanctions on Iran when the current waivers expire next year in June, assuming the 180-day wind-down begins in January. For example, the U.S. has taken a more active role in re-starting exports of oil from Iraq's semi-autonomous Kurdish province - some 400k b/d, which would flow to Turkey and on to Western consumers. Without higher production from Iraq and others in OPEC 2.0, the Iran waivers almost surely will have to be extended when they expire. As we have shown in our research, Brent prices mostly likely would push toward $100/bbl without a substantial increase in spare capacity within OPEC 2.0.6 President Trump gives every impression he and his administration now share our assessment, as the FT noted: "US president Donald Trump said this week he was 'driving' oil prices down and that he had granted waivers to some of Iran's customers as he did not want to see '$100 a barrel or $150 a barrel' crude."7 BCA's Geopolitical Strategy notes the waivers also send two very important messages to KSA: "First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output."8 Forecasting supply-demand fundamentals and, therefore, prices in this environment is extremely difficult, as it involves reconciling conflicting goals between the Trump Administration and OPEC 2.0. If President Trump prevails and KSA increases output - against its own best interests, given it requires higher prices to fund its budget - then prices will be lower for longer, once again. We are inclined to believe President Trump's alarm bells start sounding when oil prices are approaching the $85/bbl level. This also is the price level KSA needs to fund its fiscal obligations. For this reason, we expect KSA and its Gulf allies to reduce output in the near term until the waivers-induced overhang clears. Depending on how quickly they act, this could be done in fairly short order. Bottom Line: Volatility likely will persist as global markets absorb an unexpected supply surge resulting from the Trump Administration's last-minute volte-face on Iranian export sanctions, which is compounded by the supply ramp undertaken by OPEC 2.0 ahead of sanctions being imposed, and surging U.S. production gains. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published on October 25, 2018. It is available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the OPEC - non-OPEC producer coalition formed at the end of the price collapse of 2014 - 16 to get control over global output and bring down swollen crude oil and refined product inventories. The coalition meets December 6 in Vienna to consider formalizing the union as a production-management cartel. 3 Our price-decomposition model's residual term is our proxy for the risk premium in oil prices. This is the red bar in Chart 2. Please see discussion in "Risk Premium In Oil Prices rising; KSA Lifts West Coast Export Capacity," which is cited above. 4 Please see "Asia's weakening economies, record supply threaten to create oil glut," published November 14, 2018, by uk.reuters.com. 5 Please see "OPEC and Russia Prepare for Clash Over Oil Output Cuts," published online by the Wall Street Journal November 9, 2018. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published on September 20, 2018, and "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," published September 27, 2018. Both are available at ces.bcaresearch.com. 7 Please see "Iraq close to deal to restart oil exports from Kirkuk," published by the Financial Times November 9, 2018. 8 Please see BCA Research's Geopolitical Strategy Weekly Report "Insights From The Road - Constraints And Investing," published on November 14, 2018. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl Trades Closed in 2018 Summary of Trades Closed in 2017 All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl

Highlights Falling Oil Prices & Bond Yields: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. ECB Corporate Bond Purchases: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days in this cycle for European corporate credit are behind us, as the ECB will not treat its corporate bond purchases any differently than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade & high-yield. Feature Are Falling Oil Prices Telling Us Something About Global Growth? Thus far in November, global financial markets have reversed some of the steep losses incurred during the "Red October" correction. This has occurred for U.S. equities (the S&P 500 fell -8% last month but has risen +4% so far this month), U.S. corporate bonds (high-yield spreads widened +71bps last month and have tightened -19bps this month) and emerging market hard currency debt (USD-denominated sovereign spreads widened +27bps last month and have tightened -9bps this month). One market that has not rebounded, however, is oil. The benchmark Brent oil price fell -11% in October, but has fallen another -7% in November. This has been enough to nearly wipe out the entire +20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil markets in recent years. Such a large decline in the oil price as has been seen of late would typically result in sharp drop in government bond yields, driven by falling inflation expectations. That correlation has been holding up in the major economies outside the U.S., where nominal yields and inflation expectations are lower than the levels seen before the October peak in oil prices. Nominal U.S. Treasury yields, by contrast, remain resilient, despite the fall in TIPS breakevens (Chart of the Week). This is because real Treasury yields have been climbing higher as investors acquiesce to the steady hawkish message from the Fed by making upward revisions to the expected path of U.S. policy rates. Chart of the WeekShifting Correlations Shifting Correlations Shifting Correlations The biggest impediment holding back a full recovery of the October losses for global risk assets is uncertainty over the global growth outlook. While the U.S. economy continues to churn along at an above-trend pace, there are signs that tighter monetary policy is starting to have an impact. Both housing and capital spending have cooled, although not yet by enough to pose a terminal threat to the current long business cycle expansion. The outlook for growth outside the U.S. is far more muddled, adding to investor confusion. China has seen a clear growth deceleration throughout 2018, but the recent reads from imports and the Li Keqiang index suggest that growth may be stabilizing or even modestly re-accelerating (Chart 2). Our China strategists are not convinced that this is anything more than a ramping up of imports and production in advance of the full imposition of U.S. trade tariffs, especially with Chinese policymakers reluctant to deploy significant fiscal or monetary stimulus to boost growth. Chart 2Mixed Messages On Growth Mixed Messages On Growth Mixed Messages On Growth A similar mixed read is evident in overall global trade data. World import growth has also slowed throughout 2018, but has shown some stabilization of late (second panel). A similar pattern can be seen in capital goods imports within the major developed economies. Our global leading economic indicator (LEI) continues to contract, but the pace of the decline has been moderating and our global LEI diffusion index - which measures the number of countries with a rising LEI versus those with a falling LEI - may be bottoming out (third panel). There are also large, and growing, divergences within the major developed economies. The manufacturing purchasing managers' indices (PMIs) for the euro area and the U.K. have been falling steadily since the start of the year, but the PMIs have recently ticked up in the U.S. and Japan (Chart 3). A similar pattern can be seen in the OECD LEIs, which have retreated from the latest cyclical peaks by far more in the U.K. (-1.6%) and euro area (-1.2%) than in the U.S. (-0.3%) and Japan (-0.6%). Chart 3Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields With such mixed messages from the macro data, investors understandably lack conviction. The backdrop does not look soft enough yet to threaten global profit growth and justify sharply lower equity prices and wider corporate bond spreads. Yet the growth divergences between the U.S. and the rest of the world are intensifying, creating a backdrop of rising U.S. real interest rates and a stronger U.S. dollar. That combination is typically toxic for emerging markets, but the impact of that would be muted this time if China were to indeed see a genuine growth reacceleration. This macro backdrop lines up with our current major fixed income investment recommendations. We suggest only a neutral allocation to global corporate bonds given the uncertainty over growth, but favoring the U.S. over Europe and emerging markets given the clearer evidence of a strong U.S. economy. At the same time, we continue to recommend below-benchmark overall portfolio duration exposure, but with regional allocations favoring countries where central banks will have difficulty raising interest rates (Japan, Australia, core Europe, the U.K.) versus nations where policymakers are likely to tighten monetary policy (U.S., Canada). However, the latest dip in oil should not be ignored. A more sustained breakdown of oil prices could force us to downgrade corporate bonds and raise duration exposure - if it were a sign that global growth was slowing and inflation expectations had peaked. The current pullback in oil has occurred alongside a decelerating trend in global economic data surprises, after speculators had ramped up long positions in oil and prices were stretched relative to the 200-day moving average (Chart 4). This suggests that the latest move has been corrective, and not a change in trend, although the burden of proof now falls on the evolution of global growth, both in absolute terms and relative to investor expectations. Chart 4Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Bottom Line: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. European Corporates Are About To Lose A Major Buyer Last week, we published a Special Report discussing the ECB's options at next month's critical monetary policy meeting.1 One of our conclusions was that the central bank will deliver on its commitment to end the new purchases phase of its Asset Purchase Program (APP) at year-end. The bulk of the assets in the APP are government bonds, but the ECB has also been buying corporate debt in the APP since June 2016. The ECB is set to end those purchases at the end of December, to the likely detriment of euro area corporate bond returns. The Corporate Sector Purchase Program (CSPP), as it is formally known, has been a targeted tool used by the ECB to ease financial conditions for euro area companies. This has occurred through three main channels: tighter corporate bond spreads, greater access for companies to issue debt in the corporate primary market, and increased bank lending to non-financial corporations. The CSPP was intended to complement the ECB's other monetary stimulus measures, like negative interest rates and the buying of government debt. The first CSPP purchases were made on June 8, 2016. The euro area corporate bond market responded as expected, with investment grade spreads tightening from 128bps to 86bps by the end of 2017. There were spillovers into high-yield bonds, as well, with spreads falling -129bps over the same period (Chart 5). Since then, however, spreads have steadily widened and European corporates have underperformed their U.S. equivalents. This suggests that some of the relative performance of euro area credit may have simply reflected the relative strength of the euro area economy compared to the U.S. The greater acceleration of euro area growth in 2017 helped euro area corporates outperform U.S. equivalents, while the opposite has held true in 2018. Chart 5ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads The CSPP has operated with a defined set of rules governing the purchases. Bank debt was excluded, as were bonds rated below investment grade. Only debt issued by corporations established in the euro area were eligible for the CSPP, although bonds from euro-based companies with parents who were not based in the euro area were also eligible. The latest update on the holdings data from the ECB shows that there are just under 1,200 bonds in the CSPP portfolio. Yet despite the ECB's best efforts to maintain some degree of portfolio diversification, the impact of the CSPP on euro area corporate bond markets was fairly consistent across countries and sectors (Chart 6). Italy is the notable diverging country this year, as the rising risk premiums on all Italian financial assets have pushed corporate bond yields and spreads well above the levels seen in core Europe, even with the ECB owning some Italian names in the CSPP. Chart 6Spread Convergence During CSPP Spread Convergence During CSPP Spread Convergence During CSPP There was also convergence of yields and spreads among credit tiers during the first eighteen months of the CSPP, with valuations on BBB-rated debt falling towards the levels on AA-rated and A-rated bonds (Chart 7). That convergence has gone into reverse in 2018, with BBB-rated spreads widening by +55bps year-to-date (this compares to a smaller +25bps increase in U.S. BBB-rated corporate spreads). A surge in the available supply of BBB-rated euro area bonds is a likely factor in that spread widening, as evidenced by the sharp rise in the market capitalization of the BBB segment of the Bloomberg Barclays euro area corporate bond index (top panel). Chart 7A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? More broadly, the CSPP has helped the ECB's goal of boosting the ability of European companies to issue debt in primary bond markets. Traditionally, European firms have used bank loans as their main source of borrowed funds, with only the largest firms being able to issue debt in credit markets. That has changed during the CSPP era. According to data from the ECB, gross debt issuance by euro area non-financial companies (NFCs) has risen by €104bn since the start of the CSPP, taking issuance back to levels not seen since 2014 (Chart 8). The bulk of the issuance has been in shorter-maturity bonds, but there has been a notable increase in the issuance of longer-dated debt since the CSPP began. Chart 8Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding The ECB's role as a marginal buyer of bonds in the primary, or newly-issued, market has helped boost that gross issuance figure. The share of bonds that the ECB owns in the CSPP that was issued in the primary market has gone from 6% soon after the CSPP started to the current 18% (Chart 9). The growth in euro area non-financial corporate debt went from 6% to over 10% during the peak of the CSPP buying between mid-2016 and end-2017, but has since decelerated to 7%. At the same time, the annual growth in loans to NFCs, which was essentially zero during the first eighteen months of the CSPP, has accelerated to 2% over the course of 2018. Chart 9More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance In other words, euro area companies had been substituting bank financing for bond financing in the CSPP "era", but have since shifted back towards bank loans in 2018. That shift in financing was most notable among CSPP-eligible companies, particularly those smaller firms that had not be able to issue debt in the primary market pre-CSPP, according to an ECB analysis conducted earlier this year.2 From the point of view of the investible euro area corporate bond market, however, even larger companies that have done that shift in bank financing to bond financing have seen no noticeable increase in aggregate corporate leverage. In Chart 10, we show our bottom-up version of our Corporate Health Monitor (CHM) for the euro area. This indicator is designed to measure the aggregate financial health of euro area companies using financial ratios incorporating actual data from individual companies. We separated out the list of companies used in that CHM that are currently held in the CSPP portfolio and created a "CSPP-only" version of the CHM (the blue lines in all panels). All issuers that were eligible for inclusion in the CSPP, but whose bonds were not actually purchased by the ECB, are used to create a "non-CSPP" CHM (the black dotted lines). Chart 10No Fundamental Changes From CSPP No Fundamental Changes From CSPP No Fundamental Changes From CSPP As can be seen in the chart, there is no material difference in any of the ratios for bonds within or outside the CSPP. The one notable exception is short-term liquidity, where the ratios were much lower for names purchased by the ECB than for those that were not. This lends credence to the idea that the CSPP most helped firms that were more liquidity-constrained, likely smaller companies. The biggest change in any of the ratios has been in interest coverage, but that has been for both CSPP and non-CSPP issuers, suggesting a common factor outside of ECB buying - zero/negative ECB policy rates, ECB purchases of government bonds that helped reduce all European borrowing rates - has been the main driver of lowering interest costs. Looking ahead, the ECB is likely to stop the net new purchases of its CSPP program when it does the same for the full APP next month. All of which is occurring for the same reason - the euro area economy is deemed by the central bank to no longer need the support of large-scale asset purchases given a full employment labor market and gently rising inflation. As we discussed in our Special Report last week, the ECB has other options available to them if there is a reduction in euro area banks' capacity or willingness to lend, such as introducing a new Targeted Long-Term Refinancing Operation (TLTRO). Continuing with unconventional measures involving direct ECB involvement in financial markets, like buying corporate debt, is no longer necessary. Our euro area CHM suggests that there are no major problems with European corporate health that require a wider credit risk premium. We still have our reservations, however, about recommending significant euro area corporate bond exposure while the ECB is set to end its asset purchase program. New buyers will certainly come in to replace the lost demand from the elimination of CSPP purchases, but private investors will likely require higher yields and spreads than the central bank - especially if the current period of slowing euro area growth were to continue. Bottom Line: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days for European corporate debt for the current cycle are behind us, as the ECB will not treat its corporate bond purchases any different than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade and high-yield. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Evaluating The ECB's Options In December", dated November 6th 2018, available at gfis.bcareserach.com and fes.bcaresearch.com. 2 The ECB report on its CSPP program was published in the March 2018 edition of the ECB Economic Bulletin, which can be found here. https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201804.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stubbornly Resilient Bond Yields Stubbornly Resilient Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields Gold Ratios Lead Divergence Of Global Bond Yields Gold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value Gold Trading Close To Fair Value Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC Gold Ratios Followed Global 10-Year Yields Pre-GFC Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Gold Ratios" Common Factor Correlates With 10-Year Global Yields... Gold Ratios" Common Factor Correlates With 10-Year Global Yields... Chart 6... And DM Equities ... And DM Equities ... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors Relative DM Outperformance Drives Idiosyncratic Factors Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market.   Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms Waivers Will Contain Oil Price Rises In Local-Currency Terms Waivers Will Contain Oil Price Rises In Local-Currency Terms \ Chart 9Oil Prices Rises In EM Economies Oil Prices Rises In EM Economies Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge WTI Spreads Diverge WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Trades Closed in 2018 Summary of Trades Closed in 2017 Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market

Highlights So What? Donald Trump's reelection depends on the timing of the next recession. Why? The midterm elections will not determine Trump's reelection chances. Rather, the timing of the next recession will. BCA's House View expects it by 2020. Otherwise, President Trump is favored to win. Trump may be downgrading "maximum pressure" on Iran, reducing the risk of a 2019 recession. Trade war with China, gridlock, and budget deficits are the most investment-relevant outcomes of U.S. politics in 2018-20. Feature The preliminary results of the U.S. midterm elections are in, with the Democrats gaining the House and failing to gain the Senate, as expected. Our view remains that the implications for investors are minimal. The policy status quo is now locked in - a gridlocked government is unlikely to produce a major change in economic policy over the next two years. While the election is to some extent a rebuke to Trump, this report argues that he remains the favored candidate for the 2020 presidential election - unless a recession occurs. A Preliminary Look At The Midterms First, the preliminary takeaways from the midterms, as the results come in: The Democrats took the House of Representatives, with a preliminary net gain of 27 seats, resulting in a 51%-plus majority, and this is projected to rise to 34 seats as we go to press Wednesday morning. This is above the average for midterm election gains by the opposition party, especially given that Republicans have held the advantage in electoral districting. Performance in the Midwest, other swing states, and suburban areas poses a threat to Trump and Republicans in 2020. Republicans held the Senate, with a net gain of at least two seats, for a 51%-plus majority. Democrats were defending 10 seats in states that Trump won in 2016. While Democrats did well in the Midwest, these candidates had the advantage of incumbency. On the state level, the Democrats gained a net seven governorships, two of them in key Midwestern states. The gubernatorial races were partly cyclical, as the Republicans had hit a historic high-water mark in governors' seats and were bound to fall back a bit. However, the Democratic victory in Michigan and Wisconsin, key Midwestern Trump states, is a very positive sign for the Democrats, since they were not incumbents in either state and had to unseat incumbent Governor Scott Walker in Wisconsin. (Their victory in Maine could also help them in the electoral college in 2020.) The governors' races also suggest that moderate Democrats are more appealing to voters than activist Democrats. Candidate Andrew Gillum's loss in Florida is a disappointment for the progressive wing of the Democratic Party.1 With the House alone, Democrats will not be able to push major legislation through. In the current partisan environment it will be nigh-impossible to reach the 60 votes needed to end debate in the Senate ("cloture"), and even then House Democrats will face a presidential veto. They will not be able to repeal Trump's tax cuts, re-regulate the economy, abandon the trade wars, resurrect Obamacare, or revive the 2015 Iranian nuclear deal. Like the Republicans after 2010, they will be trapped in the position of controlling only one half of one of the three constitutional branches. The most they can do is hold hearings and bring forth witnesses in an attempt to tarnish Trump's 2020 reelection chances. They may eventually bring impeachment articles against him, but without two-thirds of the Senate they cannot remove him from office (unless the GOP grassroots abandons him, giving senators permission to do so). U.S. equities generally move upward after midterm elections - including midterms that produce gridlock (Chart 1A & Chart 1B). However, the October selloff could drag into November. More worryingly, as Chart 1B shows, the post-election rally tends to peter out only six months after a gridlock midterm, unlike midterms that reinforce the ruling party. Chart 1AMidterm U.S. Elections Tend To Be Bullish... Midterm U.S. Elections Tend To Be Bullish... Midterm U.S. Elections Tend To Be Bullish... Chart 1B... But Markets Lose Steam Six Months Post-Gridlock ... But Markets Lose Steam Six Months Post-Gridlock ... But Markets Lose Steam Six Months Post-Gridlock However, the 2018 midterms could be mildly positive for the markets, as they do not portend any major new policies or uncertainty. Trump's proposed additional tax cuts would have threatened higher inflation and more Fed rate hikes, whereas House Democrats will not be able to raise taxes or cut spending alone. Bipartisan entitlement reform seems unlikely in 2018-20 given the acrimony of the two parties and structural factors such as inequality and populism. An outstanding question is health care, which Republicans left unresolved after failing to repeal Obamacare, and which exit polls show was a driving factor behind Democratic victories. Separately, as an additional marginal positive for risk assets, the Trump administration has reportedly granted eight waivers to countries that import Iranian oil. We have signaled that Trump's "maximum pressure" doctrine poses a key risk for markets due to the danger of an Iran-induced oil price shock. A shift toward more lax enforcement reduces the tail-risk of a recession in 2019 (Chart 2). Of course, the waivers will expire in 180 days and may be a mere ploy to ensure smooth markets ahead of the midterm election, so the jury is still out on this issue. Chart 2Rapid Increases In Oil Prices Tend To Precede Recessions The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast This brings us to the main focus of this report: what do the midterms suggest about the 2020 election? Bottom Line: The midterm elections have produced a gridlocked Congress. Trump can continue with his foreign policy, most of his trade policy, his deregulatory decrees, and his appointment of court judges with limited interference from House Democrats. The only thing the Democrats can prevent him from doing is cutting taxes further. He tends to agree with Democrats on the need for more spending! While the U.S. market could rally on the back of this result, we do not see U.S. politics being a critical catalyst for markets going forward. On balance, a gridlocked result brings less uncertainty than would otherwise be the case, which is positive for markets in the short term. The Midterms And The 2020 Election There is a weak relationship at best between an opposition party's gains in the midterms and its performance in the presidential election two years later. Given that the president's party almost always loses the midterms - and yet that incumbent presidents tend to be reelected - the midterm has little diagnostic value for the presidential vote, as can be seen in recent elections (Chart 3A & Chart 3B). Chart 3AMidterm Has Little Predictive Power For Presidential Popular Vote ... The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Chart 3B... Nor For Presidential Electoral College Vote The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Nevertheless, historian Allan Lichtman has shown that since 1860, a midterm loss is marginally negative for a president's reelection chances.2 And for Republicans in recent years, losses in midterm elections are very weakly correlated with Republican losses of seats in the electoral college two years later (Chart 4). Chart 4Republican Midterm Loss Could Foreshadow Electoral College Losses The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Still, this midterm election does not give any reason to believe that Trump's reelection chances have been damaged any more than Ronald Reagan's were after 1982, or Bill Clinton's after 1994, or Barack Obama's after 2010. All three of these presidents went on to a second term. A midterm loss simply does not stack the odds against reelection. Why are midterm elections of limited consequence for the president? They are fundamentally different from presidential elections. For instance, "the buck stops here" applies to the president alone, whereas in the midterms voters often seek to keep the president in check by voting against his party in Congress.3 Despite the consensus media narrative, the president is not that unpopular. Trump's approval rating today is about the same as that of Clinton and Obama at this stage in their first term (Chart 5). This week's midterm was not a wave of "resistance" to Trump so much as a run-of-the-mill midterm in which the president's party lost seats. Its outcome should not be overstated. Bottom Line: There is not much correlation between midterms and presidential elections. The best historians view it as a marginal negative for the incumbent. This result is not a mortal wound for Trump. Chart 5President Trump Is Hardly Losing The Popularity Contest The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast 2020: The Recession Call Is The Election Call The incumbent party has lost the White House every single time that a recession occurred during the campaign proper (Chart 6).4 The incumbent party has lost 50%-60% of the time if recession occurred in the calendar year before the election or in the first half of the election year. Chart 6A 2020 Recession Is Trump's Biggest Threat A 2020 Recession Is Trump's Biggest Threat A 2020 Recession Is Trump's Biggest Threat This is a problem for President Trump because the current economic expansion is long in the tooth. In July 2019, it will become the longest running economic expansion in U.S. history, following the 1991-2001 expansion. The 2020 election will occur sixteen months after the record is broken, which means that averting a recession over this entire period will be remarkable. BCA's House View holds that 2020 is the most likely year for a recession to occur. The economy is at full employment, inflation is trending upwards, and the Fed's interest rate hikes will become restrictive sometime in 2019. The yield curve could invert in the second half of 2019 - and inversion tends to precede recession by anywhere from 5-to-16 months (Table 1). No wonder Trump has called the Fed his "biggest threat."5 Table 1Inverted Yield Curve Is An Ominous Sign The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The risks to this 2020 recession call are probably skewed toward 2021 instead of 2019. The still-positive U.S. fiscal thrust in 2019 and possibly 2020 and the Trump administration's newly flexible approach to Iran sanctions, if maintained, reduce the tail-risk of a recession in 2019. If there is not a recession by 2020, Trump is the favored candidate to win. First, incumbents win 69% of all U.S. presidential elections. Second, incumbents win 80% of the time when the economy is not in recession, and 76% of the time when real annual per capita GDP growth over the course of the term exceeds the average of the previous two terms, which will likely be the case in 2020 unless there is a recession (Chart 7). Chart 7Relative Economic Performance Could Give Trump Firepower Relative Economic Performance Could Give Trump Firepower Relative Economic Performance Could Give Trump Firepower The above probabilities are drawn from the aforementioned Professor Allan Lichtman, at American University in Washington D.C., who has accurately predicted the outcome of every presidential election since 1984 (except the disputed 2000 election). Lichtman views presidential elections as a referendum on the party that controls the White House. He presents "13 Keys to the Presidency," which are true or false statements based on historically derived indicators of presidential performance. If six or more of the 13 keys are false, the incumbent will lose. On our own reading of Lichtman's keys, Trump is currently lined up to lose a maximum of four keys - two shy of the six needed to unseat him (Table 2). This is a generous reading for the Democrats: Trump's party has lost seats in the midterm election relative to 2014; his term has seen sustained social unrest; he is tainted by major scandal; and he is lacking in charisma. Yet on a stricter reading Trump only has one key against him (the midterm). Table 2Lichtman's Thirteen Keys To The White House* The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast What would it take to push Trump over the edge? Aside from a recession (which would trigger one or both of the economic keys against him), he would need to see two-to-four of the following factors take shape: a serious foreign policy or military failure, a charismatic Democratic opponent in 2020, a significant challenge to his nomination within the Republican Party, or a robust third party candidacy emerge. In our view, none of these developments are on the horizon yet, though they are probable enough. For instance, it is easy to see Trump's audacious foreign policy on China, Iran, and North Korea leading to a failure that counts against him. Thus, as things currently stand, Trump is the candidate to beat as long as the economy holds up. What about impeachment and removal from office prior to 2020? As long as Trump remains popular among Republican voters he will prevent the Senate from turning against him (Chart 8). What could cause public opinion to change? Clear, irrefutable, accessible, "smoking gun" evidence of personal wrongdoing that affected Trump's campaigns or duties in office. Nixon was not brought down until the Watergate tapes became public - and that required a Supreme Court order. Only then did Republican opinion turn against him and expose him to impeachment and removal - prompting him to resign. Chart 8Trump Cannot Be Removed From Office The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast All that being said, Trump tends to trail his likeliest 2020 adversaries in one-on-one opinion polling. Given our recession call, we would not dispute online betting markets giving Trump a less-than-50% chance of reelection at present (Chart 9). The Democratic selection process has hardly begun: e.g. Joe Biden could have health problems, and Michelle Obama, Oprah Winfrey, or other surprise candidates could decide to run. The world will be a different place in 2020. Bottom Line: The recession call is the election call. If BCA is right about a recession by 2020, then Trump will lose. If we are wrong, then Trump is favored to win. Chart 9A Strong Opponent Has Yet To Emerge The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Is It Even Possible For Trump To Win Again? Election Scenarios Is it demographically possible for Trump to win? Yes. In 2016 BCA dubbed Trump's electoral strategy "White Hype," based on his apparent attempt to increase the support and turnout of white voters, primarily in "Rust Belt" battleground states. While Republican policy wonks might have envisioned a "big tent" Republican Party for the future, demographic trends in 2016 suggested that this strategy was premature. Indeed, drawing from a major demographic study by the Center for American Progress and other Washington think tanks,6 we found that a big increase in white turnout and support was the only 2016 election scenario in which a victory in both the popular vote and electoral college vote was possible. In other words, while "Minority Outreach" have worked as a GOP strategy in the future, Donald Trump's team was mathematically correct in realizing that only White Hype would work in the actual election at hand. This strategy did not win Trump the popular vote, but it did secure him the requisite electoral college seats, notably from the formerly blue of Wisconsin, Michigan, and Pennsylvania. Comparing the 2016 results with our pre-election projections confirms this point: Trump won the very swing states where he increased white GOP support and lost the swing states where he did not. Pennsylvania is the notable exception, but he won there by increasing white turnout instead of white GOP support.7 Can Trump do this again? Yes, but not easily. Map 1 depicts the 2016 election results with red and blue states, plus the percentage swing in white party support that would have been necessary to turn the state to the opposite party (white support for the GOP is the independent variable). In Michigan, a 0.3% shift in the white vote away from Republicans would have deprived Trump of victory; in Wisconsin and Pennsylvania, a 0.8% shift would have done the same; in Florida, a 1.5% change would have done so. Map 1The 'White Hype' Strategy Narrowly Worked In 2016 The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Critically, the country's demographics have changed significantly since 2016 - to Trump's detriment. The white eligible voting population in swing states will have fallen sharply from 81% of the population to 76% of the population by 2020 (Chart 10). Chart 10Demographic Shift Does Not Favor Trump The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast Thus, to determine whether Trump still has a pathway to victory, we looked at eight scenarios, drawing on the updated Center for American Progress study. The assumptions behind the scenarios in Table 3 are as follows: Status Quo - This replicates the 2016 result and projects it forward with 2020 demographics. 2016 Sans Third Party - Replicates the 2016 result but normalizes the third party vote, which was elevated that year. Minority Revolt - In this scenario, Hispanics, Asians, and other minorities turn out in large numbers to support Democrats, even with white non-college educated voters supporting Republicans at a decent rate. The Kanye West Strategy - Trump performs a miracle and generates a swing of minority voters in favor of Republicans. Blue Collar Democrats - White non-college-educated support returns to 2012 norms, meaning back to Democrats. Romney's Ghost - White college-educated support returns to 2012 levels. White Hype - White non-college-educated support swings to Republicans. Obama versus Trump - White college-educated voters ally with minorities in opposition to a surge in white non-college-educated voters for Republicans. Table 3Assumptions For Key Electoral Scenarios In 2020 The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The results show that Trump's best chance at remaining in the White House is still White Hype, as it is still the only scenario in which Trump can statistically win a victory in the popular vote (Chart 11). Another pathway to victory is the "2016 Sans Third Party" scenario. But this scenario still calls for White Hype, since a third party challenger is out of his hands (Chart 12).8 Chart 11'White Hype' May Be Only Way To Secure Both Popular And Electoral College Vote... The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast   Chart 12... Although Moving To The Center Could Still Yield Electoral College Vote The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast However, the data show that Trump cannot win merely by replicating his white turnout and support from 2016, due to demographic changes wiping away the thin margins in key swing states. He needs some additional increases in support. These increases will ultimately have to be culled from his record in office - which reinforces the all-important question of the timing of recession, but also raises the question of whether Trump will move to the center to woo the median voter. In the "Kanye West" and "Romney's Ghost" scenarios, Trump wins the electoral college by broadening his appeal to minorities and college-educated white voters. This may sound far-fetched, but President Clinton reinvented himself after the "Republican Revolution" of 1994 by compromising with Republicans in Congress. The slim margins in the Midwest suggest that the probability of Trump shifting to the middle is not as low as one might think. Especially if there is no recession. Independents remain the largest voting block - and they have not lost much steam, if any, since 2016. Moreover, the number of independents who lean Republican is in an uptrend (Chart 13). Without a recession, or a failure on Lichtman's keys, Trump will likely broaden his base. Chart 13Trump Shows Promise Among Independents Trump Shows Promise Among Independents Trump Shows Promise Among Independents Bottom Line: Trump needs to increase white turnout and GOP support beyond 2016 levels in order to win 2020. Demographics will not allow a simple repeat of his 2016 performance. However, he may be able to generate the requisite turnout and support by moving to the center, courting college-educated whites and even minorities. His success will depend on his record in office. Investment Implications What are the implications of the above findings for 2018-20 and beyond? The Rust Belt states of Michigan, Pennsylvania, and Wisconsin will become pseudo-apocalyptic battlegrounds in 2020. The Democrats must aim to take back all three to win the White House, as they cannot win with just two alone.9 They are likely to focus on these states because they are erstwhile blue states and the vote margin is so slim that the slightest factors could shift the balance - meaning that Democrats could win here without a general pro-Democratic shift in opinion that hurts Trump in other key swing states such as Florida, North Carolina, or Arizona. The "Blue Collar Democrat" scenario, for instance, merely requires that white non-college-educated voters return to their 2012 level of support for Democrats. Joe Biden is the logical candidate, health permitting, as he is from Pennsylvania and was literally on the ballot in 2012! Moreover, these states are the easiest to flip to the Democratic side via the woman vote. In Michigan, a 0.5% swing of women to the Democrats would have turned the state blue again; in Pennsylvania that number is 1.6% and in Wisconsin it is 1.7% (Table 4). These are the lowest of any state. Women from the Midwest or with a base in the Midwest - such as Michelle Obama or Oprah Winfrey - would also be logical candidates. Table 4Women Voters May Hold The Balance The 2020 U.S. Election: A "Way Too Soon" Forecast The 2020 U.S. Election: A "Way Too Soon" Forecast The Democrats could also pursue a separate or complementary strategy by courting African American turnout and support, especially in Florida, Georgia, and North Carolina. But it is more difficult to flip these states than the Midwestern ones. With the Rust Belt as the fulcrum of his electoral strategy and reelection, Trump has a major incentive to maintain economic nationalism over the coming two years. Trump may be more pragmatic in the use of tariffs, and will certainly engage in talks with China and others, but he ultimately must remain "tough" on trade. He has fewer constraints in pursuing trade war with China than with Europe. For the same Rust Belt reason, the Democrats, if they get into the Oval Office, will not be overly kind to the "butchers of Beijing," as President Clinton called the Chinese leadership in the 1992 presidential campaign (after the 1989 Tiananmen Square incident). Hence we are structurally bearish U.S.-China relations and related assets. Interestingly, if Trump moves to the middle, and tones down "white nationalism" in pursuit of college-educated whites and minorities, then he would have an incentive to dampen the flames of social division ahead of 2020. The key is that in an environment without recession, Trump has the option of courting voters on the basis of his economic and policy performance alone. Whereas if he is seen fanning social divisions, it could backfire, as Democrats could benefit from a sense of national crisis and instability in a presidential election. Either way, culture wars, controversial rhetoric, identity politics, unrest, and violence will continue in the United States as the fringes of the political spectrum use identity politics and wedge issues to rile up voters.The question is how the leading parties and their candidates handle it. What about after 2020? Are there any conclusions that can be drawn regardless of which party controls the White House? The two biggest policy certainties are that fiscal spending will go up and that generational conflict will rise. On fiscal spending, Trump was a game changer by removing fiscal hawkishness from the Republican agenda. Democrats are not proposing fiscal responsibility either. The most likely areas of bipartisan legislation in 2018-20 are health care and infrastructure - returning House Speaker Nancy Pelosi mentioned infrastructure several times in her election-night speech - which would add to the deficit. The deficit is already set to widen sharply, judging by the fact that it has been widening at a time when unemployment is falling. This aberration has only occurred during the economic boom of the 1950s and the inflation and subsequent stagflation beginning in the late 1960s (Chart 14). The current outlook implies a return of the stagflationary scenario. In the late 1960s, the World War I generation was retiring, lifting the dependent-to-worker ratio and increasing consumption relative to savings. Today, as Peter Berezin of BCA's Global Investment Strategy has shown, the Baby Boomers are retiring with a similar impact. Chart 14The Deficit Is Blowing Out Even Without A Recession The Deficit Is Blowing Out Even Without A Recession The Deficit Is Blowing Out Even Without A Recession Trump made an appeal to elderly voters in the midterms by warning that unfettered immigration and Democratic entitlement expansions would take away from existing senior benefits. By contrast, Democrats will argue that Republicans want to cut benefits for all to pay for tax cuts for the rich, and will try to activate Millennial voters on a range of progressive issues that antagonize older voters. The result is that policy debates will focus more on generational differences. Mammoth budget deficits - not to mention trade war - will be good for inflation, good for gold, and a headwind for U.S. government bonds and the USD as long as the environment is not recessionary. The greatest policy uncertainties are health care and immigration. These are the two major outstanding policy issues that Republicans and Democrats will vie over in 2018 and beyond. While President Trump could achieve something with the Democrats on either of these issues with some painful compromises, it is too soon to have a high conviction on the outcome. But assuming that over the coming years some immigration restrictions come into play and that some kind of public health care option becomes more widely available, there are two more reasons to expect inflation to trend upward on a secular basis. Also on a secular basis, defense stocks stand to benefit from geopolitical multipolarity, especially U.S.-China antagonism. Tech stocks stand to suffer due to the trade war and an increasingly bipartisan consensus that this sector needs to be regulated.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   1 Furthermore, victories on the state level, if built upon in the 2020 election, could give the Democrats an advantage in gerrymandering, i.e. electoral redistricting, which is an important political process in the United States. 2 Please see Allan J. Lichtman, Predicting The Next President: The Keys To The White House 2016 (New York: Rowman and Littlefield, 2016). 3 Please see Joseph Bafumi, Robert S. Erikson, and Christopher Wlezien, "Balancing, Generic Polls and Midterm Congressional Elections," The Journal of Politics 72:3 (2010), pp. 705-19. 4 Please see footnote 2 above. 5 Please see Sylvan Lane, “Trump says Fed is his ‘biggest threat,’ blasting own appointees,” The Hill, October 16, 2018, available at thehill.com. 6 Please see Rob Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, dated April 14, 2018, available at www.americanprogress.org. 7 In several cases, he did not have to lift white support by as much as we projected because minority support for the Democrats dropped off after Obama left the stage. 8 Interestingly, however, this scenario would result in an electoral college tie! Since the House would then vote on a state delegation basis, it would likely hand Trump the victory (and Pence would also win the Senate). 9 However, if they win Pennsylvania plus one electoral vote in Maine, they can win the electoral college with either Michigan or Wisconsin.

Highlights Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 Critical Reset Critical Reset FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid VIX The Comeback Kid VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Economic Impulse Yellow Flag Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Economic Growth Trouble Economic Growth Trouble Chart 5Watch Credit Quality Watch Credit Quality Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought Overvalued And Overbought Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Capex Blues Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Warning Signals... Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... ...Abound... ...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... ...Even In Intermodel... ...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets ...But There Are Offsets ...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Too Good To Be True Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion No Valuation Cushion No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... Mixed Signals... Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads ...On Crack Spreads ...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Mounting supply-side uncertainty will keep the risk premium in oil prices - and volatility - elevated after U.S. export sanctions against Iran kick in November 4 (Chart of the Week). Chart of the WeekOil-Price Risk Premium Will Continue To Increase Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity These sanctions likely will remove 1.0 - 1.5mm b/d of Iranian exports, and absorb the combined spare capacity of the Kingdom of Saudi Arabia (KSA) and Russia (Chart 2) in the process. Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put the supply-side risks sharply in focus. Chart 2Lost Iranian Exports Could Exceed KSA's and Russia's Spare Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity OPEC 2.0's production increases last month calmed markets.1 All the same, it is worth noting they occurred just before a widely expected U.S. Strategic Petroleum Reserve (SPR) release coinciding with refinery turnarounds, and one-off Asian demand shocks. On the back of these supply boosts, and an upward revision to U.S. shale output (see below), and a slight decrease in our expected demand growth next year, we lowered our 2019 Brent forecast to $92/bbl from $95/bbl. We now expect Brent prices to peak in April 2019. WTI will trade $6/bbl lower (Chart 3). Our forecasts are conditioned on Iranian export losses of 1.25mm b/d, and Venezuelan losses of just over 450k b/d. A loss of 1.7mm+ b/d of Iran exports, as Platts Analytics expects, or a Venezuela collapse, means an unplanned outage anywhere will take prices above $100/bbl. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 Highlights Energy: Overweight. The IMF downgraded global GDP growth expectations from 3.9% to 3.7% p.a. this year and next. This reduced our base case demand growth for 2019 slightly, to 1.5mm b/d from 1.6mm b/d previously. Base Metals: Neutral. Global copper stocks stand at half their late April peak - the lowest level since late 2016, on the back of restrictions on Chinese scrap imports. Precious Metals: Neutral. Palladium traded to record levels above $1,140/oz this week, as persistent physical deficits into 2020 are priced into the market. Ags/Softs: Underweight. The USDA's Crop Progress Report showed soybean harvests accelerating: 53% of the crop was harvested as of last week, below the 2013 - 17 average of 69%, but well above the previous week's 38% level. Feature U.S. Treasury Secretary Steve Mnuchin is convinced global oil markets have fully priced in the loss of Iranian crude oil exports arising from the re-imposition of export sanctions by the U.S. November 4. Speaking with Reuters over the weekend, he said, "Oil prices have already gone up, so my expectation is that the oil market has anticipated what's going on in the reductions. I believe the information is already reflected in the price of oil."2 We are not so sure. The price-decomposition model shown in the Chart of the Week is a bottom-up fundamental model that assesses how changes in OPEC and non-OPEC supplies, global demand and inventories contribute to overall price changes, as new information becomes available regarding these variables. These variables are shown in Chart 4 and Table 1.3 Chart 4BCA Global Oil Supply-Demand Balances BCA Global Oil Supply-Demand Balances BCA Global Oil Supply-Demand Balances The "residual" term in the model covers everything not explained by these fundamental variables.4 We believe the unexplained effect on prices in the residuals reflects market participants' perception of riskiness - either to supply or demand - given the big fundamental drivers of price are accounted for in the other variables. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Close inspection reveals the residual term has been increasing as we approach the deadline for the re-imposition of U.S. sanctions on Iran. And the fact is, estimates of the loss in Iranian exports are widely dispersed - from less than 1mm b/d to 1.7mm b/d by tanker trackers like Platts Analytics. As Chart 2 shows, export losses at the high end of this range would absorb almost all of the world's spare capacity - the 1.3mm b/d the U.S. EIA estimates for OPEC (most of it held by KSA, plus whatever other Gulf Arab producers can muster). Russia, which is producing at a record of ~ 11.4mm b/d, likely has ~ 250k b/d of spare capacity at its disposal. With the increase in global demand largely being covered by U.S. shales, which are constrained to ~ 1.3mm b/d of growth p.a. until 2H19, when we expect production to increase at a 1.44mm b/d annual rate, this leaves the global market perilously exposed to any and all unplanned production outages. Any deterioration in Venezuela's production, which we expect to fall to 865k b/d on average in 2019 (versus 1.3mm b/d on average this year), or an unplanned loss in exports from historically unstable states like Nigeria and Libya - where we raised our production estimates to 1.75mm b/d and 1.05mm b/d in line with OPEC survey data - almost surely will spike prices above $100/bbl.5 OPEC 2.0 Got Lucky OPEC 2.0 - the producer coalition led by KSA and Russia - picked a fortuitous moment to increase production this past month. OPEC, led by KSA, lifted crude and liquids production 140k b/d in September, while Russia's production rose 150k b/d. It is worth noting these output increases occurred just before a widely expected U.S. SPR release in October - November, which overlapped with refinery maintenance (turnaround) season in the U.S. Midwest refiners were expected to take 300k to 460k b/d of capacity offline in September and October, a relatively high level of maintenance, while Gulf Coast refiners were expected to take 430k to 535k b/d down.6 Both events raise the supply of crude relative to demand, and reduce inventory drawdowns. In addition, one-off Asian demand shocks - an earthquake and typhoon in Japan - dented demand. KSA lifted its production to 10.5mm b/d in September, bringing average 3Q18 production to 10.4mm b/d versus a bit more than 10mm b/d in 1H18. Russia's crude and liquids output rose to 11.45mm b/d in 3Q18 versus 11.2mm b/d in 1H18. The higher production calmed markets somewhat. OPEC 2.0 effectively got a two-month assist from the U.S. refinery turnarounds and a U.S. SPR release, just as markets were fretting prices would breach $90/bbl earlier this month.7 These production boosts will allow OECD inventories to rebuild somewhat going in to the Northern Hemisphere's winter (Chart 5). Nonetheless, OPEC 2.0 has begun tearing into spare capacity with these output increases. Chart 5OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild KSA Talks Markets Lower... While the U.S. SPR release and inventory builds associated with U.S. turnarounds progressed, KSA's Energy Minister Khalid al-Falih was reassuring markets the Kingdom can ramp production to 11mm b/d, and even 12mm b/d if needs be. KSA has been increasing rig counts in 2H18 as Brent prices rise, but we remain highly dubious KSA can ramp production to 11mm b/d - let alone 12mm b/d - and sustain it for any meaningful length of time (Chart 6). Chart 6KSA Increasing Rig Counts, After Price-Induced Slowdown KSA Increasing Rig Counts, After Price-Induced Slowdown KSA Increasing Rig Counts, After Price-Induced Slowdown The likelihood KSA can significantly boost production before the end of 1H19 became even more doubtful, following reports the Kingdom and Kuwait were having difficulty agreeing on restarting Neutral Zone production. We've downgraded our assessment that 350k b/d of Neutral Zone production will be returned to the market beginning in 2Q19 to a 50% likelihood, following reports KSA and Kuwaiti officials are diverging on operational control of the production. Apparently, the two states also differ on geopolitical issues in the Gulf, as well - e.g., the Qatar blockade lead by KSA, and Iran policy.8 While core Gulf Arab producers are raising output, we expect the non-Gulf members of the Cartel continue to see output decline (Chart 7). Indeed, with the exception of the core OPEC Gulf Arab producers, U.S. shale operators and Russia, the rest of the world is barely keeping its output level (Chart 8). Chart 7Non-Gulf OPEC Output Continues to Decline Non-Gulf OPEC Output Continues to Decline Non-Gulf OPEC Output Continues to Decline Chart 8Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia ...And Shores Up Export Capacity Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put global supply-side risks sharply in focus. KSA has added 3 mm b/d of oil export capacity to the Red Sea coast of the Kingdom, with an upgrade to its Yanbu crude oil terminal. Prior to the expansion, Yanbu terminal's export capacity was 1.3mm b/d; it was used mainly for refined products and petrochemicals shipments, due to its relative proximity to refineries in Yanbu, Rabigh, Yasref, Jeddah and Jazan. Shipping via the Red Sea port allows KSA to move crude to Asia through the Bab el-Mandeb Strait to the south, which at times is threatened by Yemen's Houthi militia, and the north to Western markets through the Suez Canal. In addition, KSA's national oil company, Aramco, says it intends to restore operations at al-Muajjiz crude oil terminal, which has been out of operation since Iraq's invasion of Kuwait in 1990. Aramco intends to integrate the Muajjiz terminal into the Yanbu facilities to expand Red Sea export capacity from ~ 8 mm b/d to some 11.5 mm b/d. KSA's total export capacity is scheduled to reach 15mm b/d by year-end. These expansions give KSA the option to reroute all of its ~ 7mm b/d exports through the Red Sea, in the event the Strait of Hormuz is closed by Iran. However, this option could be limited by pipeline infrastructure. The current capacity of the East - West crude pipeline is 5mm b/d, although Aramco signalled its intention to boost capacity to 7mm b/d by end-2018. No announcements indicating this was on schedule or completed could be found. Global Demand Holds Up The IMF downgraded its global GDP growth expectation from 3.9% p.a. to 3.7% this year and next. This reduced our base case demand growth for 2019 to 1.5mm b/d from 1.6mm b/d. Even so, we note that oil prices for EM consumers in local-currency terms are at or close to post-GFC highs (Charts 9A and9B). A number of EM governments relaxed or removed subsidies on fuel prices following the oil-price collapse of 2014 - 16, which means consumers in these states are feeling most or all of the effect of higher prices directly for the first time in the modern era (beginning in the 1960s, when OPEC became the dominant producer cartel in the market).9 Chart 9ALocal-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Chart 9BLocal-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies As we've noted previously, high fuel costs (in local-currency terms) coupled with high absolute prices deliver a double-whammy to EM consumers, which are the driving force in global oil-demand growth. In fact, 1.1mm b/d of the 1.5mm b/d of demand growth we expect next year in our base case is accounted for by EM growth. In our scenarios analysis, we assume every $10/bbl jump in prices above $90/bbl destroys 100k b/d of EM demand. This lowers the unconstrained oil-price trajectory, and reduces our base case growth estimate of 1.5mm b/d next year to 1.3mm b/d (Chart 10). Chart 10An Oil-Supply Shock Would Lower Demand An Oil-Supply Shock Would Lower Demand An Oil-Supply Shock Would Lower Demand An oil-supply shock that seriously erodes EM demand would - in the course of months, we believe - translate into a disinflationary impulse into DM markets. This could force the Fed to change course and dial its rates-normalization policy back, as we recently noted.10 Bottom Line: Volatility will remain elevated following the re-imposition of sanctions against Iran's oil exports next month. OPEC 2.0's fortuitously timed production increases - coincident with a scheduled U.S. SPR release and refinery turnarounds - will be absorbed by markets once turnaround season ends in the U.S. Global spare capacity is insufficient to cover Iranian export losses at the high end of market expectations, if Venezuelan production falls more than expected or that state collapses. Any unplanned outage anywhere will quickly push prices through $100/bbl, necessitating further U.S. SPR releases. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by KSA and Russia. This coalition likely will be formalized at the December 7 OPEC meeting in Vienna via treaty. This has been alluded to over the past year, most recently in an interview given to Tass, the Russian state-owned news agency. Please see "Saudi energy minister Al-Falih speaks to TASS on OPEC+, oil prices and Khashoggi," published by TASS, October 22, 2018. 2 Please see "Mnuchin says it will be harder for Iran oil importers to get waivers," published by uk.reuters.com October 21, 2018. 3 The Federal Reserve Bank of New York publishes a similar price-decomposition model weekly in its "Oil Price Dynamics Report," which is available online. 4 We can assume USD effects will be reflected in demand and supply at the margin - i.e., a stronger USD reduces demand by raising the local-currency costs of oil, and increases supply by lowering the local-currency costs of production, and vice versa. Uncertainty as to the USD's trajectory adds to overall uncertainty in the model. 5 This likely would trigger withdrawals from the U.S. SPR, or the EU's strategic petroleum reserves, but that will take time to implement. Both Libya and Nigeria likely will hold elections next year: Nigeria in February, Libya possibly on December 10, but more likely next year following passage of a UN resolution to extend the mandate of its political mission there to September 15, 2019. Civil unrest in Libya has been increasing, as ISIS fighters increase the tempo of operations on the ground. 6 Please see "Falling into refiner Turnaround Season & Maintenance outlook," published by Genscape August 23, 2018. 7 This occurs at a fortuitous time in the U.S. election cycle, as mid-terms will be held November 6, two days after Iran sanctions kick in. We expected an SPR draw ahead of midterms; please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018. It is available at: ces.bcaresearch.com. 8 Please see "Oil output from Saudi, Kuwait shared zone on hold as relations sour," published by uk.reuters.com October 18, 2018. 9 The U.S. Federal Reserve is in the process of a rates-normalization cycle, which likely will keep the USD appreciating against EM currencies into next year. Our House view calls for five additional hikes between December and the end of 2019. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018, for further discussion. ces.bcaresearch.com. 10 We discuss this at length in a Special Report published last week with BCA Research's entitled "Man Bites Dog: Could Sharply Rising Oil Prices Lead To Lower Global Bond Yields in 2019?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Trades Closed in 2018 Summary of Trades Closed in 2017 Summary Of Trades Closed In 2017 Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity

Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating Global Trade Is Decelerating Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Bank And Non-Bank Credit Has Diverged Bank And Non-Bank Credit Has Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money China: The Velocity Of Money China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? China: What Drives Interest Rates? China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier China: Money Multiplier China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices A Risk To Oil Prices A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging Global Oil Output Has Been Surging Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations