Europe

Highlights We expect limited upside to gas prices from current levels as the comeback of US Liquefied Natural Gas (LNG) exports will add to an already oversupplied market. In the short term, prices will remain below full-cycle costs. This will limit investment in LNG and the infrastructure required to get it to market in future. European storage will peak below maximum capacity. Gas forwards are pricing a rapid drawdown over the winter. Whether this occurs depends critically on winter demand in the northern hemisphere and a continued recovery in world economic activity. In the US, declining production in the prolific natural-gas shales and rising LNG exports will help balance its domestic gas markets: Rig counts in the Appalachian basin are at multiyear lows, which is weighing on output. Collapsing oil production in major shale-oil basins is dramatically reducing associated gas output, which represents more than 16% of total gas production. Still, a second wave of COVID-19 that results in another round of widespread lockdowns could send natgas prices back below $2/MMBtu as storage fills. Over the next few months, the balance of risk in natgas markets – especially in the US – remains to the downside, though highly uncertain. We are staying on the sidelines for now.  Over the medium term, global demand for LNG will catch up with supply by 2024, supported by additional coal-to-gas switching and slower supply growth. Feature The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. Global natural gas markets have been severely hit by the COVID-19 pandemic. Natgas prices in Asia, Europe, and the US were amongst the worst performing commodities during the crisis (Chart 1). This reflects weak fundamentals – i.e. a significant global supply surplus – which gas markets faced even before the exogenous shock. The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. This development renders shipments of US gas overseas uneconomical. The cancellation of US cargoes is acting as the primary balancing factor and will allow inventories to stay below full capacity – assuming global economic activity continues to accelerate in 2H20. Henry Hub prices surged by 34% since the beginning of the month on the back of higher gas demand – from warmer-than-normal weather and rebounding global economic activity – depressed US LNG exports, and prolonged maintenance at Australia’s Gorgon plant. Chart 1Global Gas Benchmarks Collapsed In 1H20 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 2Relative Prices Will Favor Additional US LNG Exports Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks As storage-related fears abate, LNG economics is turning favorable for cargoes to be delivered in 4Q20 and 1Q21. This will allow exports of US gas to Europe and Asia to resume as regional demand rises. This improvement is already apparent in relative futures curves (Chart 2). Still, we expect only limited price gains from current levels, especially in the US. The resurgence in US LNG exports will add to the global supply surplus and cap the upside. Relative prices will remain below LNG offtakers' (exporters) full-cycle costs, limiting additional investments in LNG projects over the medium term. We expect demand to catch up to supply by 2024. Gas Fundamentals Worsened In 2019 Global gas demand increased by 2% y/y in 2019, led by growth in the US and China as coal-to-gas switching intensified amid the low-price environment (Chart 3). However, this rate of growth is a marked slowdown relative to the average 3.5% y/y growth from 2016-2018. It was also slower than the strong global supply growth – up 3.4% y/y – and LNG export growth – up 12.7% y/y. Chart 3US, China Supported Gas Demand Growth In 2019 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks The US was the largest contributor to both new gas and LNG supply, accounting for 65% of the world’s incremental gas production (Chart 4). The liquefaction capacity addition from the first wave of investments – i.e. projects that received a final investment decision (FID) before 2017 – is now mostly operational. Chart 4US Dominated Natgas Supply And LNG Growth In 2019 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks US LNG capacity stands at ~10 Bcf/d and serves as a needed pressure valve to its oversupplied domestic market – a consequence of rapid shale production growth – forcing the excess gas to Europe and Asia. However, the economic slowdown in Asia in 2H19 meant the region could no longer adequately absorb these new volumes. As a result, global gas markets moved to a supply-surplus. Relative gas price spreads began trending downward and moved in favor of exports to Europe over Asia.1 Europe plays a growing role as a market of last resort for global natural gas – particularly US LNG – due to its well-developed storage infrastructure, regasification units, and pipeline networks. Around 80% of LNG exports from newly added terminals were absorbed by European markets, and most of that went into storage. Around 40% of the global natural gas supply increase last year ended up in storage, according to the IEA (Chart 5). Moreover, milder-than-expected weather last year exacerbated these trends and forced global prices to converge closer to Henry Hub. Chart 5European Storage Absorbed ~ 40% Of Global Gas Supply Growth Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks By the end of 2019, gas storage in Europe was drastically higher than its 5-year average for that period (Chart 6). Chart 6Elevated US And Europe Gas Storage Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks European Storage Will Stay Below Capacity-Testing Levels Cargo cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Global gas markets confronted the COVID-19 pandemic from a fragile starting point. The shock reinforced the imbalances that began in 2019 and completely erased US LNG’s competitiveness in European and Asian markets. As demand fell in response to lockdowns – down 2.8% in the US and 7% in Europe y/y in Jan-May by IEA’s reckoning – storage in Europe was projected to reach full capacity by end-August.2 Consequently, in June, natural gas prices plunged to a more than two-decade low to incentivize supply and demand adjustments. Around 100 LNG cargoes from the US were cancelled for delivery in June and July, based on EIA estimates (Chart 7). US LNG supply is now the main balancing factor in global gas markets: It is a high-cost source of supply when delivered to Europe or Asia and is contracted under more flexible agreements facilitating cargo cancellations. Over the short term, the number of vessels cancelled each month is an important indicator of storage availability in Europe. The decision to cancel a cargo is complex but mainly depends on whether the spreads between US Henry Hub (HH) and Dutch Title Transfer Facility (TTF) or Japan Korea Marker (JKM) prices cover the exporter's variable costs. Based on a Cheniere-type contract,3 this implies the spread must be higher than 115% of Henry Hub prices plus shipping and regasification costs (Chart 2). Chart 7US LNG Vessel Cancellations Balance Global Gas Markets US LNG Vessel Cancellations Balance Global Gas Markets US LNG Vessel Cancellations Balance Global Gas Markets The spread failed to cover variable costs for most of 2020 and even moved to a premium – i.e. HH above TTF – in July. Moreover, because most contracts have a 40-day to 70-day notice period for cancellation, the supply of US LNG only reacted to the rapid drop in demand with a lag, aggravating the supply surplus and flooding European inventories. The resulting supply adjustments, combined with stronger-than-expected demand in Europe, have slowed the storage injections rates in August and pushed prices higher.4 Cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Forward curve behavior suggests market participants expect US LNG shut-ins, combined with robust demand recovery in Asia and Europe, to move price spreads above variable costs by November this year (Chart 8). This is mostly a consequence of rising Asian LNG prices. We expect this will incentivize added exports of US LNG over the coming months which will move Henry Hub prices slightly higher over the winter. Chart 8Relative Price Spreads Cover LNG Variable Costs, But Not Total Costs Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks In fact, some cargoes are reportedly already selling their gas in forward Asian markets and taking longer routes or reducing their travel speed to remain at sea for longer and profit from these higher deferred prices.5 Still, the increase in US prices will be limited given that relative prices need to remain wide enough to cover LNG variable costs. While global prices will move up gradually over the winter, we believe their upside is bounded by the supply surplus, especially as US exports normalize. At current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu. On the demand side, low prices will favor additional coal-to-gas switching as economies recover in 2H20 (Chart 9). Current forward TTF prices are signaling deep drawdowns in European storage this winter as demand in the region increases (Chart 10). Chart 9Cheap Gas Favors Coal-To-Gas Switching Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 10TTF Forwards Signaling Strong Inventory Draws This Winter TTF Forwards Signaling Strong Inventory Draws This Winter TTF Forwards Signaling Strong Inventory Draws This Winter In Chart 11, we simulated the remaining of the filling season based on previous monthly seasonal injection rates for Europe. This suggests storage remains at risk of being maxed out by October. However, we believe – in agreement with current forward curves – that the pickup in demand from recovering economic activity, coal-to-gas switching, and lower US exports will further diminish injection rates in Aug-Sep-Oct relative to historical rates (Chart 12). This will allow inventory to reach its seasonal peak slightly below capacity-testing levels. Chart 11Euopean Storage Remains A Significant Downside Risk Euopean Storage Remains A Significant Downside Risk Euopean Storage Remains A Significant Downside Risk Chart 12Low US LNG Exports, Warmer Weather Drastically Reduced Injections In July Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Moreover, flows from Europe to Ukraine should continue freeing up capacity in core EU storage facilities (Chart 13).6 Chart 13Filling Ukrainian Storage Acts As A Safety Valve Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 14Lower US Gas Supply Slows Inventory Builds Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks In the US, the multi-year-low active gas rigs in the Appalachian basin are starting to weigh on production. Moreover, collapsing oil production in major shale-oil basins is bringing associated gas – which is now more than 16% of total gas production – down rapidly (Chart 14). This contributes to the slowdown in domestic storage injection and to the recent Henry Hub price gains. Still, at current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu (Chart 15). Consequently, we believe short-term downside risks from lockdowns are too elevated to try to profit from the limited price increase expected this winter. Chart 15Renewed Lockdowns In Europe Would Push Storage to Capacity Renewed Lockdowns In Europe Would Push Storage to Capacity Renewed Lockdowns In Europe Would Push Storage to Capacity   Rising US-Russia Competition Keeps Prices Lower For Longer Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs. In 2019, a record volume of liquefaction capacity reached FID globally (Chart 16). By 2025, global LNG capacity is expected to reach ~73Bcf/d, a ~ 15Bcf/d increase from current levels. Despite the COVID-19 shock, most projects under construction in the US remain on track to be completed as previously scheduled in 2020.7 Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs – i.e. below variable costs plus a fixed contracted liquefaction capacity fee estimated at ~$3/MMBtu. Chart 16Record FID Risks Keeping Markets Oversupplied Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Mounting competition – especially from Russia – in both Europe and Asia will hold down prices over the coming years. In Europe, the completion of the Nord Stream 2 pipeline would add 5.3Bcf/d of cheap Russian gas supply and could keep prices ~ $1/MMBtu lower than otherwise.8 These new volumes would be absorbed by higher European consumption – fueled by low prices – and lower US LNG exports – from weak relative prices. Geopolitics is a major factor driving Russian behavior and hence oversupply: The US and Russia will vie with each other for market share in Europe. As gas markets further liberalize globally, Europe will be increasingly essential for US LNG as its destination of last resort in times of low demand elsewhere. If Russia floods this market with gas, it reduces Europe’s ability to absorb US gas, which will lead to lower Henry Hub prices. It will shut in US supply in times of low demand, making investments there riskier. While US administrations of either party almost always attempt to engage Russia at the beginning of a four-year term, the US foreign policy establishment no longer believes that engagement with Russia is beneficial (Chart 17). This is apparent under the Russia-friendly Trump administration but will be especially relevant if the Democratic Party wins the White House in November. Democrats blame Russia for undermining and ultimately reversing the Obama administration’s policies by betraying the US-Russia diplomatic “reset” and interfering in the 2016 election. Chart 17Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Hence the US will continue to impose sanctions on Russia and probably on a range of companies involved in Nord Stream 2 and Turkstream. If both pipelines are completed, then Washington will ask Europe to compensate for its Russia dealings in other ways. Meanwhile Russia will use a combination of commercial and strategic measures to woo Germany and the Europeans so that they do not commit to preferential bilateral deals with the United States. Because the US and Russia are engaged in a great power struggle – rather than healthy trade competition – they will attempt to achieve their aims through means other than price and volume. Punitive measures will create volatility by occasionally removing supplies but probably cannot change the backdrop of oversupply. The gist is that US-Russia relations will remain antagonistic and Europe will benefit from the oversupply except during times of surprise sanctions and strategic blows. In China, we expect imports of US LNG to increase. However, rising Russian LNG and pipeline supplies, increasing domestic gas output, and a persistent global oversupply of gas will limit the incentives for Chinese buyers to sign long-term agreements with US exporters at a price above full-cycle costs – i.e. ~ $7/MMBtu.9 The ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. This has large implications for the US gas market, as LNG capacity represents ~ 11% of its domestic supply – based on 1H20 production levels. Low demand growth for its gas in Europe or Asia will keep Henry Hub prices low to limit supply growth from shale gas and limit investment in additional liquefaction capacity. Here too geopolitics will undermine Henry Hub prices: China is strengthening economic ties with its strategic partner, Russia, and the ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. A Biden administration would approach China differently from the Trump administration but it would still have to face fundamental trade tensions due to China’s mercantilism and the US attempt to contain China’s technological rise. China is crucial for global LNG demand growth, but trade tensions will reignite even under Biden and spill over into China’s demand for US commodities. China has substitutes for American LNG. If trade tensions affect China’s imports of US LNG then they will lead to lower Henry Hub prices and possibly to vessel cancellations, especially if European storage once again proves unable to absorb these exports during the injection season. The Biden administration will not ultimately be China-friendly, looking beyond any diplomatic “reset” in its first year, and thus the risk of China diversifying away from US LNG is real. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. There are currently more than 6Bcf/d of approved, not yet FID, projects in the US. We do not expect much of this capacity to move forward until LNG economics turn favorable and buyers’ willingness to sign long-term contracts comes back. Large projects expected to start closer to 2025 – e.g. Shell’s LNG Canada and Total’s Mozambique LNG – could be delayed to the second half of the decade. On the demand side, persistent low prices will reinforce two ongoing trends. First, this will favor additional coal-to-gas switching in most regions, helping demand to catch up to supply by 2024 and eventually forcing European and Asian prices significantly higher in anticipation of tighter fundamentals. Second, low spot LNG prices in Asia and the availability of flexible supply will accelerate the shift to a merchant/trading market.10 The movement toward shorter and non-indexed-oil contracts continued in 2019, with spot and short term contracts reaching 34% of total LNG flows in 2019, up 32% vs. 2018 (Chart 18). The COVID-19 shock augmented the incentive to switch to non-oil-indexed contracts given the steep discount it created in LNG spot market prices versus oil-indexed contracts. Based on our Brent price forecasts, we expect this divergence to persist in 2021 (Chart 19). Chart 18Shorter, Gas-On-Gas Contracts Will Increase In Asia Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 19Spot Prices Will Decouple From Oil-Indexed Again In 2021 Spot Prices Will Decouple From Oil-Indexed Again In 2021 Spot Prices Will Decouple From Oil-Indexed Again In 2021 The convergence in regional prices that began in 2019 is disrupting the standard LNG model based on significant regional price spreads. Low and uniform prices reduce the arbitrage of moving gas overseas. Companies will need to start using sophisticated financial instruments and will increasingly resort to spot and futures markets, like in oil markets.11 Crucially, our expectation that demand will catch up to supply assumes government policies aimed at reducing carbon emissions continue being implemented in major consuming countries. Future gas consumption is a function of economic – i.e. price incentives – and policy variables. A reversal in China’s environmental policies could drastically slow gas demand growth and remains a risk to our view. At present China’s policy setting aims for growth recovery at all costs, but the driver of Xi Jinping’s green policy is the middle class demand for healthier air and environment (Chart 20). Hence the slog to diversify away from coal will resume over the medium and long run. Bottom Line: The large collapse in prices will remain bearish for US LNG over the short term as global gas markets remain firmly oversupplied and storage levels hew dangerously close to maximum capacity. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. Relative prices will be capped close to variable costs. These unfavorable conditions for additional investments in LNG projects could create a supply deficit later in the decade. Chart 20China"s Green Policy Is Driven By Its Growing Middle Class China"s Green Policy Is Driven By Its Growing Middle Class China"s Green Policy Is Driven By Its Growing Middle Class   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com         Footnotes 1     These destination adjustments in response to price incentives are possible because of the flexibility in US long-term LNG agreements. These contracts, for the most part, have no predetermined destination clause. 2     For instance see "NWE gas storage sites could be 'almost' full by end-August: Platts Analytics" published by S&P Global Platts on May 21, 2020. 3    There exists two main types of LNG contracts in the US: (1) Tolling agreements in which the LNG exporter needs to secure the feedgas, transport the gas to the liquefaction facility, and ship it to the buyer. In this model, the LNG operator charges a fixed fee – usually in the range of $2.25 to $3.5/MMBtu, paid regardless of whether they use their contracted LNG space to liquefy the gas. The ownership of the gas remains in the hand of the offtaker. (2) Chienere-type agreements – or a hybrid merchant-tolling structure – in which the LNG operator secures the feedgas and transports it to its liquefaction facilities. It takes ownership of the gas until it is liquefied and sold to the exporter responsible for shipping the gas to the final buyer – the pricing scheme is usually ~115% of Henry Hub gas prices + a fixed liquefaction fee. In the US, the Cove Point, Freeport, Cameron, and Elba terminals mostly use the tolling model, while all of Cheniere’s installations – i.e. Sabine Pass and Corpus Christi – are operating under Cheniere-type models. In our analysis we use the Cheniere-type as it is slightly more flexible and seems more vulnerable to cargo cancellations – subject to a penalty, or fixed fee, to ensure a reliable cash flow to Cheniere. Moreover, it is difficult to estimate how much of the shipping cost are truly variable, some offtakers have long-term shipping contracts to diminish total variable costs. Please see “Steady as She Goes, Part 5 - How Global Prices Drive U.S. LNG Cargo Destinations,” published by RBN Energy on August 1, 2020 for a detailed discussion of LNG exporters’ costs. 4    Maintenance delays at Australia’s Gorgon LNG plant also contributed to the price increase, especially in Asia. Please see "Chevron says expects to restart Train 2 of Gorgon LNG plant in early September" published by reuters.com on July 28, 2020 for more details. 5    Please see "Buyers of U.S. LNG cancel September cargoes but pace slows, sources say," published by reuters.com on July 21, 2020. 6    Since May this year, the Ukrainian storage and gas pipeline managing company UkrTransGaz started offering discounts on transportation fees and other arrangements to incentivize European traders to storage gas at their facilities. Natgas stored by non-resident in customs warehouses with UkrTransGaz are more than four times higher than last year. Please see “European gas storage: backhaul helps open the Ukrainian safety valve,” published by Oxford Institute For Energy Studies in May 2020. 7     A few projects reported lockdown-related delays of up to 4 months. 8    Please see "Nord Stream 2 and the battle for gas market share in Europe" published by Wood Mackenzie on July 24, 2020. 9    Please see “No Upside: The U.S. LNG Buildout Faces Price Resistance From China,” published by The Institute for Energy Economics and Financial Analysis (IEEFA), July 2020. 10   We highlighted in our October 4, 2018 report titled "US Set To Disrupt Global LNG Market" that the large LNG supply expansion in the US would incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. 11    Please see “Covid-19 And The Energy Transition,” published by Oxford Institute For Energy Studies in July 2020. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging

Feature Feature ChartThe Sales Of Makeup And Perfumes Collapsed, But The Sales Of Hair Care And Skin Care Grew The Sales Of Makeup And Perfumes Collapsed, But The Sales Of Hair Care And Skin Care Grew The Sales Of Makeup And Perfumes Collapsed, But The Sales Of Hair Care And Skin Care Grew The pandemic era is diminishing our close quarters intimacy with people, which raises a fascinating question. In a world of social and physical distancing, widespread use of face coverings, and virtual meetings on Zoom or Skype, is it still important to look good? Is it important to smell good? And perhaps the most fascinating question of all: is it important to feel good? The so-called ‘lipstick effect’ is a putative counter-cyclical phenomenon during recessions in which the demand for small treats and pick-me-ups increases while other spending is shrinking. One theory is that it is based on the basic human desire to feel good, even during hard times. When budgets are squeezed, people simply cut out large extravagances and substitute them with small luxuries, epitomised by lipstick. The lipstick effect was first recorded during the Great Depression. Between 1930 and 1933, unemployment in Germany surged to six million. But thanks to the booming demand for its cosmetics, the German firm Beiersdorf could boast that it did not have to lay off a single worker. Across the Atlantic, the same was true. When US economic output shrank by a third, cosmetics were one of the few products whose sales grew. The lipstick effect was also observed during the Great Recession. Between September 2008 and January 2009 when US consumer spending shrank, the sales of cosmetics bucked the downtrend, and grew (Chart I-2).  Chart I-2Cosmetics Sales Grew In The 2008 Recession... Cosmetics Sales Grew In The 2008 Recession... Cosmetics Sales Grew In The 2008 Recession... The Lipstick Effect Is Working In An Evolved Form Fast forward to 2020, and the pandemic-induced economic slump is the one recession in which we would expect not to observe the lipstick effect. After all, if you are in lockdown, or must maintain physical distancing with other people, or must wear a face covering when near other people, what is the point of wearing makeup or perfume? The sales of cosmetics and fragrances collapsed in the 2020 recession… Just as we would expect, between February and April this year, the US sales of cosmetics and fragrances collapsed by 18 percent, exactly in line with the plunge in US consumer spending. On the face of it, the lipstick effect does not work under a facemask (Chart I-3). Chart I-3...But Shrank In The 2020 Recession ...But Shrank In The 2020 Recession ...But Shrank In The 2020 Recession Yet on closer examination, the lipstick effect is working, albeit in an evolved form. While the sales of makeup and perfumes have collapsed in 2020, the sales of skincare and haircare products are growing (Chart I-1). As the pandemic took hold and forced hair and beauty salons to shutter, people replaced salon visits with at-home care routines. And interestingly, even in the Great Recession of 2008-09, the US sales of haircare and non-cosmetic personal products outperformed the sales of cosmetics (Chart I-4-Chart I-7). Chart I-4Hair Care And Skin Care Sales Grew In The 2008 Recession... Hair Care And Skin Care Sales Grew In The 2008 Recession... Hair Care And Skin Care Sales Grew In The 2008 Recession... Chart I-5...And Grew In The 2020 ##br##Recession ...And Grew In The 2020 Recession ...And Grew In The 2020 Recession Chart I-6Total Personal Products Sales Grew In The 2008 Recession... Total Personal Products Sales Grew In The 2008 Recession... Total Personal Products Sales Grew In The 2008 Recession... Chart I-7...And Have Held Up Well In The 2020 Recession ...And Have Held Up Well In The 2020 Recession ...And Have Held Up Well In The 2020 Recession In fact, 60 percent of the total beauty market comprises skincare and haircare products compared with 30 percent for makeup and perfumes (Chart I-8). It turns out that the cosmetics and personal products firms that have a diversified exposure to all segments of the beauty market are the ones that outperform in hard times as well as good. And it turns out that these companies are European. Chart I-8Skin Care And Hair Care Dominates The Beauty Market Does The Lipstick Effect Work Under A Facemask? Does The Lipstick Effect Work Under A Facemask? The European Cosmetics Sector Is Outperforming In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed the US cosmetics sector, led by Estee Lauder, and the Japanese cosmetics sector, led by Shiseido. In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed. Specifically, the 12-month forward earnings for the European cosmetics sector barely declined in the 2008-09 recession and have barely declined in the 2020 recession. In contrast, the forward earnings for the US and Japanese cosmetics sectors collapsed both then and now (Chart I-9). Chart I-9The European Cosmetics Sector Has Been Recession-Proof The European Cosmetics Sector Has Been Recession-Proof The European Cosmetics Sector Has Been Recession-Proof Furthermore, the latest quarterly reports show that while operating profits for L’Oréal are down by around 20 percent from a year ago, the operating profits for Estee Lauder and Shiseido have slumped by more than 80 percent.1 As a result, the L’Oréal share price took a much smaller hit than those of Estee Lauder and Shiseido in both the 2008 and the 2020 stock market crashes (Chart I-10 and Chart I-11). Chart I-10L’Oréal Took A Smaller Hit Than Estee Lauder And Shiseido In 2008… L'Oreal Took A Smaller Hit Than Estee Lauder And Shiseido In 2008... L'Oreal Took A Smaller Hit Than Estee Lauder And Shiseido In 2008... Chart I-11…And In ##br##2020 ...And In 2020 ...And In 2020 An important reason for L’Oréal’s consistent outperformance is its diversified product range. L’Oréal acknowledges that for both its consumer products and luxury divisions “the health crisis triggered a sharp deceleration in the makeup market”. But the hit to makeup was counterbalanced by continued strong growth in skin care thanks, for example, to the launch of serums in its Revitalift range. Additionally, its hair care products grew thanks to Fructis Hair Food plus very strong performance in the “highly dynamic home-use hair colour market”.  Estee Lauder confirms that “Covid-19 and its various impacts have influenced consumer preferences due to the closures of offices, retail stores and other businesses and the significant decline in social gatherings”. While the demand for makeup and fragrance has slumped, the demand for skin care and hair care products has been more resilient. The trouble is that hair care accounts for less than 4 percent of Estee Lauder’s total sales. Meanwhile, the collapse in makeup sales has forced goodwill asset impairments to several of its makeup brands causing the 80 percent collapse in its overall profits. Likewise, Shiseido blames the 83 percent slump in its operating profits largely on “a product mix deterioration” which outweighed prompt cost-saving measures in response to the rapid deterioration of the market environment. Another vulnerability is that Shiseido’s sales are highly concentrated in Asia. By comparison, L’Oréal benefits from geographical diversification, with sales almost equally split between Europe, the Americas, and Asia (Table I-1). Table I-1L’Oréal Benefits From Geographical Diversification Does The Lipstick Effect Work Under A Facemask? Does The Lipstick Effect Work Under A Facemask? The European Personal Products Sector Is Also Outperforming Turning to the general personal products sector, the leading companies are Unilever and Beiersdorf in Europe, Procter & Gamble, Colgate-Palmolive, and Kimberly Clark in the US, and Kao in Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. Indeed, while the European sector’s profits have steadily grown through the past decade, the US sector’s profits have been going nowhere since the mid-2010s (Chart 1-12). Chart I-12The European Personal Products Sector’s Profits Have Grown Through The Past Decade The European Personal Products Sector's Profits Have Grown Through The Past Decade The European Personal Products Sector's Profits Have Grown Through The Past Decade   One reason for the European personal products sector’s reliable growth is that both Unilever and Beiersdorf are highly exposed to the beauty sector – in fact, Unilever has an even larger market share than Estee Lauder (Chart I-13). And as we have just seen, a diversified exposure to all segments of the beauty sector – makeup, fragrances, skin care, and hair care – should produce resilient growth in all economic backdrops. Pre-pandemic, and potentially once the pandemic is over, makeup and fragrances were/will be the growth drivers. Whereas during the pandemic, skin care and hair care are the drivers. Chart I-13Unilever Is A Big Player In Beauty Does The Lipstick Effect Work Under A Facemask? Does The Lipstick Effect Work Under A Facemask? A final point is that despite the superior and safer growth prospects of the European cosmetics and personal products companies, they are not generally more richly valued than their peers in the US and Japan (Table I-2 and Table I-3). Table I-2The European Cosmetics Sector Is Not More Expensive Does The Lipstick Effect Work Under A Facemask? Does The Lipstick Effect Work Under A Facemask? Table I-3The European Personal Products Sector Is Not More Expensive Does The Lipstick Effect Work Under A Facemask? Does The Lipstick Effect Work Under A Facemask? To sum up, for the pandemic era and beyond, the European cosmetics and personal products sector is well set for diversified growth via product mix, price points, and regional exposures. And it is relatively well valued versus its peers elsewhere in the world. As such, the sector – dominated by L’Oréal, Unilever, and Beiersdorf – should remain a core holding in an investment portfolio.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Mohamed El Shennawy Research Associate mohamede@bcaresearch.com Footnotes 1 The most recent quarterly report for Estee Lauder is due on August 20. But at the time of writing the latest quarterly report was to the end of June 2020 for L’Oréal and to the end of March 2020 for Estee Lauder and Shiseido.

Highlights Global Credit Spreads: The relentless rally in global credit markets since the rout in February and March has driven corporate spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the coronavirus and US politics. Credit Strategy: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both. Feature Chart of the WeekA Pandemic? Credit Markets Are Not Concerned A Pandemic? Credit Markets Are Not Concerned A Pandemic? Credit Markets Are Not Concerned Global credit markets have enjoyed a spectacular recovery from the carnage seen just five months ago when investors realized the magnitude of the COVID-19 shock. The option-adjusted spread (OAS) on the Bloomberg Barclays Global Investment Grade Corporate index has tightened from the 2020 high of 326bps to 130bps, while the OAS on the Global High-Yield index has narrowed from the 2020 high of 1192bps to 556bps. Unsurprisingly, those spread peaks both occurred on the same day: March 23, the day the US Federal Reserve announced their corporate bond buying programs. We have described the Fed’s actions as effectively removing the “left tail risk” of investing in credit, and not just in the US, by introducing a central bank liquidity backstop to the US corporate bond market. The backdrop for global credit markets, on the surface, seems typical for sustained spread compression (Chart of the Week). Economic optimism is buoyant, with the global ZEW expectations index now at the highest level since 2014. Monetary conditions are highly supportive, with near-0% policy rates across all developed economies and the balance sheets of the Fed, ECB, Bank of Japan and Bank of England growing at a combined year-over-year pace of 46%. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US.  The next moves in credit will be more challenging and less rewarding than the past five months. Investment grade corporate credit spreads no longer offer compelling value in most developed economies, while high-yield spreads are tightening in the face of rising default rates in the US and Europe. While additional spread tightening is not out of the question in these markets, investors should consider rotating into credit sectors that still offer some relative value – like emerging market (EM) hard currency corporates. A World Tour Of Our Spread Valuation Indicators The sharp fall in global bond yields over the past several months has not just been confined to government debt. Yields have fallen toward, and even below, pre-virus lows for a variety of sectors ranging from US mortgage-backed securities (MBS) to EM USD-denominated sovereign debt (Chart 2). Investors are clearly reaching for yield in the current environment of tiny risk-free government bond yields, with no greater sign of this than the recent new issue by a US sub-investment grade borrower of a 10-year bond with a coupon below 3%.1 The drop in credit yields has also occurred alongside tightening credit risk premiums, although spreads remain above the pre-virus lows for most sectors in the US, Europe and EM (Chart 3). The degree of correlation across global credit markets has been intense, with very little differentiation between countries. Investment grade corporate spreads in the US, UK and euro area are all closing in on 100bps; high-yield spreads in those same regions are all around 500bps. Chart 2Global Credit Yields Are Low Global Credit Yields Are Low Global Credit Yields Are Low Chart 3Global Credit Spreads Are Getting Tight Global Credit Spreads Are Getting Tight Global Credit Spreads Are Getting Tight Last week, we introduced the concept of “yield chasing” to describe how the ranking of returns in developed market government bonds was becoming increasingly correlated to the ranking of outright yield levels.2 We have seen a similar dynamic unfold in global credit markets, especially since that peak in spreads in late March. In Chart 4 and Chart 5, we present the relationship between starting benchmark index yields, and the subsequent excess returns over risk-free government bonds, for a variety of developed market and EM credit products. The first chart covers the time from start of 2020 to the March 23 peak in spreads, while the second chart shows the relationship since then. The two charts are mirror images of each other. Chart 4Starting Yields & Subsequent Global Credit Excess Returns In 2020 (January 1 To March 20) What Next For Global Corporate Credit Spreads? What Next For Global Corporate Credit Spreads? Chart 5Starting Yields & Subsequent Global Credit Excess Returns In 2020 (Since March 23) What Next For Global Corporate Credit Spreads? What Next For Global Corporate Credit Spreads? The worst performing markets in the first three months of the year were those with the highest yield to begin 2020: high-yield corporates in the US and Europe along with EM credit, which have been the best performing markets since late March. The opposite is true for lower yielders like investment grade credit in Japan, the euro area and Australia, which were among the top performers before March 23 and have lagged sharply since then. While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Chart 6Lower Vol = Lower Credit Risk Premia Lower Vol = Lower Credit Risk Premia Lower Vol = Lower Credit Risk Premia While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Measures of bond volatility like the MOVE index of US Treasury options prices have declined to pre-pandemic lows, while the VIX index of US equity volatility is now down to 22 from the 2020 peak around 80 (Chart 6). The excess return volatility of US corporate bond markets has followed suit, thus allowing for lower US credit spreads. Even allowing for the lower levels of overall market volatility, corporate credit spreads do look relatively tight in the US and Europe. The ratio of the US investment grade index OAS to the VIX is now one standard deviation below the median since 2000 (Chart 7). A similar reading exists for the ratio of the US high-yield index OAS to the VIX, which is also one standard deviation below the long-run average (bottom panel). In the euro area, the ratios of investment grade and high-yield OAS to European equity volatility, the VStoxx index, are not as stretched as in the US, but remain below long-run median levels (Chart 8). Chart 7Very Tight US Corporate Credit Spreads Relative To Equity Vol Very Tight US Corporate Credit Spreads Relative To Equity Vol Very Tight US Corporate Credit Spreads Relative To Equity Vol Chart 8Tight Euro Area Corporate Credit Spreads Relative To Equity Vol Tight Euro Area Corporate Credit Spreads Relative To Equity Vol Tight Euro Area Corporate Credit Spreads Relative To Equity Vol While these simple comparisons of spread to market volatility suggest that corporate credit spreads are tight in most major markets, other indicators paint a more nuanced picture of cross-market valuations. Our preferred measure of the attractiveness of credit spreads is the 12-month breakeven spread. That measures the amount of spread widening that must occur over a one-year horizon for a credit product to have the same return as government bonds. In other words, how much must spreads increase to eliminate the carry advantage of a credit product over a risk-free bond, after accounting for the volatility of that product. We compare those 12-month breakeven spreads with their own history in a percentile ranking, which determines the attractiveness of spreads. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. A look at breakeven spread percentile rankings for the major credit groupings in the US (Chart 9), euro area (Chart 10) and EM (Chart 11) shows more diverging spread valuations. Chart 9US Corporate Bond Breakeven Spread Percentile Rankings US Corporate Bond Breakeven Spread Percentile Rankings US Corporate Bond Breakeven Spread Percentile Rankings Chart 10Euro Area Corporate Bond Breakeven Spread Percentile Rankings Euro Area Corporate Bond Breakeven Spread Percentile Rankings Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 11EM USD Credit Breakeven Spread Percentile Rankings EM USD Credit Breakeven Spread Percentile Rankings EM USD Credit Breakeven Spread Percentile Rankings The US investment grade breakeven spread is just below the 25th percentile of their long-run history, although the high-yield breakeven spread remains in the top quartile of its history. Euro area breakeven spreads are “fairly” valued, both sitting around the 50th percentile. The EM USD-denominated sovereign breakeven spread is in the third quartile below the 50th percentile, while the EM USD-denominated corporate breakeven spread looks better, sitting just at the 75th percentile. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. We would not be surprised to see US investment grade spreads tighten back to the previous cyclical low at some point in the next 6-12 months. There are more compelling opportunities in other global credit markets, however, especially on a risk-adjusted basis. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. Bottom Line: The relentless rally in global credit markets since the out in February and March has driven credit spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the virus and US politics. Spread valuations are looking more stretched, but “yield chasing” and “spread chasing” behavior will remain dominant with central banks encouraging risk-seeking behavior with easy money policies. Putting It All Together: Recommended Allocations One way to look at the relative attractiveness of global spread product sectors is to compare them all by 12-month breakeven spread percentile rankings. We show that in Chart 12, not just for the overall credit indices by country but also among credit tiers within each country. Sectors rated below investment grade are in red to differentiate from higher-quality markets. Chart 12Global Corporate Bond Breakeven Spreads, Ordered By Percentile Ranks What Next For Global Corporate Credit Spreads? What Next For Global Corporate Credit Spreads? The main conclusion form the chart is that there is a lot of red on the left side and none on the right side. That means junk bonds in the US and Europe have relatively high breakeven spreads, while investment grade credit in most countries have relatively lower breakeven spreads. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. To further refine the cross-country comparisons, we must look at those breakeven spreads relative to the riskiness of each sector. In Chart 13, we present a scatter graph plotting the 12-month breakeven spreads versus our preferred measure of credit risk, duration-times-spread (DTS), for all developed market corporate credit tiers, as well as EM USD-denominated sovereign and corporate debt. The shaded region represents all values within +/- one standard error of the fitted regression line. Thus, sectors below that shaded region have breakeven spreads that are low relative to its DTS, suggesting a poor valuation/risk tradeoff. The opposite is true for sectors above the shaded region. Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) What Next For Global Corporate Credit Spreads? What Next For Global Corporate Credit Spreads? The sectors that stand out as most attractive in this framework are B-rated and Caa-rated US high-yield, and EM USD-denominated investment grade corporates. The least attractive sectors are US investment grade corporates, for both the overall index and the Baa-rated credit tier. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. Looking beyond the spread and volatility measures presented in this report, we must consider the default risk of high-yield bonds. Our preferred measure of valuation that incorporates default risk is the default-adjusted spread, which measures the current high-yield index spread net of default losses. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. The current US high-yield default-adjusted spread is now well below its long-run average (Chart 14). We expect a peak US default rate over the next year between 10-12% (levels seen after past US recessions) and a recovery rate given default between 20-25% (slightly below previous post-recession levels). That combination would mean that expected default loses from the COVID-19 recession could exceed the current level of the US high-yield index spread by as much as 400bps (see the bottom right of the chart). Given that risk of default losses overwhelming the attractiveness of US high-yield as measured by the 12-month breakeven spread, we prefer to stay up in quality by focusing on Ba-rated names within an overall neutral allocation to US junk bonds. For euro area high-yield, where default-adjusted spreads are also projected to be negative next year but with less attractive 12-month breakeven spreads, we recommend a cautious up-in-quality allocation to Ba-rated names only but within an overall underweight allocation. After ruling out increasing allocations to US B-rated and Caa-rated high-yield, that leaves the two remaining valuation outliers from Chart 13 - US investment grade and EM USD-denominated investment grade corporates. The gap between the index OAS of the two has narrowed from the March peak of 446bps to the latest reading of 259bps (Chart 15). We believe that gap can narrow further towards 200bps, especially given the supportive EM backdrop of USD weakness and China policy stimulus – both factors that were in place during the last sustained period of EM corporate bond outperformance in 2016-17. Chart 14No Cushion Against Credit Losses For US & Euro Area HY No Cushion Against Credit Losses For US & Euro Area HY No Cushion Against Credit Losses For US & Euro Area HY Chart 15EM IG Corporates Remain Attractive Vs US IG EM IG Corporates Remain Attractive Vs US IG EM IG Corporates Remain Attractive Vs US IG We upgraded our recommended allocation to EM USD-denominated credit out of US investment grade back in mid-July, and we continue to view that as the most attractive relative value opportunity in global spread product on a risk/reward basis. Bottom Line: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-08-10/u-s-junk-bond-market-sets-record-low-coupon-in-relentless-rally 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Next For Global Corporate Credit Spreads? What Next For Global Corporate Credit Spreads? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns