Equities

Prefer Large Caps To Small Caps (High-Conviction) This week’s NFIB survey showed that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel). This has coincided with the continued slide of small cap stocks relative to their large cap peers. What stood out to us was the percentage of small businesses with planned labor compensation increases continuing to set new all-time highs and deviating substantially from the national trend (second panel). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of balance sheet discipline small caps have shown in the past five years (bottom panel), ongoing large cap outperformance seems ever more likely. Bottom Line: We reiterate our high-conviction call favoring large over small caps.    

Highlights All of our recent investment recommendations have performed very strongly but have further to go: 1.   Own a combination of European banks plus U.S. T-bonds. 2.   Overweight EM versus DM. 3.   Overweight European versus U.S. equities. 4.   Overweight Italian assets versus European assets. 5.   Overweight the JPY. Feature Chart of the WeekBank Outperformance Corroborates A Growth Rebound 2019 will be the investment mirror-image of 2018. Last year started with growth fading and inflation on the cusp of picking up, both in Europe and around the world. This year has started with the European and global economies in the mirror-image configuration: growth likely to rebound, albeit modestly, and inflation set to fade (Chart I-2). Chart I-2Why 2019 Is The Mirror-Image Of 2018 However, as 2019 unfolds, the configuration will reverse, requiring a flip from a pro-cyclical to a pro-defensive investment tilt later in the year. This contrasts with 2018 which started pro-defensive and ended pro-cyclical. In this regard, the economic and investment shape of 2019 will be the mirror-image of 2018. Growth To Rebound, Inflation To Fade A tell-tale sign of a growth rebound is the recent outperformance of banks. Around the world, yield curves have flattened – or even inverted – meaning that banks’ net interest margins have compressed. This compression of bank profit margins is normally bad news for bank equities. Yet banks have been outperforming, not just in Europe but globally (Chart I-3). If margins are compressing, the plausible explanation for outperformance would be an improved outlook for asset growth, reflecting both a reduction in bad debt provisioning and a pick-up in bank credit growth. Chart I-3Banks Have Been Outperforming Since October Independently and reassuringly, our proprietary credit impulse analysis supports this thesis (Chart of the Week). Six-month credit impulses have been rebounding not only in Europe, but also in the United States and very impressively in China (Chart I-4).   Chart I-46-Month Credit Impulses Have Rebounded Everywhere At the same time, inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater “dependence on the incoming data”, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields. In this configuration, the combination of European banks plus U.S. T-bonds which we first recommended in November is still appropriate (Chart I-5). The position is up 3 percent in little more than a month and has further to go.1 Chart I-5Own A Combination Of Banks And Bonds Europe’s largest economy, Germany, should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-6). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.2 Chart I-6German Auto Exports Suffered A WLTP Hit Regional Allocation Is Always And Everywhere About Sectors The European equity earnings cycle is tightly connected with global growth oscillations (Chart I-7). The simple reason is that the European equity market is over-exposed to classically growth-sensitive sectors such as banks and industrials. Chart I-7The European EPS Cycle Is Tightly Connected With Global Growth Oscillations The emerging market earnings cycle is also connected with global growth oscillations (Chart I-8) because emerging markets have a very high exposure to banks. But the much less understood reason is that emerging markets have a near-zero exposure to healthcare (Table I-1). In sharp contrast, the U.S. equity earnings cycle has almost no connection with global growth oscillations (Chart I-9) because the U.S. equity market is over-exposed to technology and healthcare, neither of which are classically cyclical sectors. Chart I-8The EM EPS Cycle Is Also Connected With Global Growth Oscillations... Chart I-9...But The U.S. EPS Cycle Is Not Connected With Global Growth Oscillations Hence the allocation to emerging market (EM) versus developed market (DM) equities, and to Europe versus the U.S. reduce to simple equity sector calls. A quick glance at Chart I-10 and Chart I-11 will reveal two fundamental and inescapable truths: Chart I-10EM Outperforms DM When Global Banks Outperform Healthcare Chart I-11European Equities Outperform U.S. Equities When Global Banks Outperform Technology EM outperforms DM when global banks outperform global healthcare. European equities outperform U.S. equities when global banks outperform global technology. But is this just about so-called ‘beta’? No, banks can outperform in a rising market by going up more or, as recently, in a falling market by going down less. So this is always and everywhere about head-to-head sector relative performances. My colleague Arthur Budaghyan, our chief emerging market strategist, remains steadfastly pessimistic on the structural outlook for EM versus DM. We agree with Arthur, albeit we arrive at the structural conclusion from a completely different perspective. To reiterate, for EM to outperform DM global banks must outperform global healthcare. However, over an extended period this will prove to be an extremely tall order. As detailed in European Banks: The Case For And Against, blockchain is a long-term extinction threat to banks’ business models and profitability. Whereas healthcare is still a major growth sector as people focus more spending on improving the quality and quantity of their lifespans.3  Nevertheless, from a purely tactical perspective, the growth up-oscillation phase that started in October can continue for a little while longer allowing the recent countertrend moves to persist – especially as the recent decline in bond yields could further spur credit growth in the near term. So for the moment stay overweight: EM versus DM. European equities versus U.S. equities. Italian assets versus European assets. Bargain Basement Currencies Another of my colleagues Doug Peta, our chief U.S. strategist, has coined a lovely metaphor: “you cannot get hurt falling out of a basement window”. The metaphor beautifully captures the asymmetry when you are near the floor or ‘zero-bound’. Doug uses it to explain that small contributors to an economy have a limited capacity to damage economic growth because they cannot fall very far. We think the metaphor applies equally to interest rates when they are at or near their lower bound, which is to say, in the basement. This begs the obvious question: if interest rates are in the basement, then what is it that cannot get hurt much? The answer is: the exchange rate. The payoff profile for exchange rates just tracks expected long-term interest rate differentials. This means that when the expected interest rate is in or near the basement, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy – such as the BoJ and ECB – policy rate expectations are effectively in the basement. They cannot go significantly lower. In contrast, policy rate expectations for the Federal Reserve are somewhere between the seventh and twelfth storey of the building (Chart I-12). From which you can get seriously hurt if you fall out of the window! Chart I-12You Cannot Get Hurt Falling Out Of A Basement Window The upshot is that currency investors should always own at least one currency whose interest rate is in the basement against one whose interest rate is high up in the building, susceptible to fall out at some point, and get seriously hurt. The near term complication is the risk, albeit low, of a no-deal Brexit which would hurt European economies and currencies to a greater or lesser extent. Until the Brexit fog shows some signs of clearing, we would prefer the currency whose interest rate is in the basement to be a non-European currency. So for the moment, our favourite major currency remains the JPY. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* We are pleased to report that the 50:50 combination of Litecoin and Ethereum has surged by 42 percent in just two weeks! Also, long EUR/NZD achieved its 2.5 percent profit target and is now closed. This week’s trade is in line with the recommendation in the main body of this report to become pro-cyclical. Go long global industrials versus global utilities with a profit target of 3 percent and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The European banks position is relative to the broader equity market, and the recommended combination is 25 cents in the banks and 75 cents in the bonds. 2 German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1, 2018. 3 Please see the European Investment Strategy Special Report “European Banks: The Case For And Against”, November 8, 2018 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Dear Client, This Wednesday January 9th 2019, we are publishing a joint report co-written with BCA’s Geopolitical Strategy team. There will be no report on Friday. Best Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Highlights So What? U.S. President Donald Trump is not solely focusing on stock prices, but he does not want an entrenched bear market to develop under his watch. Why? Entrenched bear markets often herald recessions. A recession would seriously endanger Trump’s re-election chances. The Federal Reserve will not alter its course to please Trump, but it will pause in order to safeguard the economy. While at first the dollar will weaken in response to a Fed pause, economic fundamentals argue that the greenback will enjoy a last hurrah before a true bear market can begin. Feature Despite U.S. President Donald Trump’s legendary concern for the stock market, the S&P 500 is nonetheless down 6.7% since his G-20 truce with Chinese President Xi Jinping. We mark that date as notable on Chart I-1 – not because we think it caused the markets to plunge, but because many investors thought it would buoy equities into a Santa Claus rally. Further, many investors predicted that the G-20 truce would come about specifically because Trump wanted stocks to do well. Chart I-1Santa Did Not Show Up After The Buenos Aires Meeting There are so many methodological problems with this train of thought that it could be the main thrust of a PhD dissertation. But, for starters, the assertion that Trump is obsessed with stocks embeds causality into a dependent variable. In simple terms, it posits that the stock market’s performance is an end in of itself for President Trump, and thus he will do whatever it takes to prolong the bull market. Here’s a hint for the collective investment community: If something sounds too good to be true, it is almost definitely not true. The idea that the President of the United States, no matter how unorthodox… …Exclusively cares about the stock market… … And has the extraordinary power… ... and mental acumen… …to keep the stock market perpetually rising, is indeed too good to be true. First, President Trump has clearly shown that he does not exclusively care about the stock market, by shutting down the government midway through a bear market. Now, it is not clear to us how a federal government shutdown directly impacts the earnings of U.S. companies, but it is clear that it does not instill confidence among investors that Trump and the incoming Democrat-held House will be able to play nice together, or at least nice enough, to avert a potentially recession-inducing 2020 stimulus cliff (Chart I-2). Chart I-2Can Trump And The Democrats Play Nice Enough To Dodge The Cliff? BCA’s Geopolitical Strategy noted the danger of the government shutdown by calling it “the one true midterm-related risk.” The reasoning was that, “A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020.” Further to this point, Trump has not exactly been a boon to the stock market since passing his signature legislation – the tax reform bill – at the end of 2017. Throughout 2018, he has focused his policy on a trade war with China, and we would also argue with a view towards the 2020 election. Now admittedly, the stock market completely and utterly ignored all bad news on the trade front (Chart I-3) – ironically, until a truce was called! – but the fact remains that President Trump did not listen to the almost-certain advice from his “globalist” advisors that a trade war could, at some point, hurt the S&P 500. Chart I-3The Market's Schizophrenic Relationship With The Trade War Second, the President of the United States of America is not a medieval king. He is not even the president of China nor even the prime minister of Canada (both policymakers with far more power inside their own political systems than the American president).1 The president is massively constrained in terms of economic policy by the Congress, a branch of government he only nominally has influence over. Further, his regulatory policy can be impeded by the bureaucracy and the courts. In addition, steering an economy as massive and multifaceted as that of the U.S. is not a one-man job. It is not a “job” at all. The best a president can do is set the conditions in place – through regulation, tax policy, and rhetoric – which stokes animal spirits in a positive direction. For much of 2017 and early 2018, President Trump did this. But the stock market, and the economy by extension, always wants more. More pro-business regulation and more reassuring rhetoric. President Trump generally gets an A on the former, but an F on the latter. Not only is the trade war a concern to investors, but so are a slew of other confidence-deflating comments by the president on FAANG regulation, the government shutdown, the White House staffing, the Fed’s independence, and foreign policy writ large. As for the question of mental acumen, President Trump may be a “stable genius,” but no single policymaker is able to influence equities. As an aside, we are shocked by how much the investment community has changed in the past eight years. When we began taking politics seriously in our investment strategy, back in 2011, it took a lot of convincing that systemic political analysis had a role to play with respect to one’s asset allocation. Now, investors are willing to bet their shirt on the actions of one politician. It is as if the investment community is trying to overcorrect for decades of ignoring politics as a valuable input in one single presidential term. So, what does this mean for U.S. equities from here on out? We agree with our clients that the one thing President Trump wanted to avoid was a bear market. We staunchly disagreed that equities could not correct significantly under his watch, and we shorted the S&P 500 outright in September, but we begrudgingly agreed that President Trump, as with all other presidents before him, would rather not deal with a bear market. Those tend to foreshadow a recession, and recessions tend to end re-election bids (Chart I-4). For much of 2019, we expect that President Trump will focus on ensuring that a recession does not occur ahead of his 2020 election bid. This is likely to become a defining motivating factor in all policy, whether domestic, foreign or trade. Can he be successful? It is not up to the U.S. President to determine when a recession hits, but the point is that he is likely to put his re-election bid above all other considerations. As such, we would expect that: The government shutdown will be resolved in January. A compromise will emerge to end the shutdown that falls short of president Trump’s demands. Ultimately, Trump needs Democrats to play ball with the White House and the Republican Senate in order to avert the stimulus cliff in 2020. Trade negotiations may produce a truce. There is a combined, subjective, probability of 70-75% that the ongoing trade negotiations produce either an outright deal (45-50%) or an extension of the talks with no further tariffs (25%). Trump is likely to back off from further trade antagonism, at least until the run-up to the 2020 election. There will be a parallel process where a China-U.S. tech war continues. Attacks on the Fed will cease. At least until the 2020 election, or until the recession actually hits. But with the Fed itself already signalling that it won’t be dogmatic, the reasons to go after the central bank will recede. Bottom Line: President Trump does not care about stock prices any more than other presidents have in the past. What matters to him is to avoid a protracted bear market in equity prices, as it would severely raise the probability of an upcoming recession, endangering his chances of re-election. This means the government shutdown will likely end this month, that the trade negotiations have a solid chance of producing a protracted truce, and that attacks on the Fed will ebb. Can The Dollar Rally Further? Is a U.S. president focused on avoiding a recession in order to get re-elected a good thing or a bad thing for the dollar? While stronger U.S. growth is inherently a positive for the dollar, the current juncture muddies the waters. To begin with, the risk of a correction in the U.S. dollar has risen considerably in recent weeks. The dollar is historically a momentum currency, implying that as much as strength begets further strength, weakness begets additional weakness.2 As a result, the fall in the DXY from 97.5 in December to 96 raises a red flag. This red flag is even more worrisome when looking at the dollar’s technical picture (Chart I-5). The 13-month rate-of-change has been forming a bearish divergence with prices, and both sentiment and net speculative positioning are holding at lofty levels. Not only does this confirm that on a tactical basis, the dollar is losing momentum, but it also highlights that if momentum deteriorates further, a large pool of potential sellers exist. Chart I-5Tactical Risks For The Greenback Policy too constitutes a risk. President Trump could relent on his attacks on the Fed, but as we mentioned, the Fed seems to also be relenting on its own hard-nosed approach to monetary policy. Last Friday, Fed Chairman Jerome Powell highlighted that policy was not on autopilot, and that monetary policy is ultimately data dependent. In fact, the Federal Open Market Committee is not antagonistic to a pause in its hiking campaign, nor to tweaking its balance-sheet policy if economic and financial conditions deteriorate further. The Fed moving away from hiking once every quarter should provide ammunition to sellers of the greenback. However, the interest rate market already has very muted expectations for the Fed, anticipating 6 basis points and 17 basis points of cuts over the next 12 and 24 months, respectively (Chart I-6). Thus, to be a durable headwind to the dollar, the Fed needs to be more dovish than what is already priced in. We doubt this will be the case: Chart I-6Scope For A Hawkish Fed Surprise In 2019 The ISM may have been weak, but the U.S. continues to generate a healthy level of job growth, and wages continue to accelerate (Chart I-7). Down the road, this will be inflationary. Consumption, or 68% of GDP, remains healthy. Real retail sales excluding motor vehicle and part dealers are still growing at a 4.3% pace. Robust job and wage growth will continue to support the ultimate driver of household spending: disposable income. Moreover, the household savings rate stands at 6% of disposable income, debt-servicing costs at 9.9%, and overall household debt has fallen to 100%, a level not seen since the turn of the century. The financial health of households insulates them against the negative impact of the tightening in financial conditions recorded this past fall.  Despite the recent deterioration in the ISM and the rise in credit costs, commercial and industrial loan growth continues to accelerate, with both the annual and the quarterly-annualized growth rates of this series rising the most in more than two years (Chart I-8). Chart I-7U.S. Wages Are Still Accelerating Chart I-8Positive Developments On The U.S. Credit Front Based on this combination, we would anticipate the Fed pausing in its hiking campaign for one to two quarters. This would nonetheless represent a more hawkish outcome than the one expected by the market, and thus would not be a dollar-bearish configuration. In our view, the biggest domestic risk for the Fed remains the housing market, which for most of this cycle has been the principal vehicle through which monetary policy has been transmitted to the economy. Housing has indubitably slowed, but the recent pick-up in the purchases component of the Mortgage Bankers Association index gives hope that this sector is making a trough as we write. What about tighter financial conditions: could they also threaten the dollar? After all, the tightening in FCI in the second half of 2018 is acting as a break on growth, diminishing the need for Fed hikes. If stocks and high-yield bonds sell off further, the Fed will likely hike less than we anticipate. However, a Fed pause and the more attractive valuations created by the recent selloff suggest that FCI should not deteriorate much more. Indeed, the 64-basis-point contraction in high-yield spreads since January 3rd shows that financial conditions have begun to ease. Our Global Investment Strategy team thinks that stocks are a buy, a view also consistent with an easing in U.S. FCI.3 As a result, we do not believe that U.S. financial conditions will force the Fed to cut rates, and thus will not create a handicap for the dollar. Finally, the most important factor for the dollar remains global growth. The dollar historically performs best when both global growth and inflation are decelerating (Chart I-9). Because the U.S. economy has a low exposure to both manufacturing and exports, it is a low-beta economy, relatively insulated from the global industrial cycle. Hence, when global growth decelerates, the U.S. suffers less than the rest. As a result, the U.S. syphons funds from the rest of the world, lifting the dollar in the process. Currently, the outlook for global growth remains poor. At the epicenter of it all lies China. Chinese manufacturing PMIs have fallen below 50. There are plenty of reasons to worry that the slowdown will not end here. Chinese consumers too are feeling the pinch, despite having been the recipient of much governmental support, including tax cuts (Chart I-10). Moreover, the fall in the combined fiscal and credit impulse also suggests that Chinese imports could suffer more in the coming months, creating a greater drag on the trading nations of the world (Chart I-11). Finally, China’s rising marginal propensity to save confirms these insights, pointing to slowing Chinese industrial activity and imports as well as deteriorating global export growth and industrial activity (Chart I-12).4 Chart I-10The Chinese Consumer Is Also Hungover   Chart I-11Chinese Credit Trends Point To Weaker Imports...   Chart I-12...And China's Rising Marginal Propensity To Save Corroborates This Risk Ultimately, these developments suggest that China needs to ease policy a lot more before growth can be revived. The reserve-requirement-ratio cuts announced last week are not enough to do the trick and may in fact only alleviate the traditional liquidity crunch associated with the Chinese New Year celebration – nothing more. Instead, we expect Chinese interest rates to continue to lag behind U.S. rates, a development historically associated with a strong dollar (Chart I-13). A tangible symptom that China’s reflation is positively affecting the global growth outlook will be when Chinese rates rise relative to U.S. ones. This is what is needed for the dollar to peak this cycle. We are not there yet. Continued weakness in the global PMI and German factory orders only gives more weight to this view. Chart I-13Rising U.S.-China Spreads Point To A Stronger Dollar Practically, we think a move in DXY to 94 or EUR/USD to 1.17 is likely in the coming weeks. However, the combined realization that the U.S. economy will not go into recession – and that therefore the Fed will not pause for the whole of 2019 – and that global growth has yet to bottom, means at those levels the dollar will be a buy. The yen is likely to suffer most in this context. If the markets begin pricing in a stronger U.S. economy than what is currently anticipated, U.S. 10-year yields will rise and the U.S. yield curve will steepen, hurting the JPY in the process. EUR/JPY is an attractive buy right now (Chart I-14). Chart I-14EUR/JPY Set To Rebound Bottom Line: As the market begins digesting the reality of a Fed pause, the dollar could experience some short-term vulnerability, pushing DXY toward 94 and EUR/USD toward 1.17. However, we would anticipate the dollar’s weakness to end at those levels. Interest rate markets are already pricing in Fed rate cuts, something we believe is not warranted. Moreover, financial conditions are set to ease, which will give comfort to the Fed that it can resume hiking. Finally, Chinese growth has more downside, which normally leads to a dollar-bullish environment.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com ​​ Footnotes 1 The comparison may not entirely be apt since not even the President of China was able to avert the stock market collapse in China in 2015. 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies in Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Global Investment Strategy Special Report, titled “Market Alert: The Correction Cometh, The Correction Came: Upgrade Global Equities To Overweight”, dated December 19, 2018, available at gis.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled “Fade The Green Shoots”, dated December 14, 2018, available at fes.bcaresearch.com

Highlights Our leading indicator for China’s old economy continues to point to slower growth over the coming months, which is consistent with the bearish message from China’s housing market and forward-looking export indicators. We would caution investors against interpreting the recent relative outperformance of Chinese stocks as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. We remain tactically overweight, in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. Onshore corporate bond spreads remain wide relative to pre-2017 levels, suggesting that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the primary trend for China’s old economy remains down, although measures of freight remain supported by trade front-running activity (which will wane over the coming months). Our Li Keqiang leading indicator continues to suggest that economic activity will slow from current levels, a conclusion that is reinforced by recent developments in the housing market and December’s PMI release. Table 1The Trend In Domestic Demand, And The Outlook For Trade, Remains Negative   Table 2Financial Market Performance Summary From an investment strategy perspective, we remain tactically overweight Chinese investable stocks versus the global benchmark in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. However, China’s recent outperformance has been passive in nature (i.e. reflecting declining global stocks), suggesting that Chinese stocks have simply been the winner of an “ugly contest” over the past few months. This is hardly a basis to be cyclically long, and we continue to recommend that investors remain neutral for now. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Bloomberg’s measure of the Li Keqiang index (LKI) fell in November for the third month in a row, although our Alternative LKI has risen due to a pickup in freight transport turnover. We showed in our December 5 Weekly Report that trade front-running has clearly boosted economic activity since Q1 of 2018,1 implying that freight volume growth is set to decelerate in the months ahead. Our Li Keqiang leading indicator ticked lower in December, after having risen non-trivially in the third quarter of 2018 (Chart 1). The December decline was caused by a pullback in the monetary conditions components of the indicator, which in turn was caused by the recent rise in CNY-USD. This echoes a point that we have made in previous reports, that the improvement in our leading indicator last year was not broad-based and that it does not yet herald a positive turning point for China’s old economy. Chart 1The Q3 Rise In Our Leading Indicator Was Not Broad-Based The October housing market slowdown that we highlighted in our November 21 Weekly Report continued into December,2 with floor space started and sold decelerating further (Chart 2). The latter, which typically leads the former, has returned to negative territory which, in conjunction with weaker Pledged Supplementary Lending from the PBOC, does not bode well for housing over the coming few months. House price appreciation remains strong outside of tier 1 cities, but a peak in our price diffusion indexes signals slower price gains are likely over the coming months. Chart 2China's Housing Market Activity Continues To Weaken On the trade front, nominal Chinese US$ import and export growth is now trending lower, confirming the negative signal provided by China’s manufacturing PMIs over the past few months. Notably, the new export orders components of both the official and Caixin PMIs declined in December, despite the tariff ceasefire that emerged during the G20 meeting at the end of November, suggesting that export growth is set to slow further in the first quarter of 2019. In relative US$ terms, Chinese investable stocks rose nearly 10% versus the global benchmark from mid-October until the end of 2018. However, as Chart 3 shows, this outperformance was entirely passive in nature, as Chinese stocks have not been trending higher in absolute terms. Chart 3Recent Equity Outperformance Has Been Passive, Not Active We remain tactically overweight Chinese investable stocks; the Chinese market remains deeply oversold in absolute terms, and signs of a potential trade deal over the coming few weeks may significantly improve global investor sentiment towards the country’s bourse. However, we would caution investors against interpreting the recent relative outperformance as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. The underperformance of Chinese health care stocks over the past two months has been stunning, with investable health care having fallen nearly 30% in relative terms since mid-November (Chart 4). However, this decline appears to have been caused by a sector-specific event (a massive profit margin squeeze due to a new government generic drug procurement program), and does not seem to imply anything about the outlook for Chinese consumers. Chart 4A Stunning, Idiosyncratic, Collapse In Health Care Stocks Despite the recent collapse in the health care sector, Chinese consumer discretionary (CD) stocks remain the largest losers within the investable universe, having declined over 40% in US$ terms over the past 12 months. The next twelve months may look quite different for CD, especially if China’s efforts to stimulate consumer spending succeed. The recent changes to the global industrial classification system (GICS) mean that Alibaba (China’s largest e-commerce retailer) is now included in the sector with a significant weight, overwhelming the heavy influence that auto producers used to wield. Auto stocks have struggled in the past due to China’s pollution controls, weak auto sales, and pledges to open up the auto sector (which would be negative for the market share of domestic firms). We will be watching over the coming several months for a pickup in retail goods spending combined with a technical breakout in relative performance as a sign to overweight Chinese consumer discretionary stocks relative to the investable index. Chinese interbank rates have fallen substantially over the past month (Chart 5), in response to additional efforts by the PBOC to boost liquidity in the financial system. Whether the additional liquidity (and lower borrowing rates) will feed into materially stronger credit growth remains to be seen, as we have presented evidence in past reports showing that China’s monetary policy transmission mechanism is impaired.2 Chart 5More Liquidity Has Lowered Interbank Rates Chinese onshore corporate bond spreads have creeped modestly higher since early-November, although by a small magnitude. While we remain optimistic that onshore defaults over the coming year will be less intense than many investors believe, onshore corporate bond spreads have been one of the more successful leading indicators of economic growth in China over the past two years, and remain wide by historical standards. This suggests that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. While it is too early to call a durable bottom, the gap between CNY-USD and its 200-day moving average is steadily closing (Chart 6). The recent (modest) uptrend has been caused by two factors: 1) cautious optimism about the possibility of a durable trade deal with the U.S., and 2) retreating U.S. interest rate expectations. We would expect further weakness if the trade ceasefire collapses and President Trump moves forward with the previously-announced tariffs, but also a sizeable rally if a deal is negotiated. Chart 6A Tentative, But Noteworthy Improvement   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report “Trade Is Not China's Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, January 9th at 10 AM EST, when I will be discussing the economic and financial market outlook for 2019 and answering your questions. Best regards, Peter Berezin, Chief Global Strategist Highlights The lack of major financial and economic imbalances in the U.S., as well as the Fed’s ability to moderate the pace of rate hikes, reduce the risk of a vicious cycle where tighter financial conditions lead to slower economic growth and even tighter financial conditions. The scope for central banks to cut rates is more limited outside the United States. Imbalances are also greater abroad. Nevertheless, the news is not all bleak, with the recent rebound in China’s credit impulse being a case in point. We turned more bullish on risk assets following December’s post-FOMC equity sell-off. A moderately overweight position in global equities over a 12-month horizon is currently justified. While we continue to favor the U.S. over other bourses in dollar terms, our conviction level in this regional bias has decreased. Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. Outside Japan, global government bond yields will also increase in 2019. We are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. We are also taking profits on our March-2019 EEM ETF put for a gain of 104%. Feature Merry Crisis And A Happy New Fear Santa arrived early this year. The plunge in stocks allowed investors to buy some of the world’s premier companies at a mouthwatering 20%-to-30% discount to what they would have paid just a few months earlier. What a gift! Needless to say, most investors would not regard last month’s stock market performance in such a favorable light. But why not? One answer is that investors must mark their portfolios to market. Thus, even if the decline in equity prices raised future returns, it still implied a decline in present net worth. Yet, this cannot be the whole explanation, because if all investors expected stocks to bounce back quickly, they would not have sold in the first place. Clearly, many investors must have come to the conclusion that the stock market would not only go down but stay down. However, this presents a puzzle. The economic environment did not change that much in the weeks leading up to the October sell-off. Growth has slowed more recently (Chart 1), with this morning’s disappointing ISM manufacturing report being the latest example, but this appears to have been mainly a response to the souring market climate rather than the cause of it. Chart 1Tighter Financial Conditions Have Led To Slower Growth Reverse Causality? This raises an intriguing possibility: What if the drop in stock prices and jump in credit spreads that began in late September hurt expectations of economic growth by enough to justify a further discount in risk asset valuations? Such a “Financial Conditions Index (FCI) doom loop” is not just a theoretical construct. The last two U.S. recessions were both the products of burst asset bubbles — first the dotcom bubble and then the housing bubble. Could such a self-fulfilling vicious cycle be erupting again? If so, any rally in stocks or credit should be sold into, just as was the case in both 2001 and 2007. U.S. Fairly Resilient To A Doom Loop Fortunately, there are two reasons to think that such an outcome will not reoccur, at least not in the United States. First, as Box 1 explains, an FCI doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. That does not appear to be the case today. Unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart 2). Cyclical spending – the sum of residential investment, business capex, and expenditures on consumer durable goods – is also far below prior business-cycle peaks as a share of GDP (Chart 3). Chart 2The U.S. Private Sector Is A Net Saver Chart 3U.S. Economy: Cyclical Spending Is Still Restrained Despite recent releveraging in some categories, U.S. household debt has continued to decline in relation to the size of the economy. The ratio of personal debt-to-disposable income is now 34 percentage points below pre-crisis levels (Chart 4). Chart 4Household Leverage Is Below Its Peak U.S. corporate debt has moved in the opposite direction. Nevertheless, while the ratio of U.S. corporate debt-to-GDP has climbed to a record high, it is still quite low by global standards (Chart 5). Perhaps more importantly, corporate debt is generally held by non-leveraged institutions. If corporate defaults were to rise unexpectedly, the losses to lenders would not pose the same systemic risk to the financial sector as mortgage defaults did during the Global Financial Crisis. Chart 5U.S. Corporate Debt Is High, But It Is Higher Elsewhere The Fed’s Reaction Function It is not surprising that the stock market sell-off accelerated in early October following Fed Chairman, and failed golfer, Jay Powell’s comment that interest rates were “far from neutral.” We think that worries that the Fed will tighten too quickly are misplaced. Yes, monetary policy operates with “long and variable lags.” However, financial conditions, which lead growth, can be observed in real time (Chart 6). Chart 6Global Financial Conditions Have Tightened Most of the tightening in financial conditions since late September has been due to falling equity prices. Our baseline scenario envisions a gain of roughly 10% in the S&P 500 in 2019. A rebound in stocks of this magnitude will reverse most of the recent FCI tightening, thereby allowing the Fed to raise rates three times this year. But if equities continue to sag, the Fed will scale back further monetary tightening or even cut rates. The mere possibility of such a policy response reduces the odds of an FCI doom loop. A Mixed Bag Outside The U.S. The economic outlook is murkier outside the United States. Economic and financial imbalances are greater in the EM space and parts of Europe. Non-U.S. central banks also have less scope to respond to adverse shocks, either because of fears that looser monetary policy will spark capital outflows (as is the case in many emerging markets) or because of the presence of the zero-bound constraint on interest rates (as is the case in the euro area and Japan). Nevertheless, the situation is not that bad. EM assets have been fairly resilient over the past few months, at least in comparison to their developed economy counterparts (Chart 7). China’s credit impulse has actually perked up, an indication that while credit growth is falling, it is doing so at a slower pace. Chart 8 shows that the Chinese credit impulse is highly correlated with global industrial commodity prices. We still expect global growth to slow in the first half of 2019, but at this point, much of the slowdown has been discounted in asset markets. With that in mind, we are raising the stop on our short AUD/JPY trade to 10% and instituting a profit target of 15%. Chart 7EM Assets Have Been Outperforming Recently   Chart 8The Increase In China's Credit Impulse Bodes Well For Industrial Commodity Prices The Perils Of Discrete Decision-Making One of the annoyances of being an investment strategist is that you often feel compelled to take discrete views on where the markets are heading. Are you bullish, bearish, or neutral? Actually, it is usually just bullish or bearish because most people regard neutral views as lacking in conviction and insight. This incentive structure is counterproductive. Not only does it cause analysts to turn a blind eye to incoming data that may challenge their thesis, it disregards how professional investors actually operate. Successful investors scale into positions as the market gets cheaper and scale out as it becomes more expensive. Trying to time the bottom (or the top) with exact precision is futile. With that in mind, we are going to tweak the way we make recommendations going forward in order to improve transparency, accountability, and accuracy. Rather than simply stating whether we are bullish, bearish, or neutral, we will assign the main asset classes a subjective score between zero and one hundred, with 0-to-40 being bearish, 40-to-60 being neutral, and 60-to-100 being bullish. We will adjust the score in every publication. To add analytic rigor to this framework, we will also compare our subjective model score with that of our MacroQuant model. Where Things Now Stand We downgraded global equities last June, but moved back to overweight following December’s post-FOMC meeting sell-off, as valuations reached that rather blurry line at which a modest equity overweight was warranted. Our subjective score for global equities currently stands at 65%, above the model’s estimate of 50%. Our moderately bullish view reflects our expectation that global growth will stabilize by mid-year and monetary policy will remain accommodative, even if the Fed raises rates by more than what the markets are currently discounting. Tempering our enthusiasm is the recognition that the business cycle is getting long in the tooth – especially in the U.S. – and that global equity valuations, while far cheaper than they were a few months ago, are still significantly less favorable than they were near past market bottoms (Chart 9). Chart 9Global Equity Valuations Have Improved Regionally, we continue to favor U.S. stocks over other developed markets, and DM over EM more broadly. However, our conviction level on this view is not high, and we are prepared to revise it if it looks like global growth is accelerating, an outcome that would limit any further dollar strength (our subjective dollar score currently stands at 70%, below the model’s estimate of 92%). Reflecting our expectation of decent global equity returns in 2019 and our waning conviction to be underweight EM, we are taking profits on in our March-2019 EEM ETF put for a gain of 104%.  Please note that our view on EM is more optimistic than that of Arthur Budaghyan, BCA’s chief emerging markets strategist, who continues to see considerable downside risks to EM assets. For now, Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. We assign the 10-year yield a score of 30%, which is close to our model estimate of 32%. Accordingly, we are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. Core European bond yields will increase, reflecting diminished excess capacity in the euro area and the end of ECB net asset purchases. U.K. yields should also grind higher, as the odds of a soft Brexit (or no Brexit) improve. Only in Japan will yields remain contained, thanks to the BoJ’s ongoing yield curve control regime. We do not expect spread product to have a banner year, but the current yield pick-up should be sufficient to ensure that risky credit outperforms cash. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Box 1 The Analytics Of Doom Loops When will a tightening in financial conditions stemming from lower equity prices and higher borrowing costs lead to a vicious circle of slower economic growth and even tighter financial conditions? The answer depends on how sensitive economic growth is to financial conditions in relation to how sensitive financial conditions are to growth. Figure 1 shows two equilibrium schedules, one for the economy (EE) and one for asset markets (AA). Both schedules slope downward. The EE schedule is downward-sloping because easier financial conditions boost growth. If growth is too strong given the prevailing level of financial conditions, economic activity will slow (Panel A). The AA schedule is downward-sloping because equity prices tend to fall and credit spreads rise when growth slows. If equity prices are too high and credit spreads are too narrow for a certain level of growth, then financial conditions will tighten (Panel B). Suppose economic growth is not very sensitive to changes in financial conditions, perhaps because imbalances in the economy are limited (Panel C). Then changes in financial conditions will be fleeting: A decline in equity prices or a widening in credit spreads will not hurt growth very much, allowing the stock market and credit market to quickly normalize. In contrast, suppose that economic growth is very sensitive to financial conditions, so much so that the EE schedule is flatter than the AA schedule. In this case, the economy will be vulnerable to self-reinforcing booms and busts (Panel D). In particular, a small random jump from U to UI will send the economy careening towards a doom loop of ever-weaker growth and tighter financial conditions.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2018.  The quant model reduced Spain’s large overweight to a slight overweight, and further downgraded the U.S. allocation. As a result, the model now has assigned overweight allocations to Germany, Switzerland, the Netherlands, Canada and Italy, with underweight allocations to the U.S., Japan, France and U.K.  Australia and Sweden are now in the neutral zone, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI world benchmark by 38 bps in December, with a 48 bps of outperformance from Level 1 model offset by a 21 bps of underperformance from Level 2. Since going live, the overall model has outperformed by 96 bps, with Level 2 outperforming by 120 bps and level 1 outperforming by 57 bps. Table 2Performance (Total Returns In USD %)   Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)     Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.     GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Feature No Recession – Add To Risk Again Markets have been notably weak and volatile since we published our 2019 Outlook1 in late November. Over the past couple of months, global equities have fallen by more than 10%, the 10-year U.S. Treasury yield has dipped from above 3.2% to below 2.7%, and high-yield bond spreads have risen by more than 200 basis points. The market is sniffing out the risk of recession on the near-term horizon. We think the market has got this wrong, and so we move back to overweight global equities (from neutral, to where we lowered our recommendation last June). Recommendations Last year, U.S. growth was much stronger than growth in the rest of the world (Chart 1). Markets are implying that the global slowdown will soon infect the U.S., with the stock market pointing to the manufacturing ISM, currently at 59.3, falling back to 50 in very short order (Chart 2). Chart 1Will U.S. Growth Also Fall Back? Chart 2Stocks Imply ISM At 50 It is, indeed, probable that growth will slow this year: the FOMC’s median forecast suggests a slowdown in real GDP growth from 3.0% in 2018 to 2.3%. And it may take the market a little longer to digest that deceleration. However, growth is likely to remain above trend (currently estimated at 1.8%). Higher interest rates have begun to take their toll on the housing market (with a noticeable deterioration in new housing starts and builder confidence). But residential investment is now only 4% of GDP, compared to 7% in 2006, so the impact of the slowdown will be limited. Moreover, consumption is likely to remain buoyant, with wage growth accelerating, consumer confidence strong, and the savings rate with room to fall (Chart 3). Additionally, though fiscal stimulus will not be as powerful in 2019, the IMF estimates that it will add a further half of one percentage point to U.S. GDP growth. Chart 3Consumption Likely To Remian Buoyant The Fed is reacting very pragmatically to the evolving circumstances. Chair Jerome Powell emphasized in his post-FOMC press conference in December that “some cross currents have emerged” and that “policy decisions are not on a pre-set course”. The FOMC cut its forecast for hikes in 2019 from three to two and lowered its estimate of the terminal rate from 3.0% to 2.8% (currently the fed funds rate is at 2.4%). This implies that it will take approximately two more 25 basis point rate hikes before the Fed gets rates back to neutral. As we have often shown, risk assets tend to outperform bonds until monetary policy is restrictive (Chart 4). Meanwhile, market sentiment has turned excessively bearish. Our sentiment index is at a level that has historically pointed to a good buying opportunity (Chart 5). The AAII survey shows that recently only 25% of U.S. retail investors expect the market to rise over the next six months, compared to 47% who expect it to fall. Valuations are cheap again: the forward PE for the MSCI All Country World Index (ACWI) is now back to the range it traded at in 2013 (Chart 6). The classic indicators of recession, such as the yield curve, are not yet flashing warning signals: the 3-month/10-year curve, which we have shown has historically been the most reliable,2 remains at +20 basis points (Chart 7). It needs to invert to signal recession – and, typically, it does that as much as 18-24 months in advance. Chart 5Sentiment Is Very Bearish   Chart 6Global PE Back To To 2013 Level Chart 7Yield Curve Has Not Inverted Certainly, there are risks (we would highlight a reignition of the trade war after March 1, Brexit, U.S. government shutdown, the possibility that falling stock and house prices hurt consumer and business sentiment, and China’s reluctance to implement a massive 2016-style reflationary stimulus). But our analysis suggests there is significantly more upside than downside risk for equities over the next 12 months. If earnings growth, particularly in the U.S., comes in close to our top-down forecasts (Chart 8), it is hard to imagine – given the current depressed multiples – equities underperforming bonds this year. Accordingly, we recommend raising global equities to overweight in a multi-asset portfolio on a 12-month horizon, and lowering cash to neutral. For now, we have not changed our other tilts, and continue to recommend an overweight on U.S. equities and defensive sectors, a preference for equities over credit, and a high degree of caution towards emerging market assets. Chart 8Earnings On Track To Grow Healthily In 2019 Currencies: With growth likely to remain stronger in the U.S. than in the rest of the world, we expect appreciation of the dollar over the next six months. BCA’s Central Bank Monitors point to the need for the Fed to tighten policy further, but for the ECB to remain dovish. The gap between these two monitors has done a good job at forecasting EUR/USD over the past 10 years (Chart 9). However, speculative positions are already quite long dollar (Chart 10) and so the upside might be limited to around 5% in trade-weighted terms. If global growth begins to reaccelerate midway through 2019, the dollar might weaken again. Chart 9Relative Policy Suggests Stronger USD Equities: We prefer DM equities over EM. Further rises in the dollar and long-term U.S. interest rates, combined with continuing slowdown in global trade and Chinese growth, will remain headwinds for EM equities even if the market moves into a more risk-on phase. Valuations in EM do not look attractive either, with forward PE relative to DM in line with recent averages, and earnings growth forecasts likely to be revised down into negative territory over the coming months given the challenges facing developing economies (Chart 11). Within DM, we have a preference for the U.S., given its stronger growth and likely currency appreciation, over the euro zone and Japan, which are more sensitive to the global manufacturing cycle. Europe, in particular, will continue to be held back by the travails of its banks, which have been a major determinant of relative equity market performance in recent years (Chart 12). In a recent Special Report, we concluded that the long-term outlook for euro zone bank profitability remains lackluster.3 Chart 11EM Equities Are Not Cheap Chart 12Banks Will Weigh On Euro Zone Stocks Fixed Income: We see further upside for long-term rates in 2019, driven by a combination of above-trend economic growth, more Fed hikes than the market is pricing in, a moderate pick-up in inflation, and the unwinding of the Fed’s balance-sheet. We do not see rates being an impediment to growth until they reach the level of trend nominal GDP growth, currently 3.8% (which was the crunch point in both 1999 and 2006 – Chart 13). Despite our more positive view on equities, we remain more cautious on credit. Spreads have widened recently to more attractive levels (Chart 14). However, we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009 (Chart 15). Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  At this stage of the cycle, credit spreads are unlikely to tighten much, even with an equity market rally. Furthermore, given the high leverage, credit is an asset class that is likely to perform particularly poorly in the next recession. Chart 13Only At 3.8% Do Rates Become A Risk Chart 14Credit Spreads Not More Attractive Chart 15U.S. Corporate Leverage Is A Problem Commodities: The sell-off in crude oil over the past two months was due to short-term supply-side shocks, most notably the U.S.’s agreeing to 180-day exceptions on Iranian sanctions. But supply is likely to tighten in coming months (Chart 16). Saudi Arabia and Russia intend to reduce production by 1.2 million barrels/day, and U.S. shale oil supply growth is likely to slow since one-year forward WTI is now around $49, slightly below the average breakeven level for shale oil producers. With global oil demand set to remain strong, our energy strategists see Brent oil rebounding to around $80 a barrel in 2019, with WTI $6 below that.4 Industrial commodities will continue to face headwinds from a stronger dollar and slowing China. Only when the effects of China’s moderate reflation measures start to come through in 2H 2019 would we expect to see a recovery in metals prices. Chart 16Oil Supply Set To Tighten   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1      Please see “Outlook 2019: Late-Cycle Turbulence,” dated 27 November 2018, available at bca.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?”, dated 15 June 2018, available at gaa.bcaresearch.com 3      Please see Global Asset Allocation Special Report, “Euro Area Banks: Value Play Or Value Trap?”, dated 14 December 2018, available at gaa.bcaresearch.com 4      For the detailed rationale of their forecast, please see Commodity & Energy Strategy Weekly Report, “2019 Key Views Policy-Induced Volatility Will Drive Markets,” dated 13 December 2018, available at ces.bcaresearch.com GAA Asset Allocation