Gold
Overweight Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel). The longer the global soft-patch lasts, the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks. Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (bottom panel). Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US); please see Monday’s Weekly Report for more details.
Not only is there a tight inverse correlation with the trade-weighted U.S. dollar, but over the past three years the Chinese renminbi has moved in lockstep with gold. Now that Chinese policymakers are tentatively injecting stimulus in their economy, odds are…
Highlights Portfolio Strategy While equities will likely be higher in the coming 9-12 months, we would refrain from committing fresh capital to the market at this juncture. A better entry point lies ahead. Tactically, this market needs a breather to digest the V-shaped formation since last December’s G20 meeting before it resumes its bull run. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Augment positions to neutral. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Recent Changes Lift the S&P 1500 auto components index to neutral and cement gains of 36% today. From a portfolio management perspective, downgrade the S&P semi equipment index to neutral for a gain of 16% since the December 17, 2018 inception. Table 1 Feature The S&P 500 hit a trouble spot last week, despite positive news on the U.S./China trade tussle. Clearly, there is an element of “buy the rumor sell the news” in the market as equities have come a long way this year, reversing all of last December’s steep losses. But, the SPX now faces stiff resistance at the most important 2,800 level as we highlighted in recent research.1 Chart 1 shows “The Good”. From a sentiment/technical perspective, fresh all-time highs in the S&P 500 advance/decline line portend ongoing gains in this broad-based equity market advance. The junk bond market sends an equally encouraging signal: The Barclays total return high yield corporate bond index has vaulted to new highs, which bodes well for the SPX (middle panel, Chart 1). Finally, all three of the S&P risk parity total return indexes2 have slingshot into uncharted territory and suggest that the S&P 500 is headed there next. Chart 1The Good… Nevertheless, there are some cracks appearing in the U.S. economy. News of an abysmal retail sales report was quickly discredited by pundits, with some blaming poor data collection due to the government shutdown. Chart 2 shows “The Bad”. Worrisomely, contracting intermodal rail carloads and a nosedive in the “First Data merchant services dollar spend” at retailers likely corroborate the Commerce Department’s weak retail sales data. Moreover, the recent plunge in the Goldman Sachs MAP (Macro-data Assessment Platform) Surprise Index, which is now probing a three year low, suggests that the U.S. economy is in a soft-patch. Chart 2…The Bad… Charts 3 & 4 show “The Ugly”. Our Economic Impulse Indicator (EII) first introduced last October,3 has taken a turn for the worse. Six economic indicators encapsulating the U.S. economy comprise the EII, and there is clear deterioration in economic activity on a second derivative basis. The recent contraction in the overall business (manufacturing, wholesale and retail) sales-to-inventories (SI) ratio also warns of profit trouble in the coming quarters (Chart 4). Keep in mind that this data series only goes to November 2018 and once it gets updated to include December later this week, the SI ratio will likely fall deeper into the contraction zone. Chart 3…And The… Chart 4…Ugly So should investors take some chips off the table given this macro backdrop? Prior to answering the question, as a reminder, BCA’s view remains that the business cycle is alive and well and there is no recession on a cyclical time horizon. Therefore, equities should be higher in the coming 9-12 months. Our end-2019 SPX target remains at 3,000 based on $181 EPS for calendar year 2020 assuming a 16.5 multiple.4 Nevertheless from a shorter-term perspective, we would refrain from committing fresh capital to this market, as we believe a better entry point lies ahead. Tactically, this market now needs a breather to digest the V-shaped formation since last December’s G20 meeting, before it resumes its bull run. In addition, we would book gains on any alpha generating tactical trades; today we crystalize 16% gains in the S&P semi equipment tactical overweight position since the December 17, 2018 inception and downgrade to neutral. This week, we book handsome profits on a long-held underweight in a consumer discretionary subindex that Trump’s hawkish tariff rhetoric and actions have badly wounded. We also update a materials subsector that benefits from the ongoing global reflationary impulse. Auto Components: Aiming For Pole Position? We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. We are lifting exposure to neutral from underweight, locking in relative gains of 36% since inception. Global auto sales are the main driver of auto components profits, thus identifying where we stand in the global auto sales cycle is key. Bellwether German automakers have been caught in an emissions-related downdraft with “Dieselgate” weighing heavily on this sector when new emissions-test procedures were implemented last quarter. The top panel of Chart 5 shows that the worst is likely behind this drubbing in German automobile production as new orders have recently gone vertical. Backlogs are also sky-high and suggest that a definitive turn looms in German motor vehicle output. The upshot is that global auto sales may come out of their recent funk. Chart 5Global Auto Sales Are About To Turn The Japanese car industry, the other global heavyweight, also suffered a minor setback last year, but leading indicators of Japanese auto production are also ticking higher. Japanese industrial robot shipments are at fresh cyclical highs and signal that global auto sales will hook up (bottom panel, Chart 5). In the U.S., light vehicle sales have been stable over the past five years, but auto industrial production growth has been roaring, rising 40 percentage points from the manufacturing recession trough (second panel, Chart 6). Chart 6Improving… All of this paints a brightening backdrop for U.S. auto components manufacturers. Indeed, auto components new orders are at all-time highs (middle panel, Chart 7), at a time when inventories remain tame. In fact the new orders-to-inventories ratio sits squarely above one and continues to firm, with unfilled orders also at all-time highs (Chart 8). As a result, selling prices are accelerating at a healthy clip (third panel, Chart 6). The upshot is that industry profits will likely overwhelm. Chart 7…Operating… Chart 8...Auto Component Metrics On the domestic demand front, the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (bottom panel, Chart 7). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel, Chart 7). Despite these tailwinds, investors have relentlessly avoided auto component stocks. Technicals remain washed out and industry valuations are a small fraction of the broad market and below the historical mean as per the relative price-to-sales ratio (Chart 9). Chart 9Cheap And Oversold… Nevertheless, we refrain from turning outright bullish on this consumer discretionary subsector given the following risks: First, auto loan delinquencies are increasing rapidly, approaching last cycle’s peak. Second, car financing interest rates are still rising, which, at the margin, dents demand for new car sales. Third, auto credit growth is decelerating and demand for auto loans is also anemic according to the Fed’s latest Senior Loan Officer survey (Chart 10). This stands in marked contrast to the aforementioned Conference Board’s survey of consumers’ plans to buy a car. Finally, were President Trump to proceed with auto tariffs on European car manufacturers once he strikes a deal with China, U.S. auto parts producers will suffer a setback. Chart 10…But There Are Some Risks Netting it all out, the easy money has already been made by shying away from auto component manufacturers. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Bottom Line: Lift the S&P 1500 auto components index to neutral and crystalize gains of 36% today. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP. A Modest Gold Portfolio Hedge Still Makes Sense Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. There is compelling evidence that gold bullion is a reliable reflationary gauge. The shiny metal troughed in mid-August, leading even the JP Morgan EM FX index. Since then, it has been in an uninterrupted run rising over $180/oz. or 15% and sniffing out a reflationary impulse. Not only is there a tight inverse correlation with the trade-weighted U.S. dollar, but over the past three years the Chinese renminbi also moves in close lockstep with gold (Chart 11). Now that Chinese policymakers have opened the credit spigots (January credit data revealed the largest ever month-over-month loan increase in the history of the data, please refer to the second panel of Chart 2 in last week’s publication)5 reflating their economy, there are high odds that gold can break out of its past five year trading range in a bullish fashion. Chart 11Gold Is Sniffing Out A Reflationary Impulse Commodity sentiment and positioning data suggest that gold’s run up will prove durable and continue to underpin the relative share price ratio (second & third panels, Chart 12). Chart 12Bullish Bullion Positioning Underpins Global Gold Miners Importantly, the precious metals industry has not stood still. It has embarked on a massive consolidation phase and the recent spike in M&A activity in global gold miners signals that there is more upside for relative share prices (top panel, Chart 12). But the good news does not stop there. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel, Chart 13). The longer the global soft-patch lasts the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. This macro backdrop represents fertile ground for gold and gold related equities (bottom panel, Chart 14). Chart 13Rising Uncertainty, Global Growth Softpatch And… Chart 14…Falling Real Rates Are Excellent Gold Mining Supports Keep in mind that gold bullion yields zero and the gold mining equities’ dividend yield trails the broad market by 100bps; thus, there is an opportunity cost to holding gold and gold related equities, especially now that even U.S. cash yields 2.5%. This explains the inverse correlation with real interest rates and the recent 30bps fall in the U.S. 10-year TIPS yield reinforces gold bullion and the relative share price ratio (TIPS yield shown inverted, middle panel, Chart 14). Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel, Chart 13), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks (top panel, Chart 13). Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (third panel, Chart 13). While some semblance of normality has returned to global bourses year-to-date, fixed income investors do not share the euphoria their equity peers are emitting. Such a dichotomy favors global gold mining stocks. Finally, with regard to relative valuations and technicals, global gold equities remain in undervalued territory, but have recently recovered smartly from deeply oversold conditions (Chart 15). Chart 15Valuations Ready To Shine In sum, gold bullion is sniffing out a reflationary impulse that is bullish for global gold mining equities. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US), and remove the downgrade alert. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019,available at uses.bcaresearch.com. 2 https://us.spindices.com/documents/methodologies/methodology-sp-risk-parity-indices.pdf?force_download=true 3 Please see BCA U.S. Equity Strategy Report, “Icarus Moment” dated October 22, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, “Reflationary Or Recessionary” dated February 25, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
For most of 2018, the U.S. dollar and real rates were the primary determinants of investor sentiment and positioning toward gold. As these variables rose, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in…
The hiatus in the Fed’s rates-normalization policy in 1H19 in the wake of its capitulation to financial markets, supports our bullish view on gold prices, as it raises the risk of an inflation overshoot later this year. Per the Fed’s dual mandate, inflation and employment gauges are signaling the need for tighter policy, according to BCA’s proprietary Fed Monitor. The pause in hiking fed funds raises the likelihood the Fed will find itself behind the inflation curve, as the economy enters a late-cycle phase. Gold will outperform other commodities and equities in this phase. We remain long gold as a portfolio hedge. Highlights Energy: The U.S. imposed sanctions on state-owned Petróleos de Venezuela, S.A. (PDVSA), including a ban on the company’s Houston-based Citgo remitting earnings back to the parent company. This raises the likelihood production and exports will fall sharply as we expect. Separately, Saudi Energy Minister Khalid al-Falih said the country will reduce output below its recently agreed 10.3mm b/d cap in 1H19, in line with our own balances expectation.1 Base Metals/Bulks: Neutral. Iron ore prices likely will continue to move higher, following the collapse of a wet-processing dam at Vale’s Córrego do Feijão mine. The company suffered a similar breach at its Samarco mine in March 2016, which still has not re-opened. Output will fall, if it follows through with additional dam closures. Precious Metals: Neutral. Gold prices will continue to move higher, as the Fed’s near-term capitulation on its rates-normalization policy raises the odds the U.S. central bank will find itself behind the inflation curve. (See below.) Ags/Softs: Underweight. USDA reported soybeans inspected for export to China during the week ended January 24 accounted for close to 37% of the total beans inspected. This made China the No. 1 importer of American soybeans again. Feature In February 2018, we wrote that “price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here.” In line with this expectation, we suggested remaining long gold as a portfolio diversifier and hedge against mounting equity risks. This turned out to be an accurate call. Despite losing 8.4% between January and September 2018 because of an aggressive Fed, gold rose by 7.6% in 4Q18 amid the rising equity volatility and ended the year down a minor -1.5% compared to -6.2%, -11.2% and -7.1% for the S&P 500, global equities and the CRB commodity index. This reflects the convexity in gold returns and is the reason we favored gold in 2018. Gold returns are not simply a function of the U.S. dollar and real interest rates. As highlighted in our 2019 Key Views report last December, in mature economic cycles, gold’s ability to hedge against equity and inflation risks dominate its price formation, while its correlation with the U.S. Treasury yields diminishes (Chart of the Week).2 Chart of the WeekGold's Correlation With U.S. Rates Declines As The Cycle Matures As the current cycle extends to 2019, the skewness in gold return will prove profitable. The Fed’s retreat on its quarterly rate-hike cycle only adds to our positive view, as it increases the probability the U.S. central bank falls behind the curve. Stay long gold as a portfolio hedge. Fed’s Short-Term Capitulation Strengthens Our View The recent downward revision in the Fed’s rate-hike path reinforces our positive stance on gold prices, as risks of an overshoot in inflation rises. The dichotomy in U.S. vs. rest of the world growth puts the Fed in a difficult position. The current capitulation was mainly driven by tightening financial conditions – chiefly, the rising U.S. dollar, declining stock prices, and widening credit spreads. However, under the Fed’s dual mandate, inflation and employment still are signaling “tightening-required” per BCA Research’s Fed Monitor, a model maintained by our U.S. Bond strategists (Chart 2). Since economic growth cannot remain above-trend indefinitely, short-term productive capacity constraints (i.e. capital and labor factors of production) are already binding and will force the Fed to raise rates later this year as inflation creeps up. Chart 2Growth And Inflation Signal Tighter Money Is Required As it reaffirms its data dependence, the Fed is opening the door to falling behind the inflation curve, given inflation is a lagging indicator of the price pressures that are building up in the economy (Chart 3). As a result, we expect gold’s ability to hedge against inflation will support its price in 2H19. Chart 3Inflationary Pressure Will Rise In 2019 Short-term, a Fed pause also supports gold by readjusting investors’ expectations regarding the U.S. dollar and real interest rates lower. Our bond strategists identified two previous periods where similar conditions led to a false start in the Fed hiking cycle, 1997 and 2015. In both cases, the Fed’s capitulation led to a reversal in gold’s downward price trajectory, as the market perceived the central bank was keeping its short-term policy rate at a level that was inconsistent with the so-called R-star rate or natural rate of interest – i.e., “the real interest rate expected to prevail when the economy is at full strength” (Chart 4).3 Chart 4AGold Price's Trajectory Reversed In 1997... Chart 4B Using a conceptual four-quadrant framework developed by our colleagues at The Bank Credit Analyst to describe the Fed’s behavior, we currently believe the outcome with the highest probability of being realized by the Fed’s capitulation is Policy Mistake 2 (Table 1, lower right quadrant). If we’re right, this raises the odds of an inflation overshoot above the Fed’s 2% target later this year.4 Table 1Four Fed Policy Scenarios This is not a foregone conclusion. However, generally speaking, the higher the inflation uncertainty and the higher the perception the Fed will fall behind the curve, the higher gold is bid up. Recent price action seems to corroborate this. Chart 5 shows that the recent downward revision in the median long-term fed funds rate projection coincides with a rise in gold prices. At present, gold investors are signaling that the fed funds rate is below the neutral rate consistent with R-star. Chart 5Gold Markets Signal Monetary Policy Is Accommodative Gold And The U.S. Economic Cycle Gold prices are difficult to model and predict, given the collection of time-varying, often conflicting, components determining their evolution. Its core determinants change as we move through the economic cycle. In their current late-cycle environment, inflation and equity risks – i.e., fears of a sharp correction – usually gain in importance. In this report, we characterize the market’s late-cycle phase using two metrics: (1) the fed funds rate relative to R-star, (2) the phase of the yield curve cycle.5 We have already discussed (1) in our outlook and found that when the fed funds rate is rising yet still below the estimate of R-star, gold returns are highly skewed to the upside (Chart 6).6 For (2), we compared the yellow metal’s return to other assets returns in different phases of the U.S. Treasury yield curve’s evolution. We define these yield-curve phases as follow: Phase 1: Normal (i.e., positively sloped: 10-year rates are greater than 3-month rates). The 3-month/10-year treasury slope is above 75 bps. Phase 2: On its way to flattening and returning to normal. The 3-month/10-year Treasury slope is between 0 bps and 75 bps. We divide this in two sub-phases: (a) steepening, and (b) flattening. Phase 3: Inverted (i.e., negatively sloped). The 3-month/10-year Treasury slopes is below 0 bps (Chart 7).7 Chart 7Phases Of The Yield Curve Cycle We found that: first, DM and EM equities are the best performers in the group we looked at during Phase 1, when the slope of the yield curve is steep (above 75 bps). Second, there is wide difference between the steepening and flattening sections of Phase 2. EM equities and copper experience the largest rebound once the slope’s curve steepens from below zero. Lastly, gold performs best in the flattening section of Phase 2 and, critically, it outperforms oil, copper, broad commodity indices and equities (Table 2). Table 2Gold Returns Are Positive When The Yield Curve’s Slope Flattens Our U.S. Investment and Bond Strategists believe the Fed’s policy rate will remain in the below-r-star-and-rising range, and in Phase 2 of the yield curve cycle for most of 2019. We agree, and believe our analysis indicates gold prices will increase this year on the back of these factors. Recession Fear And Equity Risks Will Drive Gold For most of 2018, investor sentiment and positioning were primarily determined by the U.S. dollar and real rates. As these variables rose last year, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in the oversold territory (Chart 8).8 In our view, the other (important) drivers of gold prices were ignored during that period. The end-of-year equity selloff led to a reshuffle of the core determinants of the yellow metal’s price, pushing the equity risk factor higher on the list of variables explaining its price. Chart 8Sentiment Collapsed In 1H18 Chart 9 shows gold and the U.S. equity risk premium disconnected in 2018, until the October equity selloff. In general, these variables are positively linked. When risk aversion is elevated, investors demand higher compensations for holding risky assets, and increase their demand for safe-haven assets. This pushes up both the equity risk premium and gold prices. Chart 9Gold And Equity Risk Premium Correlation Picked Up Gold’s performance in 4Q18 supports our recommendation for holding it as a portfolio diversifier in 2018, and why we continue to do so this year (Chart 10). Separately, our U.S. dollar and rates-only model moved up recently, easing the downward pressure on gold (Chart 11). While we believe these two variables’ marginal impact diminished since 4Q18, they are included in our gold “fair-value” model, which currently indicates it is fairly valued and that its support remains intact. Chart 11Upside Pressures Are Building Bottom Line: The Fed’s near-term capitulation raises the odds the U.S. economy will experience an inflation overshoot. Our fair-value model also is supportive of gold prices. We remain long as a diversification and portfolio hedge. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1 Please see “Saudis Pledge Deeper Oil Cuts in February Under OPEC+ Deal,” published by bloomberg.com January 29, 2019. See also “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone” published January 24, 2019, for our latest supply-demand balances and price forecasts. It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 3 Please see John C. Williams’s remarks delivered to the Economic Club of Minnesota May 15, 2018, entitled “The Future Fortunes of R-Star: Are They Really Rising?” Williams was president and CEO of the Federal Reserve Bank of San Francisco at the time, and now has the same role at the NY Fed.. We explore this further below. See also BCA Research’s U.S. Bond Strategy Weekly Report titled “An Oasis Of Prosperity,” published August 21, 2018. It is available at usb.bcaresearch.com. 4 Please see BCA Research’s The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. It is available at bca.bcaresearch.com. 5 The San Francisco Fed defines R-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. R-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 6 We presented this analysis in BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 7 For a similar analysis applied to different asset classes, please see BCA Research’s U.S. Bond Strategy Weekly Report titled “2019 Key Views: Implication For U.S. Fixed Income,” published December 11, 2018, and The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. These reports are available at usb.bcaresearch.com and bca.bcaresearch.com. Our approach is slightly different from our colleagues’ methodology. We used a threshold of 75 bps instead of 50 bps in order to increase the sample size of the Phase 2, flattening section. This improves the accuracy of using the average as our main descriptive statistic. Note that the yield curve can remain inverted for some time before a recession occurs, this explains why equity returns are positive in Phase 3 (curve inversion). 8 Our Gold Composite Indicator has three components: (1) Sentiment, (2) Speculative positioning and (3) Technical. It is meant to assess if there is any mismatch between our fundamental analysis and investors’ sentiment and expectations. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table Summary Of Trades Closed In 2018
… quick’s the word and sharp’s the action. Jack Aubrey1 Idiosyncratic supply-demand adjustments – some induced by head-spinning reversals of policy (e.g., the U.S. about-face on Iran oil export sanctions) – and uncertainty regarding monetary policy and trade will keep volatility in oil, metals and grains elevated in 2019. We remain overweight energy – particularly oil – expecting OPEC 2.0 to maintain production discipline, and for demand to remain resilient.2 We remain neutral base metals and precious metals, seeing the former relatively balanced, and the latter somewhat buoyant, even as the Fed continues its rates-normalization policy. We remain underweight ags, although weather-induced supply stress has reduced the global inventories some. While we continue to favor being long the energy-heavy S&P GSCI on a strategic basis, tactical positioning will continue to dominate commodity investing in 2019. Highlights Energy: Overweight. OPEC 2.0’s 1.2mm b/d of production cuts goes into effect in January vs. October levels, and should allow inventories to resume drawing. Base Metals: Neutral. Fundamentally, base metals are largely balanced, which is keeping us neutral going into 2019. Precious Metals: Neutral. Gold prices will remain sensitive to Fed policy and policy expectations. Palladium prices have soared as a growing physical deficit noted earlier widens.3 If China cuts sales taxes on autos again, demand could soar. Ags/Softs: Underweight. A strong USD will weigh on ag markets, particularly grains, next year. An agreement on contentious Sino – U.S. trade issues could re-open Chinese markets to U.S. exports. However, the arrest of the CFO of China’s Huawei Technologies in Canada for possible extradition to the U.S. complicates negotiations. Feature Going into 2019, commodity markets once again are sending conflicting signals. While we continue to favor exposure to commodities as an asset class by being long the energy-heavy S&P GSCI index, which fell 6% this year on the back of the collapse in crude oil prices and flattening of the forward curves in Brent and WTI. Nonetheless, we believe investors will continue to be rewarded by taking tactical exposure on an opportunistic basis. Volatility remains the watchword, particularly in 1H19, for the primary industrial commodities – oil and base metals. While idiosyncratic supply-demand adjustments will drive prices in each market, Fed policy also will contribute to volatility, as the U.S. central bank likely remains the only systemically important monetary authority following through on rates-normalization. In line with our House view, we expect the Fed to deliver its fourth rate hike of 2018 at its December meeting next week, and four additional hikes next year. On the back of Fed policy, we expect the broad trade-weighted USD to rise another 3-5% in 2019, following a 6% increase in 2018 (Chart of the Week). This will supress demand ex-U.S. for commodities priced in USD, by raising the USD cost of these commodities. Chart of the WeekStronger USD Pressures Commodity Demand Below, we highlight the key themes we believe will dominate commodities in 2019. Oil Markets Still Re-Calibrating Fundamentals We continue to expect global oil demand to remain strong next year, despite the slight downgrading of global GDP growth earlier this year by the IMF. We expect EM import volumes – one of the key variables we track to proxy EM income levels – to hold up in 1H19, which supports our assessment commodity demand will grow, albeit at a slower rate than this year (Chart 2).4 Chart 2Slowing Trade Volumes Might Pre-sage Softer Commodity Demand In 2H19, we see the volume of EM imports dipping y/y from higher levels, then recovering toward year-end. This indicates the all-important level of EM income – hence commodity demand – will remain resilient, but the rate of growth in incomes will slow. This is confirmed by the behavior of the Global Leading Economic Indicators we use to cross check our EM income expectation via import volumes (Chart 3). Chart 3Global Leading Economic Indicators Lead EM Import Volume Changes There is a chance Sino – U.S. trade relations will thaw, which would remove a large uncertainty over the evolution of demand next year. This would be supportive for EM trade volumes generally, particularly imports. However, this is not a given, and we are not assuming any pick-up in demand in anticipation of such a development. We need to see concrete actions, followed by tangible trade improvement first. On the supply side, oil markets still are in the process of re-adjusting to an extraordinary policy reversal by the Trump administration on its Iranian oil-export sanctions last month – i.e., the last-minute granting of waivers to Iran’s largest oil importers. However, following OPEC 2.0’s decision last week to cut 1.2mm b/d of production to re-balance markets in 1H19, we continue to expect prices to recover. Indeed, going into the OPEC 2.0 meeting last week, we had already lowered our December 2018 production estimates for OPEC 2.0, and also reduced 2019 output estimates by ~ 1mm b/d, so the producer coalition’s action did not come as a surprise (Chart 4).5 Chart 4BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts In addition to the cuts by OPEC 2.0, the Alberta, Canada, government mandated production cuts, which will become effective January 1, 2019, to clear a persistent supply overhang that was decimating producers’ revenues in the province. We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the government intends to draw over the course of 2019 at a rate of ~ 96k b/d. This will lower overall OECD inventories, even if the Canadian barrels are transferred south. Net, in addition to the 1.2mm b/d of cuts from OPEC 2.0, the ~ 300k b/d coming from Canada next year will mean close to 1.5 mm b/d of production, or ~1.4mm b/d of actual supply when accounting for the inventory release, is being cut or curtailed from these two sources. We cannot, at this point, forecast over-compliance with the OPEC 2.0 accord, which was one of the signal features of the deal in 2017 and 1H18. The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as highly unlikely the Trump administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and fully expect they will be extended at least for 90 days. This is because oil fundamentals will remain tight next year, despite the massive de-bottlenecking of the Permian Basin in West Texas. While an additional 2mm b/d of new takeaway capacity will be added to the region, it will not be fully operational until 4Q19. We have ~ 300k b/d of additional supply coming out of the Permian after the pipeline expansions are done in 2H19. Even as pipeline capacity is filled, the U.S. still needs to significantly increase its deep-water oil-export capacity to get this crude to market.6 Bottom Line: We expect the oil market to re-balance in 1H19, as production falls by ~ 1.4mm b/d – the combination of OPEC 2.0 and Canadian production cuts – and consumption grows by a similar amount. The USD will continue to appreciate next year, which, at the margin, will temper demand growth and prices. Gold: Remaining Long Equity And Inflation Risks Trump Higher Rates in 2019 As the U.S. economic cycle matures and advances into its final innings, we continue to recommend holding gold in a diversified portfolio. U.S. inflationary pressure will surprise to the upside in 2019, per our House view, which will offset the effects of somewhat less accommodative U.S. monetary policy in the U.S. The October equity correction is a reminder that, when rising UST yields drag stocks down in late-cycle markets, gold works as an effective hedge against equity risks, and can outperform bonds. In fact, both of the corrections we saw in 2018 likely were caused by a sharp increase in bond yields. This convexity on the upside and downside is what makes gold our preferred portfolio hedge. Easy Monetary Policy + Rising Rate = Bullish Gold Prices Despite being negatively correlated with interest rates, gold tends to perform well when the fed funds rate is below r-star – known as the “natural rate of interest” – and is rising (Chart 5, panel 1).7 When this happens, policy rates are below the so-called natural interest rate consistent with a fully employed economy, which, all else equal, is inflationary. In these late-cycle environments, gold’s ability to hedge against inflation and equity risks dominate its price formation, while its correlation with U.S. real rates diminishes. Chart 5Gold Will Stay in Trading Range In our view, gold will remain in an upward trading range until rates become restrictive enough to depress the inflation outlook (Chart 5, panel 2). Our U.S. strategists estimate the equilibrium fed funds rate is at ~ 3%, and project it will rise to ~ 3⅜% by end-2019. Therefore, despite our House view of four rate hikes next year, we expect the U.S. economy to remain in a below-r-star-and-rising phase for most of the year. Consistent with our House view, we believe U.S. inflation is likely to surprise to the upside next year, which will push gold prices higher (Chart 6, panel 1). The U.S. economy remains strong, particularly on the employment front. This means wage growth will work its way through inflation rates. Chart 6U.S. Inflation Likely to Surprise Admittedly, this is not the consensus view. Investors are not worried about significantly higher inflation (Chart 6, panel 2). However, our Bond strategists argue that long-maturity TIPS breakeven inflation is stuck below historical levels because of this abnormally low fear of elevated inflation (i.e. > 2.5%). Once inflation starts drifting higher, there will be an upward shift in investors’ inflation expectations. Any short-term dip in inflation on the back of lower oil prices will be transitory, given our view that oil prices will recover next year. If such a transitory dip, or concerns about a global growth slowdown spilling back into the U.S. causes the Fed to pause, we would add to our precious metal view position, given our assessment that this would raise the probability of an inflation overshoot. Lastly, gold prices recently have been depressed by an abnormally high correlation with the U.S. dollar (Table 1). We put this down to speculative positioning: Net speculative positions are stretched for both the U.S. dollar and gold, Table 1Gold Vs. USD Correlations Running Higher Than Normal therefore, any change in expectations likely will be amplified by a reversal in positioning (Chart 7). In the medium-term, we expect the gold-dollar correlation to converge back to its average, which would mute the dollar’s impact on gold. This would, all else equal, raise inflation and equity risks factors. Chart 7Spec Positioning Stretched Bottom Line: We continue to recommend gold as a portfolio hedge for investors, given its convexity – it outperforms during equity downturns, and participates on the upside (albeit not as much). Given our out-of-consensus House view for inflation, we believe gold also will provide a hedge against this risk. Palladium: China Tax Policy Could Lift Price Palladium soared to dizzying heights this year, on the back of an expanding physical deficit (Chart 8). Were it not for the loss of an automobile-tax break in China, which reduced the rate of growth in sales there to unchanged y/y, this deficit likely would have been considerably wider, inventories would have drawn even harder, and palladium prices would have been higher (Chart 9). Chart 8Palladium's Physical Deficit Expanding Chart 9Palladium Inventories Collapse Palladium’s demand is mainly driven by its use in catalytic converters for gasoline-powered cars, which dominate sales in the U.S. and China, the world’s two largest car markets (Chart 10). U.S. sales growth has leveled off this year (Chart 11), as has China’s. However, the China Automobile Dealers Association (CADA) is pressing policymakers to reduce the 10% auto sales tax by half, which could keep palladium demand elevated relative to supply, should it happen.8 Chart 10Auto Catalyst Demand Dominates PalladiumChart 11China Car Sales Could Revive With Tax Cut Russian producers, led by Norilsk Nickel, supply ~ 40% of the world’s palladium. Markets have been fearful U.S. sanctions could be imposed on Norilsk and other Russian producers throughout the year by the U.S., most recently in re Russia’s seizure of Ukrainian naval vessels in international waters, and over Russia’s response to the threatened withdraw from the Intermediate-Range Nuclear Forces (INF) Treaty by the U.S., which could be keeping a risk premium firmly embedded in palladium prices.9 With platinum trading below $800/oz, or ~ 65% of palladium’s value, autocatalyst makers could begin to switch out their catalysts (Chart 12). Chart 12Platinum Could Fill Palladium Supply Gap Base Metals: Trade Tensions, USD Cloud Outlook Base metals remain inextricably bound up with EM income growth. When EM incomes are growing, commodity demand – particularly for base metals – is growing, and vice versa. This typically shows up in EM GDP and import volume levels, which we use as explanatory variables in our base-metals price modeling (Chart 13). Chart 13Base Metals Demand Tied To EM Income, Trade Volumes There are, in our view, two significant risks to EM income growth over the short and medium terms: Sino – U.S. trade disputes, which erupted earlier this year. They carry the risk of spreading globally and unwinding supply chains that have taken decades to develop between DM and EM economies;10 Fed monetary policy, which is immediately reflected in USD levels. A strong dollar raises the local-currency costs of commodities for consumers ex-U.S., and debt-servicing costs in EM economies. In addition, it lowers the local-currency costs of producing commodities ex-U.S., which incentivizes producers to raise production to capture this arbitrage, since they are paid in USD. The trade-war risk remains, despite the agreement between presidents Trump and Xi at the G20 in Buenos Aires to work on a trade deal. Even so, the actual level of tariffs imposed by both sides is trivial relative to the level of global trade, which is in excess of $20 trillion p.a. – ~$17 trillion for goods, $5 trillion for services, according to the WTO (Chart 14). Chart 14Sino – U.S. Tariffs Remain Trivial Relative to Overall Global Trade Fed policy, on the other hand, is a threat of far greater moment to EM income growth, and, through this, import volumes, which we use to proxy that growth. The LMEX index, a gauge of base-metals prices traded on the LME, is extremely sensitive to changes in EM import volumes. This is not unexpected, given the income elasticity of trade for EM economies is greater than 1.0. Our modeling finds a 1% increase in EM import volumes translates to a 1.3% increase in the LMEX, which is consistent with the World Bank’s estimate of EM income elasticity of trade.11 Per our House view, we believe markets are too sanguine regarding the possibility of a Sino – U.S. trade deal. Such an event, should it occur, would immediately affect base metals markets, as China accounts for roughly half of base metals demand globally(Chart 15). Market participants’ default setting appears to be the U.S. and China will resolve their trade differences in short order – i.e., by the March 1, 2019, deadline agreed at the G20 meeting – resulting in a win-win for both countries and the world. We are hopeful this view is correct, but we would not take any positions in base metals in expectation of such an outcome. Instead, we think the substantive technological and strategic differences between the two countries, and underlying distrust, will result in a renewed escalation of tensions. Chart 15China Demand Remains Pivotal Base Metals Demand Could Wobble Bottom Line: We remain neutral base metals going into 2019. Fundamentally, most of the metals in the LME index are in balance, or can get there in short order. The Fed’s rates-normalization policy continues to represent a larger short-term risk to EM income growth than Sino – U.S. trade tensions, but, longer term, we continue to expect tension between the world’s dominant economies to escalate. Ags: Trade Tensions, USD Cloud Outlook That’s not a typo in the sub-head above; ags – particularly soybeans – are dealing with the same headwinds bedeviling base metals. The agreement to work on a trade agreement reached at the G20 summit between the U.S. and China lifted grain markets, and supported the upward trend in grain and bean prices. All the same, Sino – U.S. trade relations are prone to go off the rails at any time. The Buenos Aries understanding, after all, only holds for 90 days. In addition to the hoped-for agreement to resolve trade-war issues, grain prices received support from the signing of the United States-Mexico-Canada Agreement (USMCA). This helped align supply-demand fundamentals globally with prices. Focusing too much on China can obscure the fact that the USMCA, which replaces the North American Free Trade Agreement (NAFTA), eliminated major uncertainties over the fate of U.S. grain exports to Mexico, the second-largest destination for U.S grains, beans and cotton. In fact, Mexico accounts for 13% of all U.S. ag exports (Chart 16).12 Chart 16Trade Negotiations Hit American Farmers Hard All the same, the Sino – U.S. trade war is hitting U.S. ags hard, particularly soybeans. The 25% tariff on China’s imports of U.S. grains created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. Close to 60% of U.S. bean exports historically went to China. The U.S. – China trade war caused a soybean shortage in Brazil, as demand from China for its crops soared, while a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 17). Chart 17Bean Shortage in Brazil, Supply Glut in the U.S. A successful resolution to the U.S. – China trade tensions is unlikely to reverse the over-supply of beans globally (Chart 18). In fact, we expect beans stocks-to-use (STU) ratios to build next year, unlike global corn and wheat stocks (Chart 19). This will set a record for the soybean STU ratios, pushing them above 30%. Chart 18Expect Another Bean Surplus Chart 19Bean STU Ratios Will Grow As is the case for metals, the USD will weigh on ag markets, which will make U.S. exports more expensive than their foreign competition (Chart 20). As is the case for all of the commodities we cover, a strong dollar will weigh on prices at the margin. Chart 20A Strong USD Will Make U.S. Exports Expensive Bottom Line: A thaw in the Sino – U.S. trade war should realign global grain markets, but will not keep soybeans from setting new global inventory records. A strong USD will be a headwind for ag markets, as it is for other commodity markets we cover. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 This is a fictional character in the movie Master and Commander, based on the novels of Patrick O’Brian. 2 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was formed in November 2016 to manage oil production. 3 Please see “Silver, Platinum At Risk As Fed Tightens; Palladium Less So,” published by BCA Research’s Commodity & Energy Strategy February 15, 2018. It is available at ces.bcaresearch.com. 4 Please see “The Role of Major Emerging Markets in Global Commodity Demand,” published as a Special Focus in the IMF’s Global Economic Prospects in June 2018 for a discussion of income elasticities for oil, base metals and other commodities in large EM economies. 5 In our current forecast for 2019, we expect Brent to average $82/bbl next year, and for WTI to trade $6/bbl below that. Please see “All Fall Down: Vertigo In the Oil Market … Lowering 2019 Brent Forecast to $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018. We will be updating our supply-demand balances and price forecast next week. 6 At 11.7mm b/d and growing, the U.S. is the largest crude oil producer in the world, having recently eclipsed Russia’s total crude and liquids production of 11.4mm b/d, and the U.S. EIA’s projected 2019 output of 11.6mm b/d. U.S. crude oil exports hit 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data. It is worthwhile recalling crude oil exports were illegal until December 2015. U.S. product exports totalled 5.8mm b/d for the week ended November 30, and 6.3mm b/d the week before that. Total U.S. crude and product exports are running ~ 9mm b/d at present, which placed them just above total imports of crude and products – i.e., the U.S. became a net exporter of crude and products at the end of November. 7 The San Francisco Fed defines r-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. r-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 8 Please see “Exclusive: Reverse gear - China car dealers push for tax cut as auto growth stalls,” published by reuters.com October 11, 2018. 9 Please see “Is Norilsk Nickel too big to sanction?” published by ft.com on April 19, 2018, and “U.S. to Tell Russia It Is Leaving Landmark I.N.F. Treaty,” published by nytimes.com October 19, 2018. 10 We discuss this in “Escalating Trade Disputes Pressuring Base Metals,” published July 12, 2018, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 11 For a discussion of the World Bank’s trade elasticities, please see “Trade Wars, China Credit Policy Will Roil Global Copper Markets” published by BCA Research’s Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 12 Canada makes up a smaller share of U.S. exports, at ~ 2%. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Chart 6... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market. Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms\ Chart 9Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades