Oil

Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil Stronger USD, Slower EM Import Growth Bearish For Base Metals And Oil Stronger USD, Slower EM Import Growth Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth USD Strength Slows EM Trade Growth USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast BCA USD TWIB Forecast BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits BCA Continues To Expect Physical Deficits BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trades Closed in 2018 Summary of Trades Closed in 2017 Trade, Dollars, Oil & Metals ... Assessing Downside Risk Trade, Dollars, Oil & Metals ... Assessing Downside Risk

Highlights Our antennae are twitching wildly, as the Kingdom of Saudi Arabia (KSA) walks back a widely telegraphed commitment to surge production. This occurs against the backdrop of a possible loss of as much as 2mm b/d in exports from Iran and Venezuela next year, with demand expected to remain fairly strong. U.S. President Donald Trump remains silent. We believe the proximate cause of KSA's reversal boils down to one or all of the following: President Trump told KSA to expect an SPR release ahead of November mid-terms; KSA found it difficult to maintain higher production; or Short-term demand for KSA's output is falling, so they reduced production. We have questioned the ability of KSA to sustain production above 10.5mm b/d for an extended period in the past. However, we believe July's 200k b/d cut was produced by a combination of No. 1 and No. 3. We expect KSA to build storage ahead of Iran sanctions. On the back of our updated balances modeling we are maintaining our 2H18 Brent ensemble forecast of $70/bbl, and raising our 2019 forecast to $80/bbl from $75/bbl (Chart of the Week): The front-loaded production increase we expected from OPEC 2.0 could be less than expected. Highlights Energy: Overweight. The U.S. EIA reported U.S. crude and product inventories rose 17.4mm barrels for the week ended August 10, 2018. Markets traded sharply lower as a result, falling more than 3% in WTI and 2% in Brent. As we went to press, October Brent was trading just above $70/bbl. We are maintaining our $70/bbl Brent forecast for 2H18. Base Metals: Neutral. Union leaders at BHP's Escondida mine in Chile, the largest in the world, will take proposed contract terms to members this week.1 We were stopped out of our tactical Dec18 copper call spread with a 10.2% loss. Precious Metals: Neutral. Gold remains under pressure as the broad trade-weighted USD rises. We remain long as a portfolio hedge. Ags/Softs: Underweight. USDA export data show year-to-date wheat and soybean exports are down 20% and 10% y/y in the Oct17 - Jun18 period. Feature Forward guidance from OPEC 2.0's leadership and its predecessor, the regular old OPEC, has not been helpful of late.2 This complicates our balances assessment this month (Chart of the Week), and raises the odds volatility will increase sooner than we expected. Chart of the Week2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl 2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl 2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl KSA's reversal in July of its earlier, widely telegraphed decision to sharply raise production in response to aggressive tweeting from U.S. President Donald Trump beginning in May - to as much as 11mm b/d from just over 10mm b/d in the first five months of this year - was followed by an abrupt output cut of ~ 200k b/d last month. Last month, we expected KSA's crude production to average 10.60mm b/d in 2H18, and 10.50mm b/d next year. In our current balances estimate (Table 1), we now expect the Kingdom's output to average 10.28mm b/d in 2H18 and 10.35mm b/d in 2019, down 300k b/d and 150k b/d, respectively. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Russia, OPEC 2.0's other putative leader, also is complicating assessments of liquids production by the producer coalition. Given the signaling it and KSA were providing over the past couple of months, we expected Russia to raise production 80k b/d in 2H18 to 11.27mm b/d, and by 160k b/d in 2019 to 11.35mm b/d. We still expect Russia to raise its production and revised our baseline estimates to 11.32mm b/d and to 11.43mm b/d for this year and next, respectively. However, it is difficult to reconcile our expectation with the 11.13mm b/d 2H18 liquids production expected by OPEC for Russia in its August Monthly Oil Market Report (MOMR), as we are highly confident Russia signed off on that estimate before it was published. Chart 2Physical Deficit Worsens Physical Deficit Worsens Physical Deficit Worsens Our global liquids supply estimate for 2H18 now stands at 101.08mm b/d, down 680k b/d from last month's estimate. For 2019, we lowered our supply estimate by 800k b/d to 101.01mm b/d. But this could end up overstating supply, given what we're seeing from OPEC 2.0 presently. On the demand side, we've lowered our 2018 and 2019 expectations slightly - to 1.67mm b/d and 1.62mm b/d, respectively, or ~ 50k b/d on average versus our previous estimates. This is still relatively stout demand growth - supported by still-strong global trade, particularly in the EM economies - which means storage will be forced to draw harder next year than we expected even a month ago (Chart 2). Physical Deficit Worsens In 2019 We expected OPEC 2.0's supply increase would persist at a higher level during 2H18, which would allow refiners to build precautionary inventories going into next year. This no longer is a tenable assumption, given what is being reported for OPEC 2.0's largest producers - KSA and Russia. In addition, we have amended our base case supply model, to reflect the loss of 1mm b/d of Iranian exports to U.S. sanctions for most of next year; we have this occurring in 250k b/d increments in the Nov18 - Feb 19 period, leaving production from March 2019 on at 2.8mm b/d. This replaces our earlier assumption of a 500k b/d by the end of 1H19. We took this action on the back of the increasingly strident rhetoric from the U.S. administration, and press reports indicating widespread compliance with the sanctions is expected - particularly reports suggesting China and India will not be looking to increase purchases of Iranian crude. Offsetting the higher Iranian export losses we foresee, our base case includes a re-start of Neutral Zone production in 2Q19.3 We expect KSA and Kuwait to each bring 175k b/d back on line, for a total of 350k b/d. It is not clear this is counted in both countries' spare capacity, but if it is, then spare capacity will become tighter within OPEC 2.0 next year. In our scenario analysis, we continue to give a relatively high weight to the loss of Venezuela's exports - anywhere from 800k to 1mm b/d - as that country's oil industry continues to degrade. Our ensemble analysis indicates OECD storage will draw more than previously estimated (Chart 3), on the back of these higher assumed Iranian export losses, and a reduction in OPEC 2.0's front-loaded production increases, particularly in 2019. As storage draws, days-forward-cover (DFC) also will contract (Chart 4). In addition to steepening the backwardation in crude forward curves, we expect implied option volatility to increase in 2019 (Chart 5). Chart 3Storage Will Draw##BR##Harder Next Year Storage Will Draw Harder Next Year Storage Will Draw Harder Next Year Chart 4Days-Forward-Cover##BR##Will Fall In 2019 Days-Forward-Cover Will Fall In 2019 Days-Forward-Cover Will Fall In 2019 Chart 5Implied Volatilities Will Rise,##BR##As OECD Storage Falls OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Ensemble Forecast Update In addition to moving the 1mm b/d loss of Iranian exports from a scenario and into our base case - offset somewhat by higher Neutral Zone production - we expect transportation bottlenecks in the Permian Basin to slow production growth in the U.S. shales even more. We have lowered our expected U.S. production growth to 1.21mm b/d this year and 1.22mm b/d in 2019, versus earlier estimates of 1.30mm b/d and 1.34mm b/d, as a result (Chart 6 shows the trajectory we expect from this scenario).4 Coupled with the lower-than-expected production increase from OPEC 2.0 and still-strong demand growth globally, this will lead to tighter markets in 2019. Chart 6Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range We also are including a scenario showing a slowdown in demand growth, which takes y/y growth to 1.43mm b/d in 2018 and 2019, versus our current estimates of average growth of 1.64mm b/d over the two-year interval. Bottom Line: Numerous conflicting data have entered the oil pricing picture over the past month, which greatly complicates our analysis and forecasting. The fact that OPEC 2.0's leadership - KSA and Russia - is providing little in the way of forward guidance does not make this any easier. We admit to being puzzled by KSA's apparent decision to walk back its production increase going into 2019, when the likelihood of losing close to 2mm b/d of exports from Iran and Venezuela becomes markedly higher. Based on our current modeling we expect higher prices next year ($80/bbl vs. our earlier estimate of $75/bbl for Brent), and a steepening of the Brent and WTI backwardations next year. We continue to expect WTI to trade $6/bbl below Brent in 2H18 and 2019. The steepening backwardation will lift implied volatility, particularly next year. We remain long call option spreads along the Brent forward curve in 2019, in expectation prices and volatility will move higher. We continue to believe the balance of price risk is to the upside. However, as the lower-demand scenario in our ensemble forecast shows, an unexpected slowdown in growth can have profound effects on prices. 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 "Chile's Escondida union to take new labor proposal to members," published by reuters.com August 15, 2018. 2 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. At the end of June, the coalition's member states agreed to increase production to bring it into line with the originally agreed deal to remove 1.8mm b/d of output from the market. 3 Please see "Kuwait, Saudi to resume output from Neutral Zone in 2019 - Toyo Engineering," published by reuters.com July 2, 2018. 4 We place our scenarios within the context of a market-generated confidence interval, which we calculate using implied volatilities derived from Brent and WTI options markets. Please see Ryan, Bob and Tancred Lidderdale (2009), "Energy Price Volatility and Forecast Uncertainty," particularly Appendix 1 beginning on p. 18, for a derivation of the confidence intervals. The article was published by the U.S. EIA. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Trades Closed in 2018 Summary of Trades Closed in 2017 OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind

Highlights The eye of the storm is passing over the oil market. OPEC 2.0's recent production increase will temporarily halt the sharp decline in OECD commercial oil inventories, allowing stocks of crude oil and refined products in member states to level off ahead of the sharp drawdowns we expect next year (Chart of the Week).1 This will keep the front of Brent's forward curve in a modest contango going into 4Q18, and suppress short-term price volatility. Thereafter, reduced OPEC 2.0 output post-U.S. midterm elections, and lower Iranian and Venezuelan exports will force OECD inventories to resume drawing sharply, backwardating Brent's forward curve and raising oil price volatility (Chart 2).2 Chart of the WeekOECD Inventories Rebuild Slightly,##BR##Then Resume Falling Next Year OECD Inventories Rebuild Slightly, Then Resume Falling Next Year OECD Inventories Rebuild Slightly, Then Resume Falling Next Year Chart 2Brent, WTI Implied Volatility Vs. Curve Shape:##BR##Implied Vol Is Higher At Storage Extremes Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Chart 3Physical Oil Deficit Returns##BR##To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Highlights Energy: Overweight. The U.S. EIA revised its estimate of OPEC spare capacity down slightly for this year - to 1.7mm b/d from 1.8mm b/d. Spare capacity for next year was raised to 1.3mm b/d from just over 1mm b/d previously. At ~1.5% of global consumption this year and next, spare capacity is chronically low. Base Metals: Neutral. Chinese policymakers could sanction new infrastructure spending and easier credit to counter slower growth related to trade tensions, Reuters reported.3 Precious Metals: Neutral. We were stopped out of our tactical long silver position with a 10% loss. Ags/Softs: Underweight. There is more evidence that U.S. ags are finding new markets. EU imports of U.S. soybeans almost quadrupled in recent weeks. This comes amid the June plunge in prices and a thawing in trade tensions, following talks between EU Commission President Juncker and President Trump late last week.4 Feature The oil market sits in the eye of a pricing storm we expect to hit later this year. Following highly vocal - and twitter-textual - jawboning by U.S. President Donald Trump, OPEC's Gulf Arab producers lifted production in June and again in July.5 Reuters survey data indicate the OPEC Cartel (including new member Congo) lifted production by 70k b/d in July, bringing output to its highest level this year (32.64mm b/d).6 KSA boosted its output to 10.6mm b/d in June, up from less than 10mm b/d in the January - May period. This likely was a combination of higher production and inventory draws. OPEC's compliance level fell to 111% of the 1.2mm b/d of cuts agreed in November 2016, versus compliance levels exceeding 150% earlier this year. This is attributed to sharp declines in Venezuela's output, sporadic losses from Libya and Nigeria, and ongoing declines in non-Gulf OPEC states. We expect Russia, the putative co-head of the OPEC 2.0 coalition, will increase production by 200k b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Global Oil Market Will Tighten Again Post-U.S. mid-term elections in November - just when the U.S. sanctions are re-imposed against Iranian crude exports - we expect OPEC 2.0 to dial back production increases made at the behest of President Trump. Continued declines in non-Gulf OPEC output, led by ongoing and deep losses in Venezuelan output, and random unplanned production outages also will contribute to a tightening on the supply side going into 2019. Rising geopolitical tensions in the Gulf will keep markets on edge, with a predisposition to push higher. This supply-side tightness will once again come up against strong global oil demand, which we estimate will grow at a 1.7mm b/d rate this year and next. We are not expecting a repeat of the evolution of prices observed following OPEC 2.0's January 2017 agreement, which cut production to reverse the massive accumulation of inventories brought about by the original cartel's market-share war launched in November 2014. This evolution is depicted in the price-decomposition model for Brent shown in Chart 4. We segmented the fundamental price drivers - i.e. demand, supply and inventories - into distinct factors, and estimated an econometric model that allows us to track whether the evolution of prices is consistent with our expectations for these factors. Chart 4Factor Decomposition For Brent Prices Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Our modeling indicates the 2014 - 15 decline in oil prices was driven by a not-often-seen combination of every single factor, with our OPEC Supply-and-Inventory factor accounting for the largest negative contribution to the evolution of prices during this period. Since 2017, our factor model shows Brent prices have been supported by two factors acting simultaneously together: (1) the 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 (2) 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, which became the largest negative contributor to price movements, driven by strong U.S. shale production growth. Return Of Backwardation Will Spur Volatility Our ensemble forecasts for Brent in 2H18 and 2019 are $70 and $75/bbl, with WTI expected to trade $6/bbl below these levels (Chart 5). The supply-side tightening we expect, coupled with continued demand growth, will once again lead to sharp draws in OECD inventories beginning in 4Q18 and continuing into 2019, as seen in the Chart of the Week. This will steepen the backwardations in the Brent and WTI forward curves (Chart 6). Chart 5BCA Brent And##BR##WTI Forecasts BCA Brent And WTI Forecasts BCA Brent And WTI Forecasts Chart 6Backwardation Will Return##BR##To Brent's Forward Curve Backwardation Will Return To Brent's Forward Curve Backwardation Will Return To Brent's Forward Curve Our research shows that as the slope of the Brent and WTI forward curves steepen - i.e., backwardations become more positive in percentage terms (or contangoes become more negative) - the implied volatility of options written on these crude oil futures increases, as can be seen in Chart 2.7 All else equal, higher volatility makes options written on these crude futures more valuable. Higher Vol ... Higher Prices ... In the different scenarios we use to produce our ensemble forecast, we view the balance of risks to be on the upside. This can be seen in the different paths our scenarios cover over the next year and a half, which include physical and geopolitical variables affecting price expectations (Chart 7).8 Chart 7Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Our base case assumes the supply and demand estimates shown in Table 1, which include the loss of 500k b/d due to the re-imposition of U.S. sanctions against Iran. However, we also model the loss of 1mm b/d of Iranian exports. Furthermore, we account for the loss of ~ 800k b/d of Venezuelan exports in the event that country collapses and nothing but the 250k b/d of output required to produce refined products for the local market remains online. Lastly, we account for the Permian transportation bottlenecks preventing all of the crude produced in the Basin from getting to refiners or to export markets. In this week's publication, we also include an estimate of the 95% confidence interval derived from Brent and WTI options' implied volatilities, so that our scenarios can be placed in the context of market-derived assessments of the range in which prices will trade. ... Lower Prices ... ? In modeling these risks, we also must account for downside price risks. Most prominent among these is a resolution of the long-simmering U.S. - Iran conflict, which, from time to time, results in physical confrontation. This is an outcome markets were forced to consider earlier this week when President Trump offered to meet Iranian President Rouhani without any preconditions. Among other things, Trump suggested he would have interest in working on a nuclear-arms deal to replace the one negotiated under President Obama's watch, which he scuppered in May. Secretary of State Mike Pompeo walked this remark back later. We believe the odds of such a meeting are extremely low. The odds such meeting would lead to a resolution of animosities - or at least a working understanding between the two sides - are even lower. Even so, investors need to account for this tail risk, which, if realized could take $5 to $10/bbl out of the current oil price structure. That is, until KSA and Russia muster the OPEC 2.0 member states to again reduce production to keep prices at levels that work best for their economies. Bottom Line: Our modeling and the forecasts point to higher prices and a steepening of the backwardation in Brent and WTI forward curves. This will lead to an increase in implied volatilities for options written on these crude oil futures. For this reason, we suggest investors remain long call spreads further out the Brent forward curve in 2019, which can be found in the Strategic Recommendations table on page 10 of this publication. That said, downside risks have emerged, even if, at present, the likelihood of a diplomatic breakthrough that triggers them is remote. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. At the end of June, the coalition's member states agreed to increase production, which we estimate will raise its output ~ 275k b/d in 2H18 (vs. 1H18). We expect a physical deficit of ~ 430k b/d in 1H19 (vs 1H18, Chart 3). 2 "Contango" and "backwardation" are terms of art in commodity markets. In oil trading, when prompt-delivery crude is priced below deferred-delivery material markets are in contango; vice versa for backwardation. 3 Please see "Exclusive: China eyes infrastructure boost to cushion growth as trade war escalates - sources," published by uk.reuters.com July 27, 2018. 4 We discussed this possibility under Option 1 in our July 26, 2018, Commodity & Energy Strategy lead article entitled "Policy Uncertainty Could Trump Ag Fundamentals." It is published by BCA Research, and is available at ces.bcaresearch.com. 5 Please see our Special Report entitled "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," published jointly July 19, 2018, by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy. It is available at ces.bcaresearch.com. 6 Please see "OPEC July oil output hits 2018 peak, but outages weigh: Reuters survey," published July 30, 2018, by uk.reuters.com. 7 Chart 2 shows the V-shaped mapping of implied volatility as a function of the slope of the forward curve - , i.e., the difference between the 1st- and 12th-nearby futures divided by the 1st -nearby future (to get the number in %) - against the at-the-money Implied Volatilities of 3rd-nearby Brent and WTI options (also in %). Our findings extend results published in Kogan et al (2009), who show realized volatilities calculated using historical settlements of crude oil futures have a similar V-shaped mapping with the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009). "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64 (3), 1345-1375. Strictly speaking, volatility is the standard deviation of percent returns, usually measured on a per annum basis. Realized volatility uses futures prices to calculate returns and standard deviations; options' implied volatility is a parameter of an option-pricing model that is solved for once an option's premium, or price, is known (i.e., clears the market). This makes implied volatility a forward-looking market-cleared parameter, provided market participants agree the model used to calculate its value. Research shows implied volatilities do a better job of forecasting actual volatility than historical volatilities constructed using futures prices. See Ryan, Bob and Tancred Lidderdale (2009). "Energy Price Volatility and Forecast Uncertainty." U.S. Energy Information Administration. 8 We do not try to model a closure of the Strait of Hormuz or its prices implications. We do, however, consider this in our Special Report published July 19, 2018, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," referenced above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Trades Closed in 2018 Summary of Trades Closed in 2017 Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets

Highlights President Trump has taken the next step in the trade war by charging some of America's major trading partners with outright currency manipulation. However, we are not headed for Plaza Accord 2.0, because neither the ECB nor the PBOC will re-orient policy until their own economic and inflation dynamics warrant it. Moreover, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. With the labor market showing signs of overheating, the Fed will stick with its current game plan and ignore President Trump's tweets. The worsening trade dispute is the key risk that investors face and there are growing signs that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Risk tolerance should be no more than benchmark. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that most risk assets will outperform bonds and other defensive sectors in the near term. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. The flattening U.S. yield curve is also worrying. We would not ignore the signal if the curve inverts, although there are reasons to believe that it is not as good a recession signal as it has been in the past. We wish to see corroborating evidence from our other favorite indicators before trimming risk asset exposure to underweight. A peak in the S&P 500 operating margin would be a strong sign that the end of the cycle is drawing close. Even if trade tensions soon die down and global growth holds up, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. High-quality bonds will of course outperform in the next recession, but yields are likely to rise in the meantime. We believe that U.S. Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields. We also like Agency CMBS. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. Feature We warned in last month's Overview that investors had not yet seen "peak pessimism" on the global trade front. Right on cue, President Trump raised the stakes again in July by threatening to impose tariffs on virtually all imports of Chinese goods. Congress is pushing the President to be tough on China because American voters have soured on trade. China will not easily back down with the authorities responding in kind to the U.S. President's trade threats. They have also allowed the RMB to depreciate to cushion the trade blow (Chart I-1). It is not clear whether the authorities purposely depressed the RMB or whether they simply failed to lean against market pressures. Either way, it is a dangerous approach because it has clearly raised the U.S. President's ire. Chart I-1RMB Is Much Weaker Across The Board RMB Is Much Weaker Across The Board RMB Is Much Weaker Across The Board President Trump has taken the next step in the broader trade war by charging some major trading partners with outright currency manipulation. The script appears to be following previous times that the U.S. sought trade adjustment via tariffs and currency re-alignment: the early 1970s and the 1985 Plaza Accord. Adjusting currencies on a sustained basis requires much more than simply "talking down" the dollar. There must be major changes in relative monetary and/or fiscal policies vis-à-vis U.S. trading partners. On the fiscal front, expansionary U.S. policy is working at cross purposes with the desire to have a weaker dollar and a smaller trade gap. We do not foresee the U.S. President having any success in changing the broad thrust of monetary policy either. Europe and Japan enjoyed booming economies in the early 1970s and mid-1980s, and thus had the luxury of placating the U.S. by adjusting monetary policy and thereby appreciating their currencies. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that generates major bull markets in their currencies. Neither the ECB nor the People's Bank of China (PBOC) will re-orient policy until their own economic and inflation dynamics warrant it.1 It is also unlikely that the Bank of Japan will raise the 10-year yield target to either strengthen the yen or to help bank profits. This is not Plaza Accord 2.0. Powell Isn't Arthur Burns As for the Fed, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. The Fed is more open and independent today than in the 1970s and 1980s. Even if Fed Chair Powell were amenable, any hint that he is being politically manipulated to change course would result in a bond market riot that would rattle investors to their core. More likely, the Fed will stick with its current game plan and ignore President Trump's tweets. Powell could not be any clearer in his July Congressional Testimony: "With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that-for now-the best way forward is to keep gradually raising the federal funds rate." Investors should not be fooled by the uptick in the U.S. unemployment rate in June. The rise reflected a pop in the labor force participation rate. However, the labor force figures are volatile and there is no upward trend evident in the participation rate. The real story is that the labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. The Employment Cost Index for private-sector workers shows that wage growth is accelerating. Moreover, the New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already jumped to almost 3 ½% (Chart I-2). Small businesses are increasingly able to pass on cost increases to consumers (Chart I-3). Chart I-2U.S. Inflation Is Percolating U.S. Inflation Is Percolating U.S. Inflation Is Percolating Chart I-3U.S. Pricing Power On The Rise U.S. Pricing Power On The Rise U.S. Pricing Power On The Rise The Minutes from the mid-June FOMC meeting included a lengthy discussion of the growing signs of inflation pressure and labor shortage. Firms are responding to the lack of qualified labor by offering training, automating, and boosting wages. Anecdotal evidence suggests that bottlenecks and other cost pressures are boiling over in the transportation sector. Despite an acute shortage of truck drivers, the average hourly earnings data do not show any acceleration in their wages (Chart I-4, second panel). However, these data do not include bonuses, which have been on the rise. The PPI for truck transportation services was up 7.7% year-over-year in June, while the Cass Freight Index that tracks full-truckload prices rose 15.9% year-over-year. The latter does not even include fuel costs. These pipeline cost pressures have implications not only for the Fed, but for corporate profit margins as well (see below). Chart I-4U.S. Transportation Is Boiling Over U.S. Transportation Is Boiling Over U.S. Transportation Is Boiling Over The U.S. Yield Curve: A Red Flag? The FOMC expects that the fed funds rate will continue to rise and will temporarily exceed its 2.9% estimate of the neutral rate. If the true neutral rate is higher than the Fed's estimate, then the FOMC could find itself hiking too slowly and the economy could severely overheat. And vice versa if the true neutral rate is below 2.9%. We are keeping a close eye on the yield curve as an indication of policy tightness. If the curve inverts with a few more Fed rate hikes, it would signal that the market believes that policy is turning restrictive. It is possible that the yield curve is not as good a recession signal as it has been in the past. First, there is a lot of uncertainty regarding the neutral fed funds rate in the post-GFC world. The collective market wisdom on this could be wrong. Indeed, BCA's Chief Global Strategist, Peter Berezin, makes the case that the neutral rate is rising faster than most investors believe.2 Structural factors have depressed the neutral rate, including population aging and low productivity growth. However, these structural tailwinds for bond prices are now slowly turning into headwinds. Moreover, as Peter argues, cyclical pressures are acting to lift the neutral rate. Private credit growth is rising faster than nominal GDP growth again. The same is true for housing and equity wealth, at a time when the personal saving rate is falling. All this implies strong desired spending which, in turn, suggests a higher neutral rate of interest. It will be important to watch the housing market; if it remains healthy in the face of rate hikes, it means that the neutral rate is still north of the actual fed funds rate. Chart I-5 presents today's market expectation for the real fed funds rate, based on the forward OIS curve and the forward CPI swaps curve. Technical issues may be distorting forward rates in 2019, but we are more interested in expectations further into the future. The real fed funds rate is expected to hover in the 55-75 basis point range until 2024. It then rises to about 1%, but not until almost the end of the next decade. This appears overly complacent to us, suggesting that the risks are to the upside for market expectations of the terminal, or neutral, short-term interest rate. If the neutral rate is indeed higher than the market is currently discounting, then an inverted curve may be premature in signaling that policy is too tight and that an economic slowdown is on the horizon. Moreover, the term premium on long-term bonds may still be depressed by asset purchases by the Fed and the other major central banks, again suggesting that the curve will more easily invert than in the past. There is much disagreement on this issue, even among FOMC members and among BCA strategists. This publication is sympathetic to the work done by the Fed Staff which suggests that the term premium has been substantially depressed by quantitative easing. Chart I-6 shows the annual change in the size of G4 central bank balance sheets (inverted), along with an estimate of the term premium in the 10-year government bonds of the major countries. The chart is far from conclusive, but it is consistent with the view that QE has depressed term premia worldwide. Moreover, forward guidance and the low level of inflation since the GFC have undoubtedly dampened interest-rate volatility, which theory suggests is a key driver of the term premium. Chart I-5Policy Rate Expectations Policy Rate Expectations Policy Rate Expectations Chart I-6Depressed Term Premiums ##br##Distort Yield Curves Depressed Term Premiums Distort Yield Curves Depressed Term Premiums Distort Yield Curves The factors that have depressed the term premium are beginning to reverse, including G4 central bank balance sheets. Still, the premium will trend higher from a low starting point, suggesting that an inverted curve today may not necessarily signal a recession. That said, it would be wrong to completely dismiss a U.S. curve inversion, given its excellent track record. Historically, the 3-month/10-year Treasury slope has worked better than the 2/10 yield slope in terms of calling recessions. An inversion of the 3-month/10-year curve has successfully heralded all seven recessions in the past 50 years with one false positive signal. Nonetheless, the curve tends to be very early, inverting an average of almost 12 months before the recession. And, given the possible distortion to the term premium, we would want to see corroborating evidence before jumping to the conclusion that an inverted curve is sending a correct recession signal. For example, the U.S. and/or global Leading Economic Indicator would need to turn negative. The bottom line is that a curve inversion would not be enough on its own to further trim risk asset exposure to underweight. Nonetheless, we are not dismissing the message from the yield curve either, especially in the context of a trade war that could prematurely end the expansion. Trade War Hitting Economy? Estimates based on macro models suggest that the damage to global GDP growth from higher tariffs would be quite small. Nonetheless, these models do not incorporate the indirect, or second-round, effects of rising tariff walls. Business leaders abhor uncertainty, and will no doubt hold off on major capital expenditure plans until the trade dust settles. The uncertainty can then ripple through the economy to industries that are not directly affected by the trade action. The extensive use of global supply chains reinforces this ripple effect. Labor is not free to move between countries or between industries to facilitate shifts in production that are required by changing tariffs. Capital is more mobile, but it is still expensive to shift machinery. Some of the world's capital stock could become "stranded", raising the cost of the tariffs to the world economy. Finally, important economies-of-scale are lost when firms no longer have access to a single large global market. This month's Special Report, beginning on page 18, sorts out the U.S. equity sector winners and the losers from a trade war with China. Spoiler alert: there are not many winners! The bottom line is that the trade threat for the global economy and risk assets is far from trivial. The negative trade headlines have not had a meaningful economic impact so far, but there are some worrying signs. A number of indicators suggest that global growth continues to slow, including the BCA Global Leading Economic Indicator diffusion index, the Global ZEW sentiment index and the BCA Global Credit Impulse index (Chart I-7). The softness in these indicators predates the latest flaring of trade tensions. Nonetheless, business confidence outside the U.S. has dipped (fourth panel). Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies (production related to energy, consumer products and IT remain strong; Chart I-8). Chart I-7Global Growth Is Still Moderating... Global Growth Is Still Moderating... Global Growth Is Still Moderating... Chart I-8...In Part Due To Capital Spending ...In Part Due To Capital Spending ...In Part Due To Capital Spending None of these data are flagging a disaster, but they all support the view that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Even if trade tensions soon die down, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Late Cycle Investing Some of our economic and policy analysis over the past year has focused on previous late-cycle periods. Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment). This month we look at asset class returns during late cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart I-9). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM manufacturing index. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table I-1 presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the following recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in the margin to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart I-9Margin Peak Signals Very Late Cycle Margin Peak Signals Very Late Cycle Margin Peak Signals Very Late Cycle Table I-1Late-Cycle Asset Returns August 2018 August 2018 We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cases the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a six month horizon. Similar to Treasurys, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasurys after margins peaked and into the recession. High-yield bonds followed a similar pattern, but suffered negative absolute returns after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but relative performance was mixed after margins peaked. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value stocks before and after margins peaked, but tended to outperform in the recessions. Dividend Aristocrats performed well relative to the overall equity market after margins peaked and into the recessions on average, but the performance was not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge Funds are supposed to be able to perform well in any environment, but returns were a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured Product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns were attractive across all periods and cycles, except for Timberland during one of the recessions. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The historical return analysis underscores that it is dangerous to remain aggressively positioned late in an economic cycle because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears prudent. Based on this approach, investors should generally remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investors should scale back in most of these areas as soon as margins peak. For fixed income, investors should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. There are some assets other than government bonds that generated a positive average return late in the cycle and during the recession periods, suggesting that they are good late-cycle assets to hold. However, this is misleading because in some cases they experienced a significant correction either during or slightly before the recession (see the maximum drawdown columns in Table I-1; blank cells indicate that the asset did not experience a correction). These include IG credit, CMBS, ABS, Gold and Dividend Aristocrats. The only assets in our list that provided both a positive return across all the phases in Table I-1 and avoided a correction during the recessions, were mortgage-backed securities, Timberland and Farmland. A Special Report from BCA's Global Asset Allocation service found that Timberland is a superior inflation hedge to Farmland, but the latter is a superior hedge against recessions and equity bear markets.3 We believe that Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields (as long as the Treasury selloff is not extreme). Our fixed income team also likes Agency CMBS.4 When Will U.S. Margins Peak? It is impressive that S&P 500 after-tax operating margins are extremely elevated and still rising. The trend has been aided by tax cuts, but corporate pricing power has improved and wage growth has not yet accelerated enough to damage margins. Chart I-10 presents some indicators to monitor as we await the cyclical peak in profit margins. These are generally not leading indicators, but they do provide some warning when they roll over late in the cycle. The first is the BCA Margin Proxy, which is the ratio of selling prices for the non-financial corporate sector to unit labor costs. Margins have tended to fall historically when the growth rate of this ratio is below zero. The same is true for nominal GDP growth minus aggregate wages. The aggregate wage bill incorporates both changes in wages/hour and in total hours worked. We are also watching a diffusion index of the changes in margins for the industrial components of the S&P 500, as well as BCA's Corporate Pricing Power indicator. The latter takes into consideration price changes at the detailed industry level. Chart I-10U.S. Profit Margin Indicators To Watch U.S. Profit Margin Indicators To Watch U.S. Profit Margin Indicators To Watch None of these indicators are signaling an imminent top in margins, but all appear to have peaked except the Corporate Pricing Power indicator. An equally-weighted average of these four indicators, labelled the U.S. Composite Margin Indicator in Chart I-10, is falling but is still above the zero line. We would not be surprised to see S&P 500 margins peak for the cycle late early in 2019. Conclusions: The S&P 500 has so far been largely immune to shocking trade headlines with the help of a solid start to the U.S. Q2 earning season. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that investors should remain fully-exposed to most risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. These risks include a possible hard economic landing in China, crises in one or more EM countries, and an escalation in the trade war among others. Some investors appear to believe that the U.S. can "win" the trade war, but there are no winners when tariff walls are rising. We are not yet ready to go underweight on risk assets, but risk tolerance should be no more than benchmark. This includes equities, corporate bonds, EM assets and other risky sectors. An inversion of the yield curve could trigger a shift to underweight, although this signal would have to be corroborated by our other favorite U.S. and global indicators. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. The first statements by Jay Powell as FOMC Chair underscored that it is too early to hide in Treasurys. Market expectations for real short-term interest rates are overly benign out to the middle of the next decade. Moreover, the Fed is not in a position to be proactive in leaning against the negative impact of rising tariffs because inflation is near target and the labor market is showing signs of overheating. This means that bond yields are headed higher until economic pain is clearly evident. Keep duration short of benchmark. Long-term rate expectations for the Eurozone appear even more complacent than they do for the U.S. The real ECB policy rate is expected to remain in negative territory until 2028 (Chart I-5)! At some point there will be a convergence of real rate expectations with the U.S., which will boost the value of the euro. Nonetheless, we believe that it is too early to position for rate convergence. Core inflation is still well below target and Eurozone economic growth has softened recently, suggesting that the ECB will be in no hurry to lift rates once asset purchases have ended. ECB policymakers will be disinclined to cater to President's Trump's desire for tighter monetary policy in Europe, which means that the U.S. dollar has more upside versus the euro and in broad trade-weighted terms. An escalation in the trade war would augment upward pressure on the greenback. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. tend to attract capital inflows into the safe-haven Treasury market. Emerging market assets are particularly vulnerable to another upleg in the dollar because of the high level of U.S. dollar-denominated debt. Favor DM to EM equity markets and currencies. Mark McClellan Senior Vice President The Bank Credit Analyst July 26, 2018 Next Report: August 30, 2018 1 For more information on why a replay of the 1985 Plaza Accord is unlikely, please see BCA Geopolitical Strategy Weekly Report "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available on gps.bcaresearch.com 2 Please see BCA Global Investment Strategy Weekly Report "U.S. Housing Will Drive the Global Business Cycle...Again," dated July 6, 2018, available on gis.bcaresearch.com 3 Please see BCA Global Asset Allocation Service Special Report "U.S. Farmland & Timberland: An Investment Primer," dated October 24, 2017, available on gaa.bcaresearch.com 4 Please see BCA's U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem," dated July 17, 2018, available on usbs.bcaresearch.com II. U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains August 2018 August 2018 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) August 2018 August 2018 (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) August 2018 August 2018 Table II-3China Tariffs On U.S. Goods August 2018 August 2018 What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State August 2018 August 2018 Chart II-3Value Of U.S. Products Tariffed By China (By State) August 2018 August 2018 Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category August 2018 August 2018 Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events August 2018 August 2018 Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) August 2018 August 2018 Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure August 2018 August 2018 Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China August 2018 August 2018 The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) August 2018 August 2018 As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors August 2018 August 2018 Appendix Table II-2 Exports By U.S. Red States August 2018 August 2018 Appendix Table II-3 Exports By U.S. Swing States August 2018 August 2018 Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs August 2018 August 2018 III. Indicators And Reference Charts Our equity-related indicators flashed caution again in July, despite robust U.S. corporate earnings indicators. Forward earnings estimates continued to surge in July. The net revisions ratio and the earnings surprises index remained well above average, suggesting that forward earnings still have upside potential in the coming months. However, several of our indicators suggest that it is getting late in the bull market. Our Monetary Indicator is approaching very low levels by historical standards. Equities are still close to our threshold of overvaluation, at a time when our Composite Technical Indicator appears poised to break down. An overvalued reading is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Equity sentiment is close to neutral according to our composite indicator, but the low level of implied volatility suggests that investors are somewhat complacent. Our U.S. Willingness-to-Pay (WTP) indicator has fallen significantly this year, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a ‘sell’ signal in July. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. This month’s Overview section discusses the upside potential for the term premium in the yield curve and for market expectations of the terminal fed funds rate. This year’s dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but we still believe it has some upside while market expectations for the terminal fed funds rate adjust upward. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? Can Policy Be Truly 'Tight' With Negative Real Rates? Can Policy Be Truly 'Tight' With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal A Pause In The Rising Yield Trend, Not A Reversal A Pause In The Rising Yield Trend, Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Slowing Growth In China... Slowing Growth In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability ...But Not Yet Enough To Threaten Global Financial Stability ...But Not Yet Enough To Threaten Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? A Turn In European Yields On The Horizon? A Turn In European Yields On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences Wide UST-Bund Spread Reflects Monetary Policy Divergences Wide UST-Bund Spread Reflects Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals UST-Bund Spread Overshooting Fundamentals UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model UST-Bund Spread Looks Wide On Our Model UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Relative Data Surprises No Longer Support A Wider UST-Bund Spread Relative Data Surprises No Longer Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes UST-Bund Spread Momentum Got To Stretched Extremes UST-Bund Spread Momentum Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... UST-Bund Spread Narrowing Will Be Limited By Faster U.S. Growth... UST-Bund Spread Narrowing Will Be Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy ...The Result Of Looser U.S. Fiscal Policy ...The Result Of Looser U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now UST Technical Indicators Are More Mixed Now UST Technical Indicators Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market The Bond Bear Market Is Not Over The Bond Bear Market Is Not Over Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Bear Market Is Not Over The Bond Bear Market Is Not Over Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic

Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Table 1Market's Couldn't Care##br## Less About Tariffs Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions ...And On Military Tensions ...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B (Cont.) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Geopolitical Calendar

Highlights The not-so-veiled threat to Gulf Arab oil shipments through the critically important Strait of Hormuz by Iran's President Rouhani earlier this week was a response to the ramping up of maximum pressure by the Trump administration, which is demanding importers of Iranian crude reduce volumes to zero. This was a predictable first step toward what could become a chaotic oil pricing environment (Map 1).1 Map 1Iran Threatens Gulf Shipments Again Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Oil prices surged on reports of the Iranian threat Tuesday morning, sold off, and recovered later in the day. Pledges from the Kingdom of Saudi Arabia (KSA) to lift production to as much as 11mm b/d this month - a record high - were all but ignored by the market. The threat to safe passage through the Strait of Hormuz - where ~ 20% of global supply transits daily - raises the spectre of military confrontation between the U.S. and Iran, and their respective allies. The growing risks from tighter supply - markets could lose as much as 2mm b/d of Iranian and Venezuelan exports as things stand now - now must be augmented by the likelihood of a Gulf conflict. Energy: Overweight. We remain long call spreads along the Brent forward curve and the S&P GSCI, as we expect volatility, prices and backwardation to move higher. These recommendations are up 34.6% since they were recommended five months ago. Base Metals: Neutral. Treatment and refining charges are higher following smelter closings. Metal Bulletin's TC/RC index was ~ $80/MT at end-June, up ~ $3 vs end-May. Precious Metals: Neutral. Gold traded below $1,240/oz over the past week, but recovered above $1,250/oz as geopolitical tensions rise. Ags/Softs: Underweight. The USDA expects U.S. farm exports in 2018 will come in at $142.5 billion, the second-highest level on record, according to agriculture.com. Feature Oil pricing could become chaotic, as U.S. policy measures aimed at Iran are countered by responses that are not altogether unexpected. In addition to limited spare capacity, and increased unplanned production outages, markets now must discount the likelihood of renewed armed conflict (short of all-out war) in the Gulf between the U.S. and Iran, and their respective allies. To appreciate the significance of President Rouhani's not-so-veiled threat to deny safe passage through the Strait of Hormuz to oil tankers carrying Gulf Arab states' exports, one need only consider that some 20% of the world's oil supply flows through this narrow passage on any given day.2 The response of the president of Iran to U.S. policy - nominally directed at denying Iran the capacity to develop nuclear weapons, but arguably meant to force the existing regime from power - is a predictable next step in the brinkmanship now being played out between these long-standing rivals.3 Following the lifting of nuclear-related sanctions in 2015, Iran's production rose ~ 1mm b/d from 2.8mm b/d to 3.8mm b/d. We expect 500k b/d of Iran's exports will be lost to the market by the end of 1H19, as a result of sanctions being re-imposed November 4. Other estimates run as high as 1mm b/d being lost if the U.S. succeeds in getting importers to drastically reduce purchases. The ire of the U.S. also is directed at Venezuela, where the loss of that country's ~ 1mm b/d of exports would become all but certain, if, as U.S. Secretary of State Mike Pompeo pressed for last month, U.S. trade sanctions against the failing state are imposed.4 We estimate Venezuela's production is down close to 1mm b/d since end-2016, and will average ~ 1.07mm b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf BCA's Ensemble Forecast Includes Extreme Events In our updated balances modeling, our base case front-loaded the OPEC 2.0 production increase announced by the coalition at its end-June meeting in Vienna. Core OPEC 2.0's 1.1mm b/d increase (1H19 vs 1H18) is offset by losses in the rest of OPEC 2.0 amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. We assume Iran's exports fall 200k b/d by the end of this year, and another 300k b/d by the end of 1H19, resulting in a total loss of 500k b/d by 2H19. Global supply rises ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively, in our estimates. The bulk of this growth is provided by U.S. shale-oil output, which we estimate will rise by 1.28mm b/d this year, and 1.33mm b/d next year. On the demand side, we expect global growth to remain strong, powered as always by stout EM consumption. That said, rising trade frictions, signs the synchronized global growth that powered EM oil demand could move out of synch, and divergent monetary policies at systematically important central banks could take some of the wind out of our consumption-forecast sails (Chart of the Week). That said, if a supply-side event results in a sharp upward price move, we would expect demand growth to adjust lower in fairly short order. This is because many EM states removed or reduced oil-price subsidies in the wake of the prices collapse following OPEC's declaration of a market-share war in late 2014, which leaves consumers in these state more directly exposed to higher prices than in previous cycles. Our base case is augmented with three scenarios. In our simulations, the Venezuela collapse is met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. Our scenarios are: A reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks (Scenario 2, Chart 2); Venezuela production collapses to 250k b/d from current levels of ~ 1.07mm b/d, which allows it to support domestic refined product demand and nothing more (Scenario 3, Chart 2); Both of these occurring simultaneously in the Oct/18 - Sep/19 interval (Scenario 4, Chart 2). Chart of the WeekTight Supply, Strong Demand##BR##Remain Supportive of Prices Tight Supply, Strong Demand Remain Supportive of Prices Tight Supply, Strong Demand Remain Supportive of Prices Chart 2BCA's Scenarios Include##BR##Production Losses In Venezuela, Iran BCA's Scenarios Include Production Losses in Venezuela, Iran BCA's Scenarios Include Production Losses in Venezuela, Iran The Stark Reality Of Low Spare Capacity Chart 3Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Our scenario analyses - particularly Scenarios 3 and 4 - illustrate the stark reality confronting oil markets: Spare capacity will not be sufficient to keep prices below $80/bbl in the event Venezuela collapses, or if Iranian export losses are greater than the 500k b/d we currently are modeling. The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year. This will fall to just over 1mm b/d next year (Chart 3).5 As things stand now, idle and spare capacity of KSA, Russia and core OPEC 2.0 states that actually can increase production would be taxed to the extreme to cover losses of Iranian exports, if some of the higher levels projected by analysts - i.e., up to 1mm b/d - are realized (Chart 4). KSA's maximum sustainable capacity is believed to be ~ 12mm b/d; officials have indicated production will be raised to close to 11mm b/d in July, then likely held there. This record level of production will test KSA's production infrastructure, and would leave the Kingdom with 1mm b/d of spare capacity. Russia is believed to have ~ 400k b/d of spare capacity; it likely will restore ~ 200k b/d of production to the market over the near future, leaving 200k b/d as spare capacity. If just the two high-loss events described above are realized - i.e., Iran export losses come in at 1mm b/d instead of the 500k b/d we expect, and Venezuela's 1mm b/d of exports are lost because the state collapses - global inventory draws will accelerate until enough demand is destroyed via higher prices to clear the market at whatever level of supply can be maintained (Chart 5). Approaching that point, we would expect OECD strategic petroleum reserves (SPRs) to be released.6 Chart 4OPEC 2.0's Core Producers Would Be##BR##Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5A Supply Shock Would Draw##BR##Crude Inventories Sharply A Supply Shock Would Draw Crude Inventories Sharply A Supply Shock Would Draw Crude Inventories Sharply Chart 6Falling Net Imports Implies##BR##Current SPR Could Be Too Large Falling Net Imports Implies Current SPR Could Be Too Large Falling Net Imports Implies Current SPR Could Be Too Large It is difficult to forecast the price at which markets would clear if we get to the state described above. However, it is worthwhile noting that OPEC spare capacity in 2008 stood at 1.4mm b/d, or 2.4% of global consumption. The 1.8mm b/d of OPEC spare capacity EIA estimates is now available to the market represents 1.8% of daily consumption globally. By next year, the EIA's estimated 1mm b/d of OPEC spare capacity will represent a little over 1% of global daily consumption. It was in this economic setting that WTI and Brent breached $150/bbl in mid-2008, just before the Global Financial Crisis tanked the world economy.7 Bottom Line: Into the mix of tightening global supply and limited spare capacity, oil markets now confront higher odds of armed conflict in the Gulf once again. Oil pricing will remain volatile, and could become chaotic as brinkmanship raises the level of uncertainty in markets. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Rouhani says U.S. pressure to stop Iranian oil may affect regional exports," published by uk.reuters.com July 3, 2018. We explore the Trump administration's maximum pressure in a Commodity & Energy Strategy Special Report published June 7, 2018, entitled "Iraq is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. We are using the term chaotic in the sense of "... sensitive dependence on initial conditions or 'the butterfly effect'" described in "Weak Emergence" by Mark A. Bedau (1997), which appears in Philosophical Perspectives: Mind, Causation, And World, Vol. 11, J. Tomberlin, ed., Blackwell, Malden MA. 2 The U.S. EIA calls the Strait of Hormuz "the world's most important oil chokepoint" in its "World Oil Transit Chokepoints," published by the U.S. EIA July 25, 2017. By the EIA's estimates, 80% of the crude oil transiting the strait is bound for Asian markets, with China, Japan, India, South Korea and Singapore being the largest markets. 3 Please see "Mattis's Last Stand Is Iran," published by Foreign Policy June 28, 2018, on foreignpolicy.com. The essay describes the state of play within the Trump administration vis-à-vis Iran. President Trump's third national security advisor, John Bolton, has stated the goal of the administration's policy is not regime change, but denial of the capacity to develop nuclear weapons. However, Bolton repeatedly called for regime change in Iran prior to being tapped as the national security advisor, and has advocated going to war with Iran to prevent it from developing a nuclear weapons capability, in a New York Times op-ed published March 26, 2015, entitled "To Stop Iran's Bomb, Bomb Iran." 4 Please see "Pompeo calls on OAS to oust Venezuela," published by CNN Politics June 4, 2018. 5 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. On June 22, 2018, the coalition agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. The other core members of OPEC 2.0 are believed to have close to 300k b/d of spare capacity. Other estimates put the spare capacity as high as 3.4mm b/d. The ex-KSA estimates are pieced together by using the International Energy Agency's estimates for core OPEC and Citicorp's estimates for Russia. Please see "Russia's OPEC Deal Dilemma Worsens as Idled Crude Capacity Grows," published by bloomberg.com May 16, 2018. 6 In just-completed research, our colleague Matt Conlan writes the U.S. SPR, at ~ 660mm barrels, can cover more than 100 days of net U.S. crude imports (Chart 6). This coverage will rise to 140 days of net crude imports by the end of 2019. Please see "American Energy Independence And SPR Ramifications," published by BCA Research's Energy Sector Strategy July 4, 2018. 7 Please see the discussion of demand beginning on p. 228 of Hamilton, James D. (2009), "Causes And Consequences Of The Oil Shock Of 2007 - 08," published by the Brookings Institute. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Trades Closed in 2018 Summary of Trades Closed in 2017 Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf

Highlights May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Capex Indicators Still Solid... Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases Running Out Of Room Running Out Of Room The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Housing Fundamentals Are Stout Housing Fundamentals Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets Running Out Of Room Running Out Of Room On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets S&P Defensives In Sideways Equity Markets S&P Defensives In Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.

Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Global Growth Is Slowing Again Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 7U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 20China: Credit Tightening China: Credit Tightening China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win China: Currency Wars Are Good And Easy To Win China: Currency Wars Are Good And Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 23Trade In Intermediate Goods Dominates Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O Uh Oh Spaghetti-O Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 27Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Chart 32The Dollar Trades On Momentum The Dollar Trades On Momentum The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap Chart 37When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Appendix B Chart 1Market Outlook: Bonds Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 2Market Outlook: Equities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 3Market Outlook: Currencies Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 4Market Outlook: Commodities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades