Oil

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Specs Have Loaded the Boat Getting Long Brent and WTI Exposure Specs Have Loaded the Boat Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Key Variables Explaining Volatility Key Variables Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Spec Positioning Dominates Evolution of WTI Implied Volatility Spec Positioning Dominates Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement BCA's Oil Price Forecast Unchanged, Following Trump's Iran Announcement BCA's Oil Price Forecast Unchanged, Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility Trades Closed in 2018 Summary of Trades Closed in 2017 Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Inside The Beltway Inside The Beltway Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Inside The Beltway Inside The Beltway Chart 3GOP Retirements Are Unprecedented Inside The Beltway Inside The Beltway Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Inside The Beltway Inside The Beltway Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Inside The Beltway Inside The Beltway Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Inside The Beltway Inside The Beltway Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Inside The Beltway Inside The Beltway Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Inside The Beltway Inside The Beltway Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Looking Beyond The Next Few Months The next couple of months could remain tricky for equity markets. But, with economic growth set to remain above trend for another year or so and central banks cautious about the pace of monetary tightening, we continue to expect risk assets to outperform over the 12-month horizon. To begin, our short-term concerns. Global growth has clearly slowed in recent months, with Q1 U.S. GDP growth coming in at 2.3%, well below the 2.9% in Q4; global PMIs have also come down from their recent peaks, led by the euro zone and Japan (Chart 1). Inflation has begun to spook investors, with a sharp pick-up in core U.S. inflation, including a rise to 1.9% YoY in the core PCE inflation measure that the Fed watches most closely (Chart 2). Geopolitics will dominate the headlines over the next six weeks, with the waiver on Iran sanctions expiring on May 12, the end of the 60-day consultation for U.S. tariffs on China on May 21, the possible imposition of tariffs on $50 billion of Chinese goods starting on June 4, and likely developments with North Korea and NAFTA. Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1Global Growth Has Slowed Global Growth Has Slowed Global Growth Has Slowed Chart 2...And Inflation Picked Up ...And Inflation Picked Up ...And Inflation Picked Up Investors inclined to make short-term tactical shifts might, therefore, want to reduce risk over the next one to three months. For most clients of the Global Asset Allocation service with a longer perspective, however, we continue to recommend an overweight on equities and other risk assets. In the U.S., in particular, fiscal stimulus will, according to IMF estimates, boost GDP growth by 0.8 percentage points this year and 0.9 percentage points next (Chart 3). U.S. corporate earnings should grow by almost 20% this year and around 12% next and, while this is already in analysts' forecasts, it is hard to imagine equity markets struggling against such a strong backdrop. Not one of the recession/bear market warning signals we are watching (inverted yield curve, rising credit spreads, Fed policy in restrictive territory, significant decline in PMIs, peak in cyclical spending) is yet flashing. Neither do we see any signs that higher interest rates or expensive energy prices are slowing growth. Lead indicators of capex have come off a little, but still point to robust growth (Chart 4). The housing market tends to be the most vulnerable to rising rates and the average rate on a 30-year U.S. fixed mortgage has risen to 4.5% (from 3.7% at the start of the year and a low of 3.3% in late 2016). But housing data still look strong, with a continued rise in house prices and mortgage applications steady (Chart 5). Perhaps the sector most vulnerable to rising U.S. rates in this cycle is emerging markets, where borrowers have grown foreign-currency debt to $3.2 trillion, according to the BIS - one reason for our longstanding caution on EM assets (Chart 6). With crude oil rising to $75 a barrel, U.S. retail gasoline prices now average $2.80 a gallon, up from below $2 in 2016, and transportation companies are complaining of rising costs. But, historically, oil prices have needed to rise by 100% YoY before they triggered recession (Chart 7). Chart 3U.S. Stimulus Will Boost The Economy Monthly Portfolio Update Monthly Portfolio Update Chart 4Capex Remains Robust Capex Remains Robust Capex Remains Robust Chart 5No Signs Of Higher Rates Hurting Housing No Signs Of Higher Rates Hurting Housing No Signs Of Higher Rates Hurting Housing Chart 6Could EM Be Most Affected By Higher Rates? Monthly Portfolio Update Monthly Portfolio Update Chart 7Oil Hasn't Risen Enough To Cause Recession Oil Hasn't Risen Enough To Cause Recession Oil Hasn't Risen Enough To Cause Recession Eventually, however, strong growth, especially in the U.S., will become a headwind for risk assets. There is still some slack in the labor market, with another 500,000 people likely to return to work eventually (Chart 8). When that happens, perhaps early next year, the currently sluggish wage growth will begin to accelerate. Fiscal stimulus is likely to prove inflationary, since it is unprecedented for a government to stimulate the economy so aggressively when it is already close to full capacity (Chart 9). These factors will push inflation expectations back to their equilibrium level, and the market will then need to adjust to the Fed accelerating the pace of rate hikes to choke off inflation, which will push up real bond yields (Chart 10). Chart 8Still 500,000 Who Could Return To Work Still 500,000 Who Could Return To Work Still 500,000 Who Could Return To Work Chart 9Stimulus Unprecedented In Such A Strong Economy Stimulus Unprecedented In Such A Strong Economy Stimulus Unprecedented In Such A Strong Economy Chart 10Eventually Real Rates Will Need To Rise Eventually Real Rates Will Need To Rise Eventually Real Rates Will Need To Rise When that starts to happen - perhaps late this year or early next year - the yield curve will invert, and investors will start to price in the next recession. That will be the time to turn defensive, but it is still too early now. Fixed Income: Markets are currently pricing only a 50% probability of three more Fed hikes this year, and only two hikes next year. As markets start to anticipate further tightening, long rates are also likely to rise (Chart 11). We see 10-year U.S. Treasury yields at 3.3-3.5% by year-end, and so recommend an overweight in TIPs and a short duration position. The ECB is unlikely to need to rush rate hikes, however, given the slack in the euro zone (Chart 12), and so the spread between U.S. and core euro yields should widen further. Corporate credit spreads are unlikely to contract further but, as long as growth continues, we see U.S. high-yield bonds, in particular, providing attractive returns within the fixed-income bucket. Our bond strategists find that between the 2/10 yield curve crossing below 50 BP and its inverting, high-yield debt has since 1980 given an annualized 368 BP of excess return.1 Chart 11Fed Expectations Drive Long Rates Fed Expectations Drive Long Rates Fed Expectations Drive Long Rates Chart 12Still Plenty Of Slack In The Euro Zone Still Plenty Of Slack In The Euro Zone Still Plenty Of Slack In The Euro Zone Equities: Our preference remains for developed equities over emerging, and for more cyclical, higher-beta markets such as euro zone and Japan. The risk of a stronger yen over the coming months is a concern for Japanese equities in local currency terms but, as our recommendations are expressed in U.S. dollars, the currency effect cancels out, and so we keep our overweight for now. At this stage of the cycle our preference is for value stocks (especially financials) over growth stocks (especially IT): value/growth usually performs in line with cyclicals/defensives, but the relationship has moved out of sync in the past year or so (Chart 13), mostly because of the performance of internet stocks, whose premium valuation makes them very vulnerable to any bad news. Currencies: A widening of interest-rate differentials between the U.S. and euro zone is likely to push down the euro against the U.S. dollar over the next few months, especially given how crowded the long-euro trade has become. The vulnerability of EM currencies to rising U.S. rates has been seen in the past few weeks, with sharp falls in currencies such as the Turkish lira, Brazilian real, and Russian ruble. We expect this to continue. Overall, we expect a moderate appreciation of the trade-weighted U.S. dollar over the next 12 months. Commodities: The crude oil price continues to rise in line with our forecasts, and we expect to see Brent crude above $80 a barrel before the end of the year. The price next year will depend on whether the OPEC agreement is extended, and how much U.S. shale oil production reacts to the higher price. On the assumption of a moderate increase in supply from both OPEC and the U.S., the crude price is likely to fall back moderately in 2019. We see the long-term equilibrium crude price in the $55-65 range, the level where global supply can be increased enough to satisfy around 1.5% annual growth in demand. We remain more cautious on industrial commodities, and see the first signs coming through of a slowdown in China, which will dent demand (Chart 14). Chart 13Value Stocks Look Attractive Value Stocks Look Attractive Value Stocks Look Attractive Chart 14Signs Of China Slowing bca.gaa_mu_2018_05_01_c14 bca.gaa_mu_2018_05_01_c14 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt," dated 24 April, 2018, available at usbs.bcaresearch.com GAA Asset Allocation

Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment An Economy At Full Employment An Economy At Full Employment Chart 3The 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 Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher ...Which Could Take Bond Yields Higher ...Which Could Take Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Capital Spending Still Quite Robust Capital Spending Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine The Housing Sector Is Doing Fine The Housing Sector Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Dollar Could Bounce The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed U.S. Oil Imports Have Collapsed U.S. Oil Imports Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Long-Term Investors, Take Note Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 17Only The Best Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Chart of the WeekCrude Oil Prices Align With##BR##Supply-Demand Fundamentals Crude Oil Prices Align With Supply-Demand Fundamentals Crude Oil Prices Align With Supply-Demand Fundamentals Hedge funds are backing up the truck to get long oil in their portfolios, putting on record or near-record positions in everything from crude oil to gasoline, as global markets tighten and OPEC 2.0 leaders hint they are comfortable with prices that are higher for longer.1 When speculators significantly increase their positions in the market - on the long or the short side - market participants, policymakers and the general public typically begin to wonder whether prices are being artificially distorted by this activity. Our research into the effects of speculation in oil markets is not raising alarm bells at present. If anything, our fundamental models indicate prices are clearing the market in line with supply, demand and inventories (Chart of the Week). We remain overweight oil, and would use sell-offs to add to existing length, including energy-heavy commodity index exposure. Energy: Overweight. Oil markets remain on edge ahead of the May 12 deadline for U.S. President Trump to extend waivers on Iranian export sanctions. If waivers are extended, markets could sell off. Base Metals: Neutral. Aluminum prices fell ~ 10% earlier in the week on news the U.S. would extend the period during which American customers of Rusal had to comply with sanctions against Oleg Deripaska, the company's principal shareholder. U.S. officials also suggested they would lift the sanctions if Deripaska relinquished control over Rusal. Precious Metals: Neutral. Our tactical long position in spot silver established a week ago is down 3.1%, along with gold. A stronger USD weighed on both markets. Ags/Softs: Underweight. Chinese importers of U.S. sorghum petitioned their government to waive the 179% deposit required by Chinese customs for cargoes on the water, according to Reuters.2 The news service also reported soybean trade between the U.S. and China has ground to a halt. Feature Hedge funds are taking their oil exposure to record or near-record highs in crude oil and refined products markets. A tally of positioning by Reuters to the week ended April 20, 2018, shows specs took net oil and products positions to 1.41 billion barrels across CME Group's crude and products futures markets and those of the Intercontinental Exchange (ICE) (Chart 2).3 The reasons cited for the marked increase in speculative positioning in the oil markets have featured in our research since OPEC 2.0's formation in November 2016. These include: Restraint and erosion on the supply side. Production discipline by OPEC and non-OPEC producers has limited supply growth (Chart 3): We estimate crude oil production this year at 99.70mm b/d vs. our March estimate of 100.20mm b/d. Accelerated deterioration of Venezuelan supply has helped constrain global production growth; Chart 2Spec Open Interest Surges Spec Open Interest Surges Spec Open Interest Surges Chart 3OPEC 2.0 Discipline Restrains Supply OPEC 2.0 Discipline Restrains Supply OPEC 2.0 Discipline Restrains Supply Continued expansion of global demand (Chart 4). In our modeling, consumption growth for this year will be 1.70mm b/d, bringing demand to 100.30mm b/d in 2018. We expect growth for next year of 1.70mm b/d, which will take consumption to 102.00mm b/d; Together, these major fundamental drivers have combined to drain OECD commercial inventories by 395mm barrels from their peak of 3.1 billion barrels in July, 2016 (Chart 5). Chart 4Global Growth Supports Demand Global Growth Supports Demand Global Growth Supports Demand Chart 5OECD Inventories Will Continue Drawing OECD Inventories Will Continue Drawing OECD Inventories Will Continue Drawing As we noted last week, our price forecasts for Brent and WTI crude oil are unchanged at $74 and $70/bbl this year, and $67 and $64/bbl, respectively, next year. We expect OPEC 2.0 to provide forward guidance on its production for 2019, after member states agree on an organizational structure that institutionalizes it as a permanent production-management coalition. As we cautioned last week, this likely will cause us to revise our price forecast for 2019 upward.4 Measuring Speculative Influence In Oil Markets Oil speculators occupy a unique place in the academic literature, and the public's imagination. In the literature, academics largely see them either as bit players in the evolution of oil prices, or as traders who, by their activity, push price to levels far beyond anything justified by the fundamentals, particularly when commodity prices are rising.5 When that commodity is crude oil, and its chief refined product, gasoline - commodities with highly visible prices consumers can track continuously - everyone has an opinion. Not unsurprisingly, the media and politicians join this chorus of recrimination in rising markets, and vilify speculators as well.6 This is hardly surprising. Speculative influence over commodity prices - and the motives of speculators - has been debated for centuries.7 Chart 6Speculative Intensity (Working's T) Vs. Price Speculative Intensity (Working's T) Vs. Price Speculative Intensity (Working's T) Vs. Price In the modern era, Holbrook Working, the great Stanford ag economist, developed a speculative intensity index in 1960 to measure the effect of commodity market speculation.8 Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market.9 Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking."10 We plotted Working's T for Brent and WTI futures, and find speculative positioning has ranged between 1.10 and 1.60 (Chart 6). Speculative intensity was trending upward from 2000 - 2014, and then trended lower. Since January 2018, it has averaged 1.4. We would note this latter period encompasses the OPEC market-share war launched in November 2014, and the formation of OPEC 2.0 in November 2016. This was an especially difficult market for hedge funds and speculators generally, particularly last year, when many funds were forced to shutter their operations. Over the past three years, markets have had to adjust to a production free-for-all arising from OPEC's market-share war, which was followed by a supply shock induced by OPEC 2.0, when it agreed to remove 1.80mm b/d of oil production from the market.11 Given this backdrop, it is not surprising to see speculative intensity in oil markets falling, as our chart indicates. Specs And Prices Our research shows the evolution of oil prices is dominated by fundamentals - supply, demand, inventory and broad trade-weighted USD being the dominant fundamentals - and not by spec positioning.12 In forthcoming research, we will dig deeper into this, and also look at the evolution of price volatility in the oil markets. Our analysis using Working's T indicates speculators provide sufficient liquidity to hedgers in the Brent and WTI futures markets, suggesting they are fulfilling the role posited by the IEA in its 2012 medium-term analysis: "Speculators should not be viewed as adversarial agents. Rather, they are essential participants for the proper functioning of commodity derivatives markets by providing the necessary liquidity, thereby reducing market volatility."13 Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia, which pledged to remove 1.80mm b/d of production from the market. 2 Please see "China's sorghum importers ask government to drop tariff for cargoes en route," published by uk.reuters.com April 24, 2018, and "After sorghum spat, U.S. - China trade fears halt soybean imports," published April 25, 2018. 3 Please see "Commentary: Hedge fund oil bulls on the rampage as bears vanish," published by uk.reuters.com on April 23, 2018. 4 For our most recent assessment of supply-demand fundamentals, please see "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published by BCA Research's Commodity & Energy Strategy April 19, 2018. It is available at ces.bcaresearch.com. 5 Bookending this research are Hamilton, James D. (2009), "Causes and Consequences of the Oil Shock of 2007 - 08," published by the Brookings Institution re fundamentals dominating the evolution of oil prices, and, at the other end, Singleton, Kenneth (2011), "Investor Flows and the 2008 Boom/Bust in Oil Prices," available at SSRN. 6 Please see the International Energy Agency's "Oil: Medium-Term Market Report 2012," for a discussion on speculation beginning on p. 21. 7 See, for example, the discussion of how Thales of Miletus in modern-day Turkey monopolized the olive-press market, and how another unnamed individual in Sicily cornered the iron market, in the Politics of Aristotle, a Greek philosopher of the 4th century BCE (at 1259a in Politics). 8 Working was a pioneer in the analysis of prices and agricultural trading markets. Please see Working, Holbrook (1960), "Speculation on Hedging Markets," Stanford University Food Research Institute Studies 1: 185-220. 9 We use the specification of Working's T found in Adjemian, M. K., V. G. Bruno, M. A. Robe, and J. Wallen. "What Drives Volatility Expectations in Grain Markets?" Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management (pp. 18, 19). Working's T is calculated as Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil with SS = Speculative Short Open Interest, SL = Speculative Long Open Interest, HL = Hedge Long Open Interest, and HS = Hedge Short Open Interest. The U.S. Commodity Futures Trading Commission (CFTC) notes, "Working's T-index is silent on the direction of speculation (long versus short). Instead, the amount of speculation is gauged relative to what is needed to balance hedging positions. Because it is directionless Working's T-index is only tested as a causal variable for market volatility." Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 10 Please see Irwin and Sanders (2010), p. 5. 11 We discuss the extremely difficult trading environment confronted by hedge funds and others over the past two years in our Special Report titled "Key Themes For Energy Markets in 2018," which was published by BCA Research's Commodity & Energy Strategy December 7, 2017. It is available at ces.bcaresearch.com. 12 Granger-causality tests on Brent and WTI prices between 2010 and now - the post-GFC era - show the level of prices leads spec position levels in these markets. 13 Please see (p. 22) of the IEA's 2012 Medium-term Market Report cited above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil Trades Closed in 2018 Summary of Trades Closed in 2017 Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil

Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand EM Import Volumes Continue Expanding, Reflecting Rising Incomes And Oil Demand EM Import Volumes Continue Expanding, Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Oil Markets Will Tighten Further Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Lower OPEC Production Offset By U.S. Shales Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Oil Demand Remains Stout Oil Demand Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Bullish Fundamentals Drain Inventories Bullish Fundamentals Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Price Forecast Unchanged, But Upside Risks Are Rising Price Forecast Unchanged, But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Growing Pains In The Permian: Takeaway Capacity Constraints Growing Pains In The Permian: Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Permian Crude Oil Production Exceeded Takeaway In The Past Permian Crude Oil Production Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely Trades Closed in 2018 Summary of Trades Closed in 2017 Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely

Highlights Solid fundamentals will keep the backwardation in the forward curves of the benchmark crude-oil streams - WTI and Brent - intact. If our long-held thesis is correct and OPEC 2.0 becomes a durable producer coalition, we believe it will maintain some level of production cuts in 2019.1 This will, in part, keep OECD commercial oil inventories close to their 2010 - 2014 levels, thus keeping oil forward curves backwardated beyond this year. Backwardation serves OPEC 2.0's interests by limiting the rate at which shale-oil production grows.2 It also drives returns from long-only commodity-index exposure, particularly the energy-heavy index exposure we favor, by maintaining an attractive roll yield for investors.3 We expect the S&P GSCI to return 10 - 20% this year. Energy: Overweight. Our recently concluded research shows commodity index exposure hedges portfolios against inflation risk. We remain long index exposure. Base Metals: Neutral. COMEX copper traded back through $3.00/lb on the back of strong official Chinese PMI data, indicating manufacturing activity continues to expand. It has since fallen back to ~ $3.00/lb, as U.S. - Sino trade-war fears grew. Precious Metals: Neutral. Gold remains range-bound, between $1,310 and $1,360/oz. Ags/Softs: Underweight. In a tit-for-tat fashion, Beijing announced on Wednesday that it would retaliate to the U.S. tariffs on $50 billion worth of Chinese imports. U.S. soybeans and beef are among the list of 106 items China plans to impose a 25% tariff on. Feature An unlikely commonality of interests unites the fates of OPEC 2.0 and long-only commodity index investors: The desire to see the crude-oil forward curves backwardated. Turns out, both interests benefit from the same configuration of the forward curves, in which prompt prices trade premium to deferred prices. Backwardation achieves a critical goal of OPEC 2.0 by making the prices most member states in the coalition receive on their crude oil sales - i.e., the spot price indexed in their term contracts - the highest point along the forward curve. A backwardated curve means the average price U.S. shale-oil producers realize over their hedging horizon - typically two years forward - is, perforce, lower than the spot price. We have shown rig counts are highly sensitive to the level and the shape of the WTI forward curve. A backwardated curve reduces the revenue that can be locked in by hedging. This reduces the number of rigs shale producers send to the field, which restrains - but does not quash - the rate at which they can grow their production (Chart of the Week). For commodity index investors - particularly those with exposure to the energy-heavy S&P GSCI index, where ~ 60% of the index is crude oil, refined products or natural gas - backwardation drives roll-yields, which are a critical component of the index's total returns. The steeper the backwardation, the higher the roll yield.4 Our balances modeling indicates oil markets will remain tight this year, given strong global growth in demand in excess of production growth, which will keep the market in a physical deficit (Chart 2). This will cause inventories to continue to draw this year (Chart 3), which will keep the crude-oil backwardation in place. This backwardation is one of the principal drivers of returns in the S&P GSCI. Chart of the WeekBackwardation Constrains##BR##Shale's Rate Of Growth Backwardation Constrains Shale's Rate Of Growth Backwardation Constrains Shale's Rate Of Growth Chart 2Balances Model Indicates##BR##Physical Deficit Persists This Year Balances Model Indicates Physical Deficit Persists This Year Balances Model Indicates Physical Deficit Persists This Year Chart 3Tighter Inventories Keep##BR##Backwardation In Place Tighter Inventories Keep Backwardation In Place Tighter Inventories Keep Backwardation In Place As for the other components of the S&P GSCI, we are neutral base and precious metals, expecting them to remain relatively well-balanced this year, and underweight ag markets, even though they appear to have bottomed, as the USDA indicated recently. As a result, we expect an energy-heavy commodity index exposure like the S&P GSCI will continue to perform for investors, driven largely by the stronger oil prices we expect this year, and the roll yields from backwardated energy futures. Any price upside from the other commodities will be a marginal contribution to returns, as energy price appreciation plus roll yields will be the primary driver of the long-index exposure. Can Crude Oil Backwardation Persist? Beyond 2018, reasonable doubts exist as to whether OPEC 2.0 can remain a durable coalition. These doubts arise from apparent differences in the long-term goals of OPEC 2.0's putative leaders, KSA and Russia. We believe that, over the short term (two years or so) KSA favors higher prices, and that the Kingdom's preferred range for Brent is $60 to $70/bbl, at least until the Saudi Aramco IPO is fully absorbed and trading in the market. Russia's apparent preference is for lower prices ($50 to $60/bbl), which will disincentivize U.S. shale producers from adding even more volume to the market and threaten its market share. How these goals are resolved within OPEC 2.0 as it negotiates its post-2018 structure will determine whether oil forward curves remain backwardated - the likely outcome if production cuts are extended into 2019 - or if OECD inventories start to rebuild and the backwardation returns to contango (i.e., deferred prices exceed prompt prices). This would happen if Russia and its allies decide they are uncomfortable with prices staying close to or above $70/bbl for too long, and therefore lift production and exports to bring them down. OPEC 2.0 Has Reconciled KSA's And Russia's Goals We believe OPEC 2.0 has reconciled KSA's desire for higher prices over the short term to allow a smooth IPO of Aramco. Both KSA and Russia share a longer-term goal of not overly incentivizing U.S. shale production, and production by others - e.g., Norway's Statoil - which also have significantly reduced their costs in order to remain competitive.5 If OPEC 2.0 is successful in achieving higher prices over the short term, it will have to offset them with lower prices further out the forward curve to reconcile KSA's and Russia's goals. This is the principal reason we believe backwardating the forward curve, and keeping it backwardated, achieves OPEC 2.0's short- and longer-term goals. After Aramco is IPO'd - something that, from time to time, seems doubtful - and the market's trading the stock, we believe KSA and Russia will want average prices to drift lower. KSA will, by that time, have lowered its fiscal break-even cost/barrel to $60 (they're at or below $70 now) and will be executing on its diversification strategy. But even with spot prices lower - we're assuming the target level would be ~ $60/bbl - the forward curve will have to remain backwardated to keep U.S. shale's growth somewhat contained. This can be done by keeping deferred contracts (2+ years out) close to $50/bbl using OPEC 2.0 production flexibility, global inventory holdings and forward guidance re production, export and inventory policies. By keeping the average price realization over the shale producers' hedging horizon in the low- to mid-$50s, OPEC 2.0 restrains rig deployment in the U.S. shales. Keeping the front of the forward curve closer to (or above) $60/bbl, means OPEC 2.0 member states get the high price on the forward curve, since their term contracts are indexed to spot prices. Once a persistent backwardation becomes a reliable feature of the forward curve, the short-term inelasticities of the global supply and demand curves - but mostly the supply curve - mean small changes by a production manager like OPEC 2.0 can readily change the price landscape and alter expectations along the forward curve covering the shale-oil producers' hedge horizon. OPEC 2.0 states already have lived through the alternative of not managing production to the best of their abilities during the 2014 - 2016 price collapse: A production free-for-all similar to what the market experienced then would again lead to massive unintended inventory accumulations globally. This would put the Brent and WTI forward curves into super-contangos, which occurred at the end of 2015 into early 2016. At that point, the market would, once again, begin pricing sub-$20/bbl oil as a global full-storage event becomes more probable. At that point, it's "game over" for OPEC 2.0 member states. The stakes remain sufficiently high for OPEC 2.0 member states to keep the coalition intact and to maintain production cuts to keep OECD inventories tight, and thus keep markets backwardated beyond 2018. Backwardation Works For Commodity Index Investors, Too We expect the S&P GSCI to continue to perform well this year - posting gains of 10 to 20% - given our expectation OPEC 2.0 will remain committed to maintaining production discipline. We've recently shown there is a close relationship between oil forward curves and oil inventories, expressed as the deviation of Days-Forward-Cover (DFC) from its 2- or 3-year average, and y/y percentage change (Chart 4).6 This analysis supports our view that - based on our expectation of a continuation of OECD commercial inventory decline - backwardation will continue throughout 2018 and early-2019. This tight relationship, allows us to include OECD commercial inventories as a proxy among our explanatory variables for the shape of the oil forward curves, when modeling and forecasting the GSCI total return. For 2018, we are modeling a continuation of the production cuts put in place at the beginning of 2017 to year end. At some point later this year, we expect the market to get forward guidance on what to expect in the way of OPEC 2.0 production levels for next year. In lieu of actual guidance, we've modelled three different scenarios for OPEC 2.0's production levels next year, leaving everything else affecting prices unchanged. This is a sensitivity analysis on OPEC 2.0's production only (Chart 5).7 Chart 4Oil Inventories, Spreads,##BR##DFC, Closely Related Oil Inventories, Spreads, DFC, Closely Related Oil Inventories, Spreads, DFC, Closely Related Chart 5BCA's 2019 Scenario Analysis##BR##For OPEC 2.0 Production BCA's 2019 Scenario Analysis For OPEC 2.0 Production BCA's 2019 Scenario Analysis For OPEC 2.0 Production Scenario 1: Our actual balances, most recently updated in our March 22, 2018, publication, with no production cuts in 2019; Scenario 2: An extension of the OPEC 2.0 production cuts to end-2019 at 100% of 2018 levels; Scenario 3: An extension of the OPEC 2.0 production cuts to end-2019 at 50% of 2018 levels. Under scenario 1, the GSCI's y/y returns slow in 2H18 and become negative in 3Q19. Returns peak in Feb/19 at 28%, and average 21% in 2018, and 9% in 2019. In scenario 2, y/y growth remains positive this year and next, peaking in Feb/19 at 30%, then falling to 13% in 2019. Average returns in 2018 are 21%, and in 2019 19%. In scenario 3, y/y growth remains positive in both years, and bottoms close to 0% but never turns negative. GSCI returns peak in Feb/19 at 29%, then fall to 3% in 2019. Average returns in 2018 are 21%, and in 2019 14%. Given the guidance already conveyed by KSA's oil minister Al-Falih, we would put a low weight on scenario 1, and attach a 50% probability to each of the 2019 simulations in scenarios 2 and 3. GSCI As An Inflation Hedge Our analysis shows the GSCI Total Return (TR) also is highly sensitive to the USD broad trade-weighted dollar (TWIB) and U.S. headline CPI inflation (Chart 6).8 This has powerful implications for the evolution of commodity-indices going forward. A decrease (increase) in the USD TWIB increases (decreases) USD-denominated commodity demand from buyers ex-U.S., thus raising prices, all else equal. An increase (decrease) in the U.S. CPI can lead to higher commodity costs, which are reflected in the GSCI, or to a positive (negative) net-inflow of cash into commodity-indices as a hedge against inflation risks. Importantly, we found the GSCI TR and U.S. CPI relationship to be bi-directional, enhancing the magnitude of the impact of a change in any of those variables. In other words, a rise in the GSCI TR causes inflation to rise which leads to a rise in the GSCI TR, and vice-versa until a new equilibrium is reached.9 Our colleagues at BCA's Global Fixed Income Strategy desk expect inflation pressures will continue to build this year. In particular, they note, "the global cyclical backdrop is boosting inflation."10 With 75% of OECD countries operating beyond full employment, capacity-utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 7, top panel). This closing of the global output gap likely will stoke inflation. Chart 6GSCI Highly Sensitive To USD, U.S. CPI GSCI Highly Sensitive To USD, U.S. CPI GSCI Highly Sensitive To USD, U.S. CPI Chart 7Inflation Risks Picking Up Inflation Risks Picking Up Inflation Risks Picking Up Consistent with our overweight view, we expect oil prices to move higher from current levels, as refiners come off 1Q18 maintenance turn-arounds and summer-driving-season demand picks up in the Northern Hemisphere (Chart 7, middle panel).11 Lastly, global export price inflation is showing no signs of slowing, suggesting that global headline inflation will continue moving higher (Chart 7, bottom panel). From the model shown in Chart 6, which captures ~ 82% of the variance in the y/y GSCI TR, we have high conviction that three of the four explanatory variables for the GSCI - crude spreads, DFC and U.S. CPI - will support the GSCI this year, leaving only a significant appreciation in USD TWIB as a potential risk to our view. Away from our modelling, other risks to our bullish oil case as a driver of GSCI returns remains a greater-than-expected economic deceleration in China arising from a policy error in Beijing as policymakers execute a managed slowdown, or a trade war with the U.S.12 These would affect our inflation and commodity-demand - hence commodity price - outlooks. Bottom Line: We expect persistent backwardation in the benchmark crude-oil forward curves- WTI and Brent - as OPEC 2.0 extends production cuts beyond 2018. This will achieve the goals of OPEC 2.0's leadership and underpin returns in the S&P GSCI, which we expect will post gains of 10 - 20% this year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Last month, the Kingdom of Saudi Arabia's (KSA) oil minister, Khalid Al-Falih, indicated OPEC 2.0 production cuts could be extended into 2019. Al-Falih suggested the level of the cuts could be at a reduced level. Please see "Saudi expects oil producers to extend output curbs into 2019," published by uk.reuters.com March 22, 2018. 2 OPEC 2.0 is the producer coalition led by KSA and Russia, which, at the end of 2016, agreed to remove 1.8mm b/d of production from the market. 3 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. For a primer on commodity index investing, please see "Convenience Yields, Term Structures & Volatility Across Commodity Markets," by Michael Lewis in An Investor Guide To Commodities (pp. 18 - 23), published by Deutsche Bank April 2005. 4 By way of a simplistic example, assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Please see "How we cut the break-even prices from USD 100 to USD 27 per barrel" on Statoil's website at https://www.statoil.com/en/magazine/achieving-lower-breakeven.html and "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018, where we discuss how KSA's and Russia's goals have been reconciled. It is available at ces.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 7 This sensitivity analysis allows only for the path of OECD commercial inventories to vary while everything else is held constant. To obtain the forecasted values, we've combined the estimates of a set of different modelling techniques (i.e., a Markov switching model, threshold and break-OLS estimators). This increased the information and granularity obtained from the model and allowed us to capture time-varying characteristics in the global inventory/GSCI TR relationship. 8 We found there is two-way Granger-causality between the S&P GSCI and U.S. CPI y/y changes. This feedback loop indicates the GSCI will move with, and cause movement in, the CPI, as discussed herein. 9 This is supported statistically using Granger Causality tests in a VAR model of the GSCI TR and U.S. CPI inflation. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report titled "Nervous Complacency," published March 27, 2018. Available at gfis.bcaresearch.com. 11 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," for our latest oil price forecast. It was published March 22, 2018, and is available at ces.bcaresearch.com. 12 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," for a discussion of this risk. It was published March 29, 2018, and is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Backwardated Oil Forward Curves Align OPEC 2.0's And Investors' Interests Backwardated Oil Forward Curves Align OPEC 2.0's And Investors' Interests Trades Closed in 2018 Summary of Trades Closed in 2017 Backwardated Oil Forward Curves Align OPEC 2.0's And Investors' Interests Backwardated Oil Forward Curves Align OPEC 2.0's And Investors' Interests

Highlights Our supply-demand balances indicate oil fundamentals are softening slightly. All else equal, this might prompt us to lower our average-price forecasts for Brent and WTI from $74 and $70/bbl this year by $2 to $3/bbl. However, this is oil: All else equal seldom applies. An unusual confluence of risk factors has raised the likelihood of sharp price moves - down and up - this year. These range from the threat of trade wars (bearish for demand), to renewed U.S.-led sanctions against Iran and deeper sanctions against Venezuela (bullish, as they could remove as much as 1.4mm b/d of supply). The possible extended delay of the Aramco IPO compounds the uncertainty. Brent and WTI implied volatilities - the principal gauge of price risk in trading markets - had a brief spike earlier this month, but subsequently retreated (Chart of the Week). We believe the lower volatility offers an opportunity to get long a put spread in Dec/18 Brent options, to complement an existing long call spread in these options. Energy: Overweight. We are taking profit on our long Jul/18 vs. short Dec/18 WTI calendar spread to re-position for the higher volatility. As of Tuesday's close, this spread was up 90.4% since inception November 2, 2017. Base Metals: Neutral. Metal Bulletin reported the flow of zinc into China from Spain has turned into a flood, which is depressing physical premiums and causing unintended inventory accumulation. Almost 161k MT of Spanish zinc was shipped to China last year, a 15-fold increase in annual volumes. The bulk of the increase occurring during the August-to-December period. Spain accounted for a quarter of the ~ 67k MT of zinc imported by China in January. Precious Metals: Neutral. Going into Jerome Powell's first meeting as Fed Chair, gold held recent support ~ $1,310/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. U.S. Ag Secretary Sonny Perdue warned farmers a tit-for-tat trade war could hit their markets particularly hard earlier this week, according to Reuters. Cotton could be especially hard hit (please see p. 9 for details).1 Feature Fundamentally, our global supply-demand balances indicate the global oil market will remain in a physical deficit this year, even though they do suggest a slight softening. As such, we are leaving our Brent and WTI forecasts for this year at $74 and $70/bbl (Chart 2). For next year, we also are leaving our average-price Brent and WTI expectations at $67 and $64/bbl, respectively, with the caveat that these are highly conditional on OPEC 2.0's expected forward guidance later this year.2 Chart of the WeekCrude Oil Volatility Lower,##BR##Even As Price Risks Mount Crude Oil Volatility Lower, Even As Price Risks Mount Crude Oil Volatility Lower, Even As Price Risks Mount Chart 2BCA's Oil Price Forecast##BR##Remains Unchanged BCA's Oil Price Forecast Remains Unchanged BCA's Oil Price Forecast Remains Unchanged Nonetheless, it is difficult to remain sanguine regarding the oil-price outlook. A remarkable confluence of geopolitical events has introduced higher risk to the downside and the upside for oil prices this year and next. On the downside, trade-war rhetoric continues to ramp up, as the Trump administration threatens sanctions against China for alleged theft of U.S. intellectual property, and slow-walks NAFTA negotiations with Mexico and Canada. Either or both of these could be the spark that lights a global trade war. Re the latter, U.S. Agriculture Secretary Sonny Perdue is warning U.S. farmers their markets could get caught up in a tit-for-tat trade war.3 Upside oil-price risk arises from increasingly bellicose signaling by the Trump administration re the Iran nuclear sanctions deal, and hints the U.S. could impose sanctions directly on Venezuela's oil industry, which would augment sanctions against individuals already in place. Rex Tillerson's expected replacement at the U.S. State Department, Mike Pompeo, shares President Trump's hostility to the 2015 deal that lifted trade sanctions on Iran, which allowed it to increase its production and boost exports. If the May 12 deadline for issuing waivers on the Iran sanctions passes, trade penalties again will be in force against Iran, which likely will, once again, reduce its production and exports, if U.S. allies fall in line with Washington. The odds of this are now higher with Rex Tillerson no longer at the helm at the U.S. State Department. Lastly, Saudi Crown Prince Mohammad bin Salman Al Saud, who, as Minister of Defense, is leading KSA's proxy wars against Iran throughout the Middle East, is in Washington cementing relations with President Trump. Trump has indicated his administration is abandoning his predecessor's pivot away from the Middle East and re-engaging at a deeper level with KSA. The Crown Prince also indicated he will be discussing the Iran sanctions with President Trump in meetings this week.4 Fundamentals Remain Supportive ... For Now Chart 3Supply-Demand Fundamentals##BR##Remain Supportive Supply-Demand Fundamentals Remain Supportive Supply-Demand Fundamentals Remain Supportive The slight softening detected in our supply-demand balances model is largely coming from the supply side (Chart 3). Most of this is due to surging U.S. crude and liquids production. The EIA's higher-than-expected U.S. crude oil production estimates for 4Q17 provides a higher base on which continued production gains can build this year. Our colleague Matt Conlan notes in this week's Energy Sector Strategy that, over the past three months, the EIA increased its U.S. onshore oil production estimates for 4Q17 by 310k b/d.5 Although we faded this estimate earlier this year, Matt's analysis of E&P balance sheet data for the quarter confirms this surge in production. U.S. production growth dominates global growth this year - up almost 1.3mm b/d on average y/y, led by a 1.2mm b/d y/y gain in shale-oil output. For next year, we have U.S. output up just over 1mm b/d, almost all of which is accounted for by increased shale production. Total U.S. crude production goes to 10.6mm b/d this year, and 11.9mm b/d next year. In 1Q18, the U.S. will displace KSA as the second-largest crude producer in the world. U.S. crude oil production will exceed Russia's expected crude and liquids production of 11.35mm b/d next year by 2Q19 (Table 1). Total U.S. crude and liquids production (including NGLs, biofuels, and refinery gain) goes to 17.4mm b/d this year, and 19.1mm b/d next year. Strong demand continues to absorb rising production this year and next. By our reckoning, global oil demand grows 1.7mm b/d this year, and 1.64mm b/d next year, up slightly from our earlier estimate of 1.57mm b/d. Global demand averages 100.3mm b/d this year, and just shy of 102mm b/d next year. These fundamentals continue to support our judgement that OPEC 2.0's primary goal - draining OECD inventories below their current five-year average - will be met this year (Chart 4). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Price Forecast Steady, But Risks Expand Oil Price Forecast Steady, But Risks Expand Chart 4Expect OECD Inventories To Draw A Bit Slower Expect OECD Inventories To Draw A Bit Slower Expect OECD Inventories To Draw A Bit Slower Expect OPEC 2.0 To Endure Next year is a different story. Not because markets fundamentally change. But because we fully expect to be substantially revising our production estimates as OPEC 2.0 evolves into a more durable, longer-lasting structure. Chart 5Backwardation Weakens Under##BR##Provisional 2019 Estimates Backwardation Weakens Under Provisional 2019 Estimates Backwardation Weakens Under Provisional 2019 Estimates We expect OPEC 2.0 to provide forward guidance regarding its production-management goals for 2019 and beyond, once all of the particulars in formalizing its structure are agreed later this year. As a result, we fully expect to be revising our price forecasts and OECD inventory expectations in line with more definitive OPEC 2.0 production guidance throughout this year. As things stand now, we assume volumes voluntarily removed from production - some 1.1 to 1.2mm b/d by our reckoning - will slowly be returned to the market over 1H19. By 2H19, those states within OPEC 2.0 that actually cut production - mostly KSA and Russia - are assumed to be back at pre-2017 production levels. More than likely, the coalition will maintain its production cuts at a lower level so that OECD inventories do not grow excessively and place the OPEC and non-OPEC member states of the coalition in the same dire straits that led to the formation of OPEC 2.0. This will arrest the descent in prices generated by our fundamental models toward the end of 2019 (Chart 2). In addition, the renewed OECD inventory build our model generates (Chart 4) also will be arrested. This will keep markets backwardated in 2019, as opposed to moving toward contango as production growth exceeds consumption growth, restraining the erosion in the backwardation in the forward Brent and WTI curves (Chart 5). Tail Risks Rising In Oil Markets An unusual confluence of risk factors has raised the likelihood of sharp price moves to the downside and to the upside this year. These range from the threat of growth-killing trade wars, to renewed U.S.-led sanctions against Iran and deeper sanctions directed at Venezuela's oil sector. A full-blown global trade war would be bearish for prices, as it would depress growth globally, particularly in EM economies, which are the primary drivers of oil demand. At the other end of the price distribution, reimposing sanctions on Iran and targeting Venezuela's oil industry with sanctions could remove up to 1.4mm b/d of supply from markets later this year, by some estimates.6 A former Obama administration official familiar with the Iran sanctions estimates as much as 500k b/d of exports could be lost if sanctions are reimposed. Venezuela's crude oil output has been collapsing and currently is less than 1.6mm b/d. Oil-directed sanctions from the U.S. could force the Venezuelan oil industry to collapse. Added to this volatile mix, Saudi Crown Prince Mohammad bin Salman Al Saud, also known as MBS, called on President Trump this week in Washington. MBS is leading KSA's proxy wars against Iran, and remains at the forefront of efforts to deny them political and military advantage in the Gulf and the Middle East. MBS and President Trump are on the same page in their opposition to the Iran sanctions deal, as is the presumptive U.S. Secretary of State, Mike Pompeo, who, as Reuters notes, "fiercely opposed the Iranian nuclear deal as a member of Congress."7 Lastly, reports of a possible extended delay of the Aramco IPO creates additional uncertainty re our analysis. It is entirely possible KSA thus far has failed to get indicative bids for the 5% of the firm they intend to float anywhere near its $100 billion target. A target bid would value Saudi Aramco at ~ $2 trillion. Given that we view the IPO as the principal driver of KSA's oil policy over the next two years, this raises questions as to whether the Kingdom will remain committed to higher prices over the short term - $60 to $70/bbl is the range we assume - or whether it will lower its sights to a range we believe Russia favors ($50 to $60/bbl). We continue to expect KSA to favor higher prices over the short term, as it works to reduce its fiscal breakeven oil price from ~ $70/bbl to $60/bbl. A higher price range also will help the Kingdom raise debt under more favorable terms, should it decide to wait on the IPO and finance the early stages of its diversification away from oil-export revenues. Either way, we would expect the Kingdom to favor higher prices. It also is possible a lack of bids approaching KSA's Aramco target level will make a private placement more attractive. A consortium led by China's sovereign wealth fund is believed to have shown a bid for the entire 5% placement. The quid pro quo is believed to have been KSA accepting payment for its oil in yuan. This could have profound implications for the market, as we noted in a Special Report exploring the Kingdom's anti-corruption campaign. This alternative also would tend to favor higher prices, in as much as KSA would not want its new shareholder to realize a loss shortly after its purchase of 5% of Aramco.8 Investment Implications Of Higher Tail Risk As our Chart of the Week indicates, trading markets do not appear to have priced the growing tail risks into option premiums. The market's chief gauge of oil-price risk - the implied volatilities of traded put and call options - staged a brief rally, but have since retreated.9 Volatility is the critical driver of option value. We believe the low volatility levels in the market at present offer an opportunity to add to our long Brent call spreads in Dec/18 options. Specifically, we recommend getting long a $50/bbl Dec/18 Brent put and selling a $45/bbl Dec/18 Brent put option against it. This will give investors low-cost, low-risk exposure to a sudden down move, in addition to the upside exposure our existing Dec/18 $65 vs. $70/bbl Brent call spread provides to a sudden up move resulting from the risk factors we discussed above. Of course, more adventuresome investors can choose to get long put spreads and ignore taking exposure to the upside if they believe downside risks from trade tensions will dominate the evolution of oil prices this year. On the other side of the divide, those who believe the increasing geopolitical tensions discussed above will dominate price formation going forward, can choose to get long calls or call spreads and ignore taking exposure to the downside. Separately, we will be taking profits on our long Jul/18 WTI vs. short Dec/18 WTI spread trade, to re-position for our higher-volatility expectation. This position was up 90.4% as of Tuesday's close, when we mark our recommendations to market. Bottom Line: We are keeping our forecast for 2018 and 2019 unchanged, despite the unexpectedly strong U.S. oil supply growth being reported by the EIA and in E&P quarterly earnings reports. An unlikely confluence of geopolitical risks has raised price risk to the downside and the upside. To position for this, we are recommending investors get long put and call spreads in Dec/18 Brent futures. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We discussed the implications of a trade war vis-a-vis U.S. ag markets in last week's Commodity & Energy Strategy Weekly Report. Please see "Ags Could Get Caught In U.S. Tariff Imbroglio," published by BCA Research March 15, 2018. It is available at ces.bcaresearch.com. 2 In last month's publication, we noted the Kingdom of Saudi Arabia (KSA) and Russia - the putative leaders of the producer coalition we've dubbed OPEC 2.0 - favor formalizing their agreement with a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018. It is available at ces.bcaresearch.com. 3 Please see footnote 1 references, and "U.S. agriculture secretary says exports at risk in tariff disputes," published by reuters.com March 19, 2018. 4 Please see "Trump Says of Iran Deal, 'You're Going to See What I Do,' published by bloomberg.com March 20, 2018. 5 Please see "Public Companies Confirm Large Q4 2017 Production Surge," in the March 21, 2018, issue of BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see "U.S. foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts on its online site March 15, 2018. 7 Please see "Oil nears six-week high as concern grows over Middle East," published by uk.reuters.com March 21, 2018. 8 Please see our Special Report published by BCA Research's Commodity & Energy Strategy November 16, 2017. It is available at ces.bcaresearch.com. 9 Implied volatilities, or "implieds" in trading markets, are market-cleared pricing parameters for options. They are calculated once a put (the right to sell the underlying asset upon which an option is written) or call (the right to buy the asset) price (i.e., the option premium) clears the market. Implieds are the annualized standard deviation of expected returns for whatever asset is being priced in a trading market. As such, they are often used to measure the risk that is being priced in options markets by willing buyers and sellers. When implieds are high, risk expectations are high, and the range in which prices are expected to trade widens. "The opposite holds when volatility is low." Ags/Softs Can China Retaliate With Agriculture? China's outsized population means that it is a major consumer of many agricultural products. In last week's Weekly Report, we highlighted that this has made U.S. farmers increasingly wary of the impact of a prospective trade war on the agriculture sector. We concluded that while restrictions on China's imports of U.S. soybeans would have a large impact on U.S. farmers, retaliation by China may not be feasible, given that alternative sources of supply are not readily available. Instead, cotton appears to be the more vulnerable crop, in the event of retaliation. Table 2 below formalizes this analysis. The first column shows the importance of each ag to the U.S., as measured by the percent of U.S. exports that go to China. We use this measure to derive the qualitative value displayed in the third column. The results imply that restrictions on China's imports of U.S. sorghum, soybeans, and to a lesser extent cotton, would severely harm U.S. farmers of these crops. On the other hand, wheat, corn, and rice exports to China do not make up a large proportion of U.S. exports, and thus are not especially significant to American farmers of those commodities. The second column measures China's ability to substitute away from the U.S. as a supplier. We calculate a ratio using world inventories ex-U.S. versus the volume of China's imports from the U.S. for particular crops. The larger the value in column two, the greater China's ability to substitute away from the U.S. Based on these metrics, the last column reveals that China is extremely dependent on the U.S. in terms of sorghum and soybeans, while it has greater ability to find alternative suppliers of the other commodities. Cotton accounts for 16% of U.S. exports. World inventories ex-U.S. for cotton stands at 157 times more than the volume of China's 2017 imports from the U.S. This simple analysis indicates U.S. cotton exports likely will fall victim to retaliation by China, in the event of a trade war. Table 2Cotton Could Fall Victim In Trade Dispute Oil Price Forecast Steady, But Risks Expand Oil Price Forecast Steady, But Risks Expand Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Oil Price Forecast Steady, But Risks Expand Oil Price Forecast Steady, But Risks Expand Trades Closed in 2018 Summary of Trades Closed in 2017 Oil Price Forecast Steady, But Risks Expand Oil Price Forecast Steady, But Risks Expand