Latin America

Special Report

Highlights Structurally, EM corporate leverage is elevated and the interest coverage ratio is low. Cyclically, China/EM growth slowdown will lead to corporate spread widening. Rising U.S. dollar corporate bond yields in EM herald lower share prices. The recent underperformance in Mexican financial markets versus their EM peers is not sustainable. We reiterate our overweight position in Mexico. In Indonesia, the central bank is attempting to fight the Impossible Trinity, a battle that by definition cannot be won. Investors should keep underweighting this market. Feature This report focuses on the corporate health of emerging market (EM) companies, as well as the outlook for corporate bonds. We review the key drivers behind credit spreads and provide an up-to-date snapshot of overall corporate health. We also illustrate the travails in China's offshore corporate bond market, which are of high importance to the broad EM outlook. With respect to scope of coverage and data comparability, please refer to Box 1. BOX 1 Data Relevance And Its Application As there is no aggregate financial dataset for EM corporate bond issuers, we use corporate financial data provided by Worldscope for the EM equity universe - the constituents of the MSCI EM equity index. While from an individual country perspective this makes a difference, from an EM sector perspective the differences are not substantial. Excluding the technology sector, it is often the case that the same companies have both publicly traded stocks and bonds. This is especially true in sectors such as basic materials, energy, industrials, telecom, utilities and financials. This is why, in this report, we focus our attention on sectors rather than countries, and why we examine the EM companies' financial health excluding technology and banks. Banks' relevant financial ratios vary greatly from those of non-banks. For the technology sector, the largest tech names in the equity space have minimal bonds outstanding, so using financial data from the equity space for credit analysis is inappropriate. In short, the analysis below on corporate health is pertinent to both equity and corporate bond investors. However, its emphasis is on creditworthiness and ability to service debt, which is more attuned to credit investors. Drivers Of EM Credit Spreads Cyclical swings in EM corporate and sovereign credit spreads are driven by changes in borrowers' revenues, cash flow and profits. Hence, the business cycle is one of the important drivers of corporate creditworthiness. When global and EM growth accelerate, revenue and free cash flow improve, causing credit spreads to narrow (Chart I-1). The EM business cycle drives EM sovereign spreads too (Chart I-2). Chart I-1EM Corporates: Cash Flow From Operations And Credit Spreads Chart I-2EM Sovereign Spreads Move In Tandem With Business Cycle This is why we spend a lot of time gauging the global business cycle outlook and cover this topic extensively in our reports. For now, the growth outlook for China/EM and global trade remains gloomy: Chart I-3China Is A Major Risk For EM Profits China's credit and fiscal spending impulse projects further weakness in the mainland's business cycle and EM corporate earnings (Chart I-3). China's slowdown is no longer limited to the industrial sector - household spending growth has downshifted considerably since early this year, as we discussed in last week's report.1 Weakening sales of consumer goods and autos in China are one of the primary reasons behind the ongoing slump in the global technology and semiconductor sectors. Consistently, plunging growth in Taiwanese electronics exports points to both weaker global trade and EM tech earnings in the months ahead (Chart I-4). In short, even though we have excluded technology from our analysis of corporate financial health, hardware tech companies' profits remain at risk. The latter is not relevant for EM corporate bond investors, but it is critical for the EM equity space. Chart I-4Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Other pertinent financial market indicators for EM credit spreads are commodities prices, EM exchange rates and EM local rates. The basis is as follows: (1) Energy and materials make up 25% of the J.P. CEMBI EM corporate bond index, and commodities prices drive their revenues and in turn credit spread fluctuations (Chart I-5, top panel); (2) Outside the resource sector, corporate bond issuers by and large do not feature exporters, and their capacity to service foreign currency debt is greatly affected by exchange rate movements (Chart I-5, bottom panel); (3) Financials make up 30% of the J.P. CEMBI EM corporate bond index, and their credit spreads are greatly influenced by domestic interest rates and banking system health (Chart I-6). We exclude financials from our corporate health analysis because their financial ratios differ vastly from those of non-financials. Chart I-5Drivers Of Credit Spreads: Commodities And Currencies Chart I-6EM Bank Credit Spreads Will Widen If Local Bond Yields Rise Overall, we expect global trade to weaken, commodities prices to drop further and EM currencies to depreciate. The latter will push up local interest rates. In turn, several EM banking systems remain saddled with bad assets from previous credit booms that have not been recognized, and banks have not been recapitalized. These factors point to a widening in bank credit spreads. All in all, EM corporate and sovereign spreads will widen further. A Snapshot Of EM Corporate Health The following financial ratios - which are calculated for EM companies excluding technology and financials - do not justify currently tight corporate spread. Leverage measured as net debt (total debt minus cash assets) divided either by EBITDA or cash flow from operation2 (CFO) remains elevated (Chart I-7, top panel). Among 9 sectors, only energy, basic materials and consumer discretionary have seen their leverage fall over the past two years. Chart I-7EM Corporate Health: Leverage And Interest Coverage Ratios Interest coverage ratios computed as EBITDA- or CFO- to- interest expense are well below their 2007 and 2011 levels (Chart I-7, middle panel). These figures corroborate that neither EM corporate indebtedness nor companies' ability to service debt using cash from operations is back to levels that prevailed before the global financial crisis in 2008 when EM financial markets were in a secular uptrend. Crucially, this is inconsistent with presently still-tight EM corporate spreads (Chart I-7, bottom panel). This mispricing, in our opinion, reflects the global search for yield that was induced by the crowding out of investors from DM bond markets by global central banks' QE programs. A contraction in corporate profits and cash flows from operation - for the reasons discussed above - will cause issuers' credit matrixes to deteriorate. With respect to cross-sectional analysis, Table I-1 presents interest coverage ratios (computed as an average of EBITDA- and CFO-to-interest expense ratios) for mainstream countries and all sectors. The cells in red present pockets of distress where the interest coverage ratio is below 3. The cells in blue illustrate segments where moderate financial stress is present: these are sectors with an interest coverage ratio of above 3 but below 5.5. Table I-1Interest Coverage Ratios On a positive note, the rally in commodities and cutbacks in capex have allowed energy and basic materials companies to drastically improve their leverage and interest coverage ratios in the past 2 years. However, even though their present financial health is great, their cash flow from operations is set to deteriorate again as commodities prices continue to relapse. The key motive behind our negative view on credit markets in Latin America, Russia, the Middle East and Africa - which is de facto the EM universe excluding emerging Asia - is because with the exception of Turkey, they are very exposed to commodities prices. As commodities prices drop and these nations' currencies depreciate, their sovereign and corporate credit spreads will widen. We are not implying that these issuers are facing default risks. Simply, lower revenues from commodities and higher debt servicing costs due to currency depreciation warrant a re-pricing of risk. Within credit portfolios, we recommend favoring defensive low-beta credit, excluding banks, versus riskier high-beta ones. We are underweight EM banks within the EM equity space and recommend the same strategy for the EM credit universe. Based on the matrix in Table I-1, credit portfolios should overweight consumer services, tech, energy and basic materials and underweight industrials, utilities and healthcare. China's Corporate Health And Credit Market There has been little deleveraging among Chinese companies. On the contrary, the country's massive credit and fiscal stimulus in 2016 bailed out many indebted companies, lifting corporate debt levels and augmenting the misallocation of capital. In particular: Chart I-8China's Corporate Debt Is Enormous China's corporate debt remains enormous, at $19.5 trillion, or RMB 140 trillion. It is the highest in the history of any country (Chart I-8). Some 95% of corporate debt is in local currency terms. My colleague Jonathan LaBerge from China Investment Strategy has calculated that Chinese state-owned enterprises' adjusted return on assets, has fallen below the cost of capital (Chart I-9). This indicates that these companies have for now exhausted profitable investment opportunities and should arguably scale back on their investment expenditures. Further borrowing and investing by these enterprises will augment the amount of bad assets held by Chinese banks and reduce the country's overall productivity and hence, potential growth. Yet, denying these debtors financing will result in a major slump in capex, and probably labor market weakness. Chart I-9Chinese SOEs: Capital Misallocation Chart I-10Leverage And Interest Coverage For Chinese Companies Dissecting sectoral data, indebtedness is elevated for industrials, utilities and property developers. Consistently, the interest coverage ratio is extremely low for industrials, utilities and property developers (Chart I-10). Financial health of Chinese materials has improved tremendously due to de-capacity reforms - the shutdown of excess capacity that has boosted both steel and coal prices. Interestingly, this has occurred at the expense of utilities and some other heavy consumers of steel and coal. Notably, steel and coal prices are beginning to relapse (Chart I-11). For reasons discussed in our previous report,3 these commodities prices will drop further and will hurt producers' cash flow and profits, causing their creditworthiness to deteriorate. Chart I-11Steel And Thermal Coal Prices Offshore corporate bond yields and spreads are surging, foreshadowing rising borrowing costs and reduced availability of financing (Chart I-12A). The problem is especially acute for property developers (Chart I-12B). In a nutshell, Chinese corporate U.S. dollar bond yields are at their highest levels of the past five-six years. The same is true for emerging Asian corporate bond issuers. Chart I-12AChinese Offshore Aggregate Corporate Bonds Chart I-12BChinese Offshore Property Developers Not only do Chinese corporate bonds now account for 32.5% of EM and 56% of emerging Asian corporate bond indexes, but investment expenditures by Chinese companies are also critical to companies elsewhere in Asia and globally. Chinese gross fixed capital formation accounts for 6% and 5.4% of global GDP in nominal and real terms, respectively. By contrast, these numbers are 4.6% and 4.3% for the U.S. We have deliberated at great length on why China's growth will likely continue to downshift, despite the policy stimulus, and we will not repeat our arguments today.4 The financial health of Chinese companies will worsen due to dwindling sales and cash generation. This, along with less credit/financing available onshore and offshore, will erode their capacity to undertake large investment expenditures. Consequently, capital expenditures in general and construction in particular will suffer substantially. This is the main rationale behind our negative view on resources, raw materials and industrials worldwide. Investment Observations And Conclusions Apart from Turkey and Argentina, there has been no liquidation and capitulation in EM assets in general and the credit space in particular. It would be unusual if this extended selloff ends without capitulation. EM credit markets appear technically vulnerable. In particular, the excess returns on EM sovereign and corporate bonds are splintering below their 200-day moving averages (Chart I-13). Odds are there will be more downside. Chart I-13A Bad Signal Rising U.S. dollar corporate bond yields in both EM overall and in emerging Asia herald lower share prices (Chart I-14). So long as the drop in U.S. Treasury yields is offset by widening EM credit spreads, EM corporate bond yields will continue to rise and EM share prices will sell off. However, as and when EM corporate (or sovereign) yields start falling, irrespective of whether because of declining U.S. Treasury yields or narrowing EM credit spreads, EM equity prices will rally. EM sovereign and corporate bond yields are an imperative indicator to watch for equity investors. Chart I-14Rising Corporate Yields = Lower Share Prices We continue to recommend defensive positioning in EM sovereign and corporate bonds. In terms of asset allocation, EM dollar-denominated sovereign and corporate bonds should not be compared with EM local currency bonds or equities or U.S. Treasurys.5 These are credit instruments, and they should be a part of a credit portfolio with U.S. and European corporate bonds. Credit portfolios should presently be underweight EM sovereign and corporate bonds relative to U.S. corporate bonds (Chart I-15A & Chart I-15B). Chart I-15AEM Sovereign Credit Versus U.S. Credit: Relative Excess Returns Chart I-15BEM Corporate Credit Versus U.S. Credit: Relative Excess Returns Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Mexico: Is The Underperformance Overdone? Despite having a sound macroeconomic backdrop,6 Mexican financial markets have lately substantially underperformed their emerging market peers due in large part to domestic politics. Odds are that Mexican risk assets will continue to sell off in absolute terms, especially given the broad turmoil in the EM universe, which we expect to continue. That said, the recent underperformance of Mexican markets versus their EM peers is overdone, and odds are that Mexican stocks, local bonds and sovereign credit will outperform their EM peers over the coming six to 12 months: First, the Mexican authorities have been pursuing orthodox macro policies, including very tight monetary and fiscal policies. The central bank hiked its policy rate again last week in the face of a currency relapse, and the fiscal stance has been tight. Currently, the real policy rate is 4% and the 10-year local currency government bond yield is 5.5%, both deflated by core consumer price inflation (Chart II-1, top and middle panel). Real rates are very high by historical standards and are now above most other EMs. Chart II-1Mexico: Tight Monetary And Fiscal Policies The government's non-interest expenditures deflated by core consumer price inflation have been contracting (Chart II-1, bottom panel). Such a tight monetary and fiscal policy mix will not change considerably with AMLO taking the office and it should benefit the currency. We expect the peso to start outperforming its EM peers on a total-return basis. Second, the Mexican peso is very cheap - close to one standard deviation below fair value, according to the unit labor cost-based real effective exchange rate (Chart II-2). The latter is our favorite currency valuation measure. Chart II-2The Mexican Peso Is Cheap Third, economic growth is improving, as the effects from monetary and fiscal tightening are diminishing (Chart II-3). This should at the margin support Mexican financial markets versus their EM peers where growth is slowing. Chart II-3Mexico: A Moderate Cyclical Recovery Fourth, Mexico's business cycle is much more leveraged to the U.S. economy than to China's. In line with our view that U.S. growth will fare better than China's growth, the Mexican economy will likely outperform other EMs that are more leveraged to China. Finally, an important rationale behind our recommendation to maintain an overweight stance on Mexico is that Mexican risk assets are defensive plays within the broad EM universe. In other words, whenever there is broad EM turbulence and an ensuing flight to quality, Mexican risk assets tend to outperform their EM peers. This is even more likely to happen now that Mexican sovereign spreads are already elevated and local currency government bonds offer a very attractive yield relative to other EMs (Chart II-4). Chart II-4Mexican Domestic And U.S. Dollar Bonds Offer Value Still, a few words are warranted on the recent domestic political developments. Our view is that the latest measures announced by the incoming administration regarding the new airport and banking fees are more indicative of a strategy to test the markets before the AMLO administration takes office, rather than declaring war against both markets and investors. It is noteworthy how fast the AMLO government came out after each of these announcements to calm investors. This suggests to us that fears of Mexico taking an irreversible sharp political turn to the left are overblown. AMLO is likely to be pragmatic and deliberate in the way he pushes forward his policies. In a nutshell, our bias is that these announcements represent an attempt by the AMLO administration to promote competition and reduce rent-seeking activities in the economy. This can be negative for shareholders of incumbent large companies, as it will hurt corporate profits of oligopolies. However, in the long term these polices will be positive for overall economic growth as they will reduce the cost of doing business, appease structural inflation and boost the nation's competitiveness. From a structural perspective, these policies are positive for the currency and local bonds. One way to play this theme is to favor small-cap over large-cap companies. Given the oligopolistic structure of some industries, Mexican large-cap companies are much more likely to be hurt by the incoming administration's open competition policies than small-cap companies. As such, small-caps will likely outperform large-caps in Mexico over at least the next six to 12 months (Chart II-5). Moreover, small-caps are currently trading at a significant discount compared to large-caps, with the former trading at multiples that are half of the latter. Chart II-5Mexico: Small-Caps Will Outperform Large-Caps Investment Conclusion Dedicated EM investors should overweight Mexican equities, local currency bonds and sovereign credit within their respective universes. Concerning the exchange rate, we are maintaining our long MXN / short ZAR position. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Indonesia: Defying The Impossible Trinity? Indonesian stocks are attempting to rally and have lately outperformed the EM equity benchmark. The outlook for this bourse remains negative and we recommend investors to fade this rally and outperformance. Critically, Indonesian domestic interbank rates and corporate U.S. dollar bond yields are rising. Historically, this is a negative signal for share prices (Chart III-1, rates and yields are shown inverted). Chart III-1Rising Rates/Yields = Falling Stocks Weakening rupiah and rising interest rates are forcing the central bank (BI) into a policy dilemma: Should it defend the currency and allow interest rates to rise further or should it cap interest rates and let the currency find a market equilibrium? It appears the BI is trying to do both - to stop the currency from depreciating, while also capping or bringing down interbank rates simultaneously. This defies the Impossible Trinity thesis which stipulates that a central bank of a country with an open capital account has to choose between controlling either the exchange rate or interest rates. On the surface, it would seem that the BI has been focused on targeting a stable rupiah. The monetary authorities have sold foreign exchange reserves (Chart III-2, top panel), and raised the key policy rate. Chart III-2Aggressive Monetary Policy Tightening... Selling of foreign exchange reserves is a form of tightening as it drains the banking system's excess reserves at the central bank. Shrinking interbank liquidity, however, pushes up interbank rates and borrowing costs (Chart III-2, bottom panel). Higher borrowings costs not only make the currency more appealing to investors, but they also curb domestic demand and, thereby, improve the current account balance. This is an ultimate mechanism of how policy tightening leads to exchange rate stability. Yet the full picture of BI's policies is a lot murkier. While on the one hand, the central bank has sold its foreign exchange reserves and hiked policy rates to defend the rupiah, it has also offset some of the tightening by injecting local currency reserves into the banking system. Chart III-3 shows that the BI purchased/redeemed back central bank certificates from commercial banks, which has led to a sharp increase in commercial banks' excess reserves. Chart III-3... And Liquidity Injections By Central Bank Central bank liquidity injections are akin to monetary easing aimed at capping or even bringing down interbank rates. Hence, they come as a contradiction to the central bank's restrictive policies. If the BI chooses to stabilize the rupiah, then interbank rates and borrowing costs in general will have to rise and the economy will take a hit. Corporate earnings will then contract which will be bearish for the equity market. If the central bank opts to cap interbank rates, it has to inject as much liquidity (excess reserves) into the banking system as required. In this scenario, the currency could depreciate triggering capital flight and selloffs in equity and local bond markets. The BI can continue the muddle-through policy - offsetting or sterilizing its foreign exchange interventions by turning the backdoor liquidity taps on. These injections of local currency liquidity into the banking system could encourage speculation against the rupiah and allow banks to lend more, maintaining robust imports and a large current account deficit. It is not certain, but if the market perceives that interest rates are lower than warranted, the currency could very well depreciate amid this policy mix. In this scenario, the result could be a mix of gradual currency depreciation and somewhat higher interest rates. Financial markets will still do poorly in dollar terms. Overall, odds are high that the rupiah will resume its depreciation and interest rates will move higher. Indonesia's balance of payment dynamics remain a risk to the exchange rate. The current account deficit is still large and exports are heading south (Chart III-4). Chart III-4Current Account Deficit Is Large First, Chart III-5 illustrates that the sharp slowdown in the average manufacturing PMIs of Japan, Korea, Taiwan and Germany are pointing to an imminent contraction in Indonesian export volumes. Chart III-5Exports Are Heading South Second, thermal coal prices seem to be breaking down. Chart III-6 shows that the stock price of Adaro - a large Indonesian coal producing company - has already fallen by 45% in U.S. dollar terms since January, and is heralding a dismal outlook for coal prices. Chart III-6Coal Prices Are To Break Down Lower coal prices will shrink Indonesia's coal export revenues. The latter accounts for 12% of total Indonesian exports. In terms of the outlook for banks, which is a key equity sector, their share prices have been surprisingly resilient. Rising interest rates, however, will cause their NPLs to move higher hurting banks' profits, and pulling their share prices down (Chart III-7). Chart III-7Bank Stocks Are At Risk Finally, overall Indonesian equity valuations are still not attractive either in absolute terms or relative to the EM benchmark. Meanwhile, foreigners own 32% of the equity market and 37% of local currency bonds. As the rupiah slides, foreigners will rush to the exits, amplifying the currency depreciation. Bottom Line: The path of least resistance for the rupiah is down. Continue underweighting Indonesian equities and bonds and continue shorting the rupiah versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "On Domino Effects And Portfolio Outflows," dated November 15, 2018, available at ems.bcaresearch.com. 2 Cash flow from operations represents net cash flow from operating activities & excludes net cash flow financing and investing activities. 3 Please see China Investment Strategy Special Report, "Revisiting China's De-Capacity Reforms," dated October 17, 2018, available at cis.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth," dated October 25, 2018, available at ems.bcaresearch.com. 5 Please see Emering Markets Strategy Weekly Report, "Strategic Asset Allocation For Emerging Markets," dated May 7 2013, available at ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

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

Highlights The current market action in the EM equity space qualifies as a bear market, not a correction. Yet the magnitude of this drawdown (25%) is still considerably smaller than the median stock price drop (45%) of previous bear markets. Hence, more downside in EM share prices in dollar terms is to be expected. The Federal Reserve is not about to rescue EM - not until U.S. share prices fall considerably and the dollar appreciates sharply. For EM dedicated equity portfolios, we are downgrading Taiwan from overweight to neutral (please see page 11). We reiterate our underweight stance on Peruvian stocks (please see page 14). Feature All happy families are alike; each unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina To rephrase Leo Tolstoy's famous quote from Anna Karenina: All bull markets are alike; but, each bear market is distinctive in its own way. The emerging market stock index has dropped by 25% from its January high. We reckon EMs are in a bear market - not a correction. Thus, there is still meaningful downside in EM financial markets, and it is still too early to bottom-fish. Many commentators and investors are comparing the current selloff with other bear markets, most notably those that occurred in 1997-'98 and 2014-'15. Our answer to these comparisons is the above quote from Tolstoy. This EM rout is different from the previous ones, including the most recent one that occurred in 2015. Yet just because this selloff is in certain aspects unlike previous bear markets does not mean it is not a full-fledged bear market. Bear Markets Versus Corrections There is no scientific distinction between a bear market and a correction. The below considerations suggest to us that EMs are in a genuine bear market, not a correction. These deliberations complement rather than substitute our fundamental analysis that foreshadows weakening growth and deteriorating profitability in EM/China - the topics that we regularly discuss at great length in our weekly reports. Chart I-1 portrays EM share prices since the mid-1980s and identifies periods of bear markets. Bear markets differ from corrections not only by the magnitude of drawdowns but also by duration. We define an EM bear market as a drawdown that either lasted longer than six months or in which peak-to-trough price declines exceeded 25%. Chart I-1EM Stock Prices: A Long-Term Perspective Of Bear Markets Table I-1 and Table I-2 illustrate EM equity corrections and bear markets over the past 30+ years, respectively. Median and mean EM equity market corrections have historically lasted one and a half to two months, with price drawdowns of 18% in U.S. dollar terms each (Table I-1). On the other hand, median and mean EM equity bear markets have lasted eight to 10 months, with share prices falling by 45% (Table I-2). The current selloff is already more than eight months old, with share prices down 25% in dollar terms. Its duration has by far surpassed that of previous corrections. Therefore, the current market action in the EM equity space qualifies as a bear market. If this bear market produces a drawdown of 45%, on par with the median bear market, it would require another 30% drop in EM share prices in dollar terms from current levels. The range of price declines of previous EM equity bear markets is between 31% and 67%. For the current selloff to match the lowest point of this range (31%), share prices should fall another 10%. These estimates should help investors conduct their own scenario analyses. Our bias is that there will likely be at least another 15% drop in EM share prices before the risk-reward profile of this asset class improves. The way this EM selloff has been evolving is more consistent with a bear market than a correction. As a rule, EM equity corrections are sharp but short-lived. Table 1 shows that EM equity corrections have typically lasted from one to three months. In corrections, all markets drop together at once. In contrast, bear markets are drawn out, and domino effects leading to rotational selloffs are the norm. The current episode corresponds more to this pattern. Initially, the EM market riot was concentrated among discernably vulnerable markets such as Turkey, Argentina and Brazil. Then, the epicenter of the selloff rotated to emerging Asia, where large equity markets including China, Korea, Taiwan and Hong Kong took a beating1 (Chart I-2). Chart I-2EM: Rotational Selloffs A similar pattern of rotational selloffs prevailed in the 1997-'98 bear market in EM and in 2007-'08 in the U.S. (Chart I-3A and Chart I-3B). Chart I-3ARotational Selloffs During EM Bear Markets Chart I-3BRotational Selloffs During U.S. Credit Crisis In 2007-08 With the exception of bombed-out cases like Turkey and Argentina, there has been no panic-selling or forced liquidation. Although the current EM selloff has already been stretched out, it appears that selling has been rather reluctant. It would be unusual if a selloff of this magnitude and duration, occurring amid worsening EM/China growth and Fed tightening, does not culminate into liquidation/capitulation. We still expect such capitulation to occur. In fact, this would be one of the signposts for us to turn positive on EM. Bottom Line: Taking into account the duration and disposition of the current selloff, EM stocks are in a bear market, not a correction. That said, the magnitude of this drawdown (25%) is still smaller than the median price falloff (45%) and the range of price declines of previous EM bear markets. Hence, there is potentially another 10-30% price drop for EM stocks in dollar terms for this bear market to be on par with the smallest and median EM bear markets, respectively. Technical Signposts Of A Bear Market There are a number of technical signposts that are consistent with further downside in EM risk assets and currencies: Relative share price performance of EM versus DM has failed to break above its long-term moving average that has in the past served as an important technical support or resistance (Chart I-4). This entails that the relative bear market in EM versus DM is intact, and major fresh lows lie ahead. Chart I-4EM Versus DM: Relative Stock Prices In U.S. Dollars In absolute terms, the crest in EM share prices early this year was typical of a major top. The EM equity index has failed to break above its previous tops (Chart I-1 on page 1). This represents bearish price formation. Usually, when a market fails to break above its previous tops, a major downslide ensues. In short, the chart formation of EM stocks is in line with a bear market - not a correction. The breadth of the EM equity selloff has been extensive, entailing a genuine bear market. The stock market selloff has not been limited to large-cap names. Both the EM small-cap and equally-weighted stock indexes have in fact sold off more (Chart I-5). Chart I-5EM Equity Selloff Is Broad-Based The global equity sectors exposed to EM/China growth such as industrials, chemicals, mining and steel have all relapsed after failing to break above their 200-day moving averages (Chart I-6). This entails more downside in their share prices, and corroborates our view that global trade growth will deteriorate further. Chart I-6Global Cyclicals Are Breaking Down Asian semiconductor stocks are breaking down - another bad omen for global trade and Asian growth (Chart I-7). Chart I-7Asian Semiconductor Stocks Are Plunging U.S. Treasury yields as well as U.S. TIPS yields have broken out, and there is more upside to come. Odds are that U.S. interest rate expectations will continue to ratchet higher, which will weigh on EM currencies and risk assets. In terms of risks to our view, the technical profile of the U.S. dollar looks worrisome (Chart I-8). The broad trade-weighted greenback might potentially be forming a head-and-shoulder pattern. If the dollar relapses, EM risk assets will rally, and our negative stance on EM will turn out wrong. Chart I-8Trade-Weighted Broad U.S. Dollar: At A Vulnerable Spot? For now, however, we maintain that current global macro dynamics warrant a stronger dollar. In particular, a stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world.2 Specifically, the U.S. needs a strong dollar to cap budding inflation. For now, we view the recent dollar's softness as a short-term correction from overbought levels. Is A Replay Of February 2016 In Cards? A number of clients have been questioning whether current global macro dynamics - in certain aspects - is reminiscent of the peak in the dollar and the bottom in EM and global equity and credit markets that occurred in February 2016. Back then, the Fed paused its tightening cycle, and China's fiscal and credit stimulus put a floor under mainland growth. These measures combined marked a major top in the dollar and a bottom in EM risk assets. Presently, conditions are substantially different from those that prevailed during that time. In particular: Presently, there is no basis for the Fed to halt its tightening. The U.S. economy is now much stronger - nominal GDP growth is 5.4% versus 2.4% in the first quarter of 2016 (Chart I-9, top panel). Manufacturing production - excluding oil and mining output - is presently very robust (Chart I-9, middle panel). This stands in stark contrast to early 2016 when it was shrinking. Chart I-9U.S. Growth Is Much Stronger Today Than In Early 2016 Importantly, the U.S. output gap is positive, and core inflation is 2% and rising (Chart I-9, bottom panel). Overall, the Fed is not about to pause. On the contrary, U.S. interest rate expectations are still low relative to what is required to restrain America's growth and cap budding inflation. In short, the Fed is not about to rescue EM - not until the latter's financial and economic conditions deteriorate much more, U.S. asset prices fall considerably and the dollar appreciates sharply. In China, the fiscal and credit stimulus implemented so far has been insufficient to bolster growth. The impact of previous tightening is working its way through the economy, and the recent liquidity and fiscal stimuli have so far been insufficient to kick off a new business cycle upturn. We will re-visit this issue in next week's report. EM equities are not yet as cheap as they were at their 2016 lows, according to their cyclically adjusted P/E (CAPE) ratio (Chart I-10). Another 15% decline in EM share prices will bring the EM CAPE ratio to one standard deviation below its mean - the level where the EM CAPE ratio bottomed in early 2016. Chart I-10EM Cyclically-Adjusted P/E Ratio: Not Very Cheap Crucially, the CAPE ratio is a structural valuation metric. It matters for investment horizons beyond two to three years. It is not a useful gauge for the next 12 months or so. As such, even for long-term investors, the risk-reward trade-off for EM stocks is not yet favorable. Bottom Line: Conditions do not exist for the Fed to halt its tightening campaign. This, along with the currently limited stimulus from China and not-so-cheap EM equity valuations, entail that a major bottom in EM stocks is not in the cards. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrading Taiwanese Stocks 18 October 2018 We have been overweighting Taiwanese stocks within an EM equity portfolio since 2007, and this bourse has outperformed the EM index by 30% since that time (Chart II-1). Presently, odds of a pullback in relative performance have risen considerably, and we recommend reducing allocation to this bourse from overweight to neutral. Chart II-1Take Profits On Overweight Taiwanese Stocks Position With the exception of DRAM prices, semiconductor prices are collapsing (Chart II-2). This is a nail in the coffin for this semi- and technology hardware-heavy bourse. Chart II-2Deflation In Semiconductor Prices In the past, Taiwan has depreciated its currency to offset the impact of falling export prices in dollar terms on corporate profitability. This option is no longer available to the authorities. It seems the Trump administration has made it clear to the island that its political and military support partially hinges on Taiwan not intervening in the currency market. In short, the authorities will not be able to resort to material currency depreciation to fight deflation in manufacturing goods as they have in the past. This is bad news for Taiwan's manufacturing-heavy economy, and especially corporate profitability. Exports and manufacturing are decelerating (Chart II-3). Chart II-3Taiwan's Business Cycle Exports of electronic products parts lead non-financial EBITDA, and currently foreshadow a deteriorating profit outlook (Chart II-4). Chart II-4Taiwan: Corporate Profits Are At Risk The recent underperformance of Taiwanese small-cap stocks versus their EM peers is a red flag for the relative performance of large caps. Last but not least, Taiwan is extremely exposed to U.S.-China strategic tensions, as our geopolitical team has argued.3 Escalating geopolitical and strategic tensions between the U.S. and China are taking us closer to a point where these risks are set to materialize, and the risk premium on Taiwanese equities to rise. This will hurt Taiwanese stocks' performance in both absolute and relative terms. Bottom Line: We are downgrading our allocation to Taiwanese stocks from overweight to neutral within an EM equity portfolio. This bourse is also vulnerable in absolute terms. This shift is also consistent with our overall portfolio strategy of reducing equity allocations to Asia in favor of Latin America, as well as with our new equity trade of shorting emerging Asia versus Latin America - a recommendation we made last week. In emerging Asia, having downgraded Taiwan, we now remain overweight only in Korea and Thailand. Peru: An Unsustainable Divergence 18 October 2018 Relative performance of Peruvian equities to EM has been resilient over the past nine months despite falling industrial and precious metals prices and a buoyant dollar (Chart III-1, top panel). Banks, and in particular Peru's financial behemoth, Credicorp, have been the primary contributors to Peruvian market outperformance.4 Excluding banks from the stock index shows that non-financials stocks have not outperformed the EM benchmark since early 2017 (Chart III-1, bottom panel). Chart III-1Peruvian Relative Equity Performance Has Diverged From Metals Prices Is such a divergence between metals prices and Peru's relative equity performance sustainable over the coming year? We think not. Balance of payment (BoP) dynamics has historically driven the macro cycle in Peru. In 2016-17, a favorable external backdrop - high commodity prices and capital inflows into EM - led to a stable exchange rate that in turn allowed the Peruvian central bank to cut interest rates by 150bps. Domestic demand has recovered briskly. However, based on our overall global macro view, we expect Peru's BoP to deteriorate and the virtuous cycle to reverse for the time being. Terms of trade are set to deteriorate with lower industrial and precious metals prices. Mining exports represent 60% of total exports, and the drop in copper and gold prices will dampen the value of exports. Historically, the currency and share prices perform poorly when the trade balance deteriorates (Chart III-2). Chart III-2Current Account Dictates Currency And Equity Trends Importantly, a strong dollar and a global EM riot will lead to diminishing foreign portfolio inflows. Foreigners own 42% of the local fixed-income market and any currency weakness could prompt hedging of currency risk. This will necessitate the central bank (the BCRP) to intervene in the foreign exchange market to defend the sol. By doing so, the central bank will withdraw domestic liquidity - banks' excess reserves at the BCRP will shrink (Chart III-3). Tightening local currency liquidity will lead to higher interbank rates (Chart III-4). Chart III-3Central Bank Selling FX Reserves = Lower Domestic Liquidity Chart III-4Lower Domestic Liquidity = Higher Rates Rising interbank rates will dampen banks' net interest margin as well as constrain loan growth in the process. In short, banks' profitability will be materially affected. Interestingly, interest rates, shown as inverted in the chart, correlate with banks' share prices (Chart III-5, top panel). Chart III-5Higher Rates Will Hurt Bank Stocks Finally, a slowdown in the economy and higher borrowing costs, both local and U.S. dollar, will cause non-performing loans (NPLs) to rise. Banks will be forced to increase provisions for non-performing assets, hurting bank profits in the process (Chart III-5, bottom panel). In terms of financial markets implications, we have the following observations and recommendations to make: Peruvian stock prices have been unable to break above their previous highs in absolute terms, pointing to a major top (Chart III-6). Chart III-6A Major Top? We recommend maintaining an underweight allocation to Peru in an EM dedicated equity portfolio. A negative external backdrop - rising U.S. interest rates, a strong dollar and falling commodities prices - constitute a major headwind for this equity market. Fixed income investors with local market exposure should consider betting on curve flattening given the outlook of higher short-term rates and decelerating growth. Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 We discussed the domino effect in Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, the link is available on page 19. 2 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, the link is available on page 19. 3 Please see Geopolitical Strategy/Emerging Markets Strategy Special Report "Taiwan Is A Potential Black Swan," dated March 30, 2018, the link is available on ems.bcaresearch.com 4 Credicorp constitutes 70% of the Peru MSCI Index. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Chart 3A Tight Race The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Chart 7Net Approvals Advantage Bolsonaro However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Chart 8Haddad Is Ahead##br## In These Polls To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Table 2Voter Profile Of Each Candidate As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Chart 10BBrazil's Parliament Is Fractious No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Diagram 1The J-Curve Of Structural Reform On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Chart 17A New##br## Paradigm Shift? Chart 18Sovereign Credit Spreads Will##br## Continue Widening We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Highlights Recent estimates by ship trackers put the loss of Iranian exports at close to 1mm b/d as of mid-September vs April levels. This loss is higher (and sooner) than our previous baseline expectation, and prompts us to raise our estimate of lost Iranian oil exports to 1.25mm b/d by November, when U.S. sanctions kick in. Venezuela still is close to collapse, but may avoid a complete meltdown with Chinese companies stepping in to safeguard the $50 billion loaned to the country's oil industry.1 We expect production to fall below 1mm b/d next year - to less than half its end-2016 level. With Fed policy likely to continue tightening into 2019 as oil prices surge, the odds of an equity bear market and recession arriving in 2H19 - vs our 2H20 House view - also increase. Our dominant scenario now includes a supply shock and higher prices in 1Q19, which is followed by a U.S. SPR release and price-induced demand destruction (Chart of the Week). As a result, we are raising the odds of Brent prices reaching or exceeding $100/bbl by as early as 1Q19, and lifting our 2019 forecast to $95/bbl. Energy: Overweight. U.S. refining capacity utilization remains close to 19-year highs. At 97.1% of operable capacity, it is within a whisker of the four-week-moving-average highs of 97.3% recorded in August, driven by strong product demand ex U.S. Base Metals: Neutral. The U.S. Treasury granted permission to Rusal's existing customers to continue signing new contracts with the aluminum producer. The announcement stopped short of a full removal of sanctions, which are set to come into effect on October 23. Precious Metals: Neutral. The strong trade-weighted USD continues to hold gold prices on either side of $1,200/oz. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA's Crop Production report forecasts record yields for corn and soybeans - 181.3 and 52.8 bushels/acre, respectively - which continues to weigh on prices. The bean harvest is expected to be a record. Feature Chart of the WeekBCA Ensemble Forecast Lifts Brent To $95/bbl, As Market Tightens With the loss of Iranian exports occurring faster and sooner than expected, and Venezuela remaining on the brink of collapse, senior energy officials from the U.S., Russia and the Kingdom of Saudi Arabia (KSA) are going to great lengths to reassure their domestic consumers everything - particularly on the supply side - is under control. We are inclined to believe their comfort level re global oil supply is inversely proportional to the amount of reassurance they provide their domestic audiences. The more they meet and talk - particularly to the media - the more concerned they are. And right now, they're pretty concerned. Rick Perry, the U.S. Energy Secretary, held a presser in Moscow following his meeting with Alexander Novak, Russia's Energy Minister, saying the U.S., KSA and Russia can lift output over the next 18 months to compensate for the loss of exports from Iran, Venezuela, and other unplanned outages.2 That might be true, but the market's already tightening far faster and far sooner than many analysts expected. Covering a supply shortfall in 18 months does nothing for the market over the next few months, particularly with demand remaining robust (Chart 2) and OECD inventories falling (Chart 3). Since 2017, our factor model shows Brent prices have been supported by two factors acting simultaneously together: Chart 2Fundamentals Support Strong Prices Chart 3Inventory Draws Will Accelerate Strong compliance of OPEC 2.0 members to the coalition's production-cutting agreement, which reduced the OPEC Supply-and-Inventory factor's role, and The pickup in global oil demand, particularly in EM economies, which pushed our Global Demand factor up. These effects were partly counterbalanced by the rise in our non-OPEC Supply factor - driven by strong growth in U.S. shale-oil output - which became the largest negative contributor to price movements. Global demand's been strengthening since the end of 1H17 on the back of stellar EM income growth. This remains the fundamental backdrop to global oil for now. While our base case remains relatively supportive for oil prices, we are raising the odds of a price spike resulting from a supply shock as early as 1Q19 on the back of larger- and faster-than-expected Iranian export losses, and continued declines in Venezuelan production. Should this occur, we believe it would trigger a U.S. SPR release, and produce demand destruction at a rate that could be faster than historical experience would suggest (Table 1). This further tightens balances, and leads us to raise our 2019 forecast for Brent crude oil to $95/bbl on average, up from $80/bbl last month, with WTI trading $6/bbl below that (Chart 4). This forecast is highly conditional, given our assumptions re supply-side variables, a U.S. SPR release, and demand destruction estimates. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 4BCA's Oil Balances Tighter Oil Balances Tighten As Supply Contracts In our monthly balances update, we are incorporating a sharply accelerated loss of Iranian export barrels to the market, which already is evident. Bloomberg this week reported its tanker-tracking service registered a decline in Iranian exports of close to 1mm b/d between April, when sanctions were announced, and mid-September.3 At this rate, the assessment by Platts Analytics last week that as much as 1.4mm b/d of Iranian exports could be lost by the time U.S. sanctions kick in November 4 appears more likely.4 However, to be conservative, we are building in a loss of 1.25mm b/d in our balances, and have it developing over the July - November period in increments of 250k b/d, instead of the November - February interval we assumed in last month's balances. We will monitor this situation and revise our estimates as new information arrives. Also on the supply side, we are assuming the U.S. SPR releases 500k b/d starting a month after Brent prices go over $90/bbl in March 2019. This is in line with the SPR's enabling legislation, which limits drawdowns to 30mm b/d over a 60-day period, after the President authorizes such action to meet a severe energy supply interruption. Lastly, we continue to carry supply constraints arising from the lack of sufficient take-away capacity to get all of the crude produced in the Permian Basin to refining markets in our models. To wit: We continue to expect 1.2mm b/d of supply growth from the U.S. shales, driven largely by Permian production, vs an earlier expectation of 1.4mm b/d of growth. We expect the Permian to be de-bottlenecked by 4Q19. We expect the Big 3 producers Secretary Perry expects to fill supply gaps in 18 months - the U.S., Russia, and KSA - to produce 10.83mm, 11.4mm and 10.4mm b/d in 2H18, and 11.79mm, 11.43mm and 10.4mm b/d next year, respectively. They will get some help from OPEC's Gulf Arab producers - i.e., the core OPEC producers (Chart 5) - but, supply will continue to fall/stagnate in most of the rest of the world, particularly in offshore producers (Chart 6). Chart 5While Core OPEC Can Increase Supply... Chart 6... 'The Other Guys' Output Stagnates We also note the EIA and IEA have lowered their supply-growth estimates this month. The EIA this month reduced expected U.S. crude production growth by 210k b/d in 2019, and the IEA lowered its estimate of offshore production growth in Brazil from 260k b/d to just 30k b/d this year. These are non-trivial adjustments in a market that was tight prior to the downgrade in supply growth. Still, there are significant marginal disagreements on the supply side among the major data supporters (the EIA, IEA and OPEC), which can be seen in Table 2. Table 2Comparison Of Major Balances Estimates Demand Destruction Likely As Prices Spike In 1Q19 We expect the rate of growth in EM incomes and trade - a proxy for income - to slow slightly this year vs 2017, on the back of a strengthening USD. This will reduce the rate of growth in EM imports and the rate of growth in EM commodity demand, at the margin. However, y/y growth in EM incomes is expected to remain positive over the next 12 months in our baseline scenario, which will keep the level of commodity demand - particularly for oil and industrial metals - robust. This will drive global demand growth of ~ 1.6mm b/d this year, roughly unchanged from last month. Higher prices risk slowing next year's growth. This is where it gets tricky. An oil-supply shock occurring when global demand is strong most likely will produce a price spike, as we've been arguing for the past several weeks.5 This price spike, coupled with continued monetary-policy tightening by the Fed, raises the likelihood of demand destruction globally. Higher oil prices and a stronger USD act as a double-whammy on EM oil demand. The problem we have now is gauging the elasticity of oil demand, particularly in EM. Oil markets are fundamentally different now than at any point in the modern era - roughly beginning in the early 1960s with the ascendance of OPEC - because many big oil-importing EM economies removed or relaxed subsidies following the prices collapse of 2014 - 2016. Prominent among these states are China and India. OPEC states also took advantage of the price collapse to relax or remove subsidies, e.g., KSA.6 The price shock we anticipate, therefore, will be the first in the modern era in which EM consumers - the principal driver of oil demand in the world, accounting for roughly 70% of the demand growth we expect - are exposed directly to higher prices. How quickly they will respond to higher prices is unknown. For this reason, we're introducing what we consider a reasonable first approximation of how EM demand might respond to higher prices and a stronger USD into the scenarios we include in our ensemble forecast (Chart 7). As a first approximation - subject to at least monthly adjustment, as more data become available - we are modeling a 100k b/d loss of demand for every $10/bbl increase in crude oil prices.7 We will continue to iterate on this as new information becomes available. Chart 7Ensemble Scenarios Reflect New Risks Bottom Line: We've raised the odds of a supply shock in the oil markets that takes Brent prices to or through $100/bbl by 1Q19. Should this occur, we expect it will be met by a U.S. SPR release of 500k b/d a month after prices breach $90/bbl. This price spike will set off a round of demand destruction, which we expect will be quicker than history would suggest, given many large EM oil-consuming states have relaxed or eliminated fuel subsidies, leaving their consumers exposed to the price shock. This will be exacerbated by a stronger USD going forward, as the Fed likely looks through the price spike and continues with its policy-rate normalization. In this scenario, a U.S. recession could arrive in 2H19 vs our House view of 2H20 or later. In addition, we would expect an equity bear market to ensue sooner than presently anticipated. We recommend using Brent call spreads to express the view consistent with our research. At tonight's close, we will go long April, May and June 2019 calls struck at $85/bbl and short $90/bbl calls. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Venezuela hands China more oil presence, but no mention of new funds," published by reuters.com September 14, 2018. 2 U.S. Energy Secretary Rick Perry made this claim at a press conference after meeting with Russian Energy Minister Alexander Novak last Friday. Please see "Big Three oil states can offset fall in Iran supplies: Perry," published by reuters.com September 14, 2018. 3 Please see "Saudi Arabia Is Comfortable With Brent Oil Above $80," published by bloomberg.com September 18, 2018. 4 Please see "OPEC crude oil production rises to 32.89 mil b/d in Aug as cuts unwind: Platts survey" published by SP Platts Global September 6, 2018. 5 Please see "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy Weekly Report on September 13, 2018. It is available at ces.bcaresearch.com. For a discussion of the effect of a stronger USD on global oil demand, please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by the Commodity & Energy Strategy August 23, 2018. 6 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse," beginning on p. 49. 7 In this simulation, we employ an iterative one-step-ahead forecasting methodology that reduces demand by 100k b/d for every $10/bbl increase in prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2018