Oil

Special Report

Highlights A supply-driven spike in oil prices in early 2019 is now a highly likely scenario. This represents a potential risk to our current high-conviction view that global bond yields will continue to rise over the next year. Oil prices north of $100/bbl would have negative implications for global growth, especially with a rising U.S. dollar likely to magnify the inflationary impact outside the U.S. A spike in oil prices could alter the recent positive correlation between global bond yields and oil (through higher inflation expectations), even turning into a negative correlation (through weaker expected economic growth). The most reliable historical correlations suggests that more volatile oil prices will lead to greater volatility for both bond yields and corporate credit spreads. Feature The BCA house view remains unequivocally bond bearish, led by additional upside potential for U.S. Treasury yields. The Fed will continue to deliver a steady pace of rate hikes over at least the next year in response to a strong U.S. economy that is fueled by fiscal stimulus and operating well beyond full employment. U.S. bond markets are not discounting enough potential tightening and inflation expectations remain below levels consistent with the Fed's 2% inflation target, so Treasury yields have room to rise further. While we are comfortable with our high-conviction bearish view on government bonds, we recognize that it is prudent to look for potential scenarios that could derail our base-case scenario. Especially since our once out-of-consensus expectation of higher global yields is now a widely-held view among investors, with Treasury yields breaking out to new cyclical highs in recent weeks. One such risk could come from a spike in oil prices in early 2019, and its potential aftermath. A confluence of geopolitical (Iran, Venezuela) and monetary policy risks (Fed tightening, rising U.S. dollar) will likely stoke oil price volatility next year. This will eventually lead to higher bond market volatility both in developed markets (DM) and emerging markets (EM) - a relationship that has had a far more reliable correlation over time than the direct relationship between oil prices and yields (Chart 1). Chart 1Oil Vol & Bond Vol Are Linked In this joint Special Report, BCA's Commodity & Energy Strategy and Global Fixed Income Strategy services explore how a changing relationship between oil and interest rates could affect the future behavior of global bond markets and, by association, returns to fixed income portfolios. Growing Odds Of A 2019 Oil Price Spike Global oil markets are tightening. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. U.S. sanctions against the former, and the unabated collapse in the latter's economy will together remove some 2mm barrels/day (b/d) of supply from an already tight market next year. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage even in a minor oil-exporting state. The confluence of these factors is setting the global oil market up for a supply shock, which could take prices to $100/bbl in 1Q19 (Chart 2).1 Those high prices are likely to be sustained, and we expect Brent crude oil, the global benchmark, to trade at $95/bbl on average over the course of next year. Chart 2Get Ready For $100/bbl Oil In Q1 2019 Against this physical reality, the Fed remains set to continue normalizing interest rates. With other major central banks remaining relatively accommodative, widening rate differentials (Chart 3) will continue to support the U.S. dollar (USD). This will, all else equal, increase the cost of oil in local currency terms outside the U.S., hitting EM economies particularly hard if the price move is both as large, and as rapid, as we expect. Chart 3Rate Differentials Will Remain USD-Supportive It is important here to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by pushing up the inflation expectations components of global bond yields at a time when strong economic growth is also pushing up real bond yields. An oil price spike, however, can eventually produce a DIS-inflationary impulse by depressing real economic growth and destroying oil demand, which ultimately lowers oil prices, inflation expectations and real yields. The IMF, in its most recent World Economic Outlook, highlighted a scenario for 2019 where a big enough rise in oil prices could even cause the Fed to reverse its rates-normalization policies.2 While this is not BCA's base case view, a period of sharply higher oil prices in 1Q19 followed by lower prices in 2H19 would whipsaw global oil markets and raise oil price volatility. History suggests that bond price volatility is likely to also increase in the process, both for government bonds (through more uncertainty over the future path of inflation and policy rates) and corporate bonds (though more uncertainty over future economic growth). Expect Higher Bond Volatility As Oil Volatility Rises Since the end of the Global Financial Crisis (GFC), oil volatility has strongly influenced volatility in DM and EM bond markets. Indeed, we find all grades of corporate and junk bonds grouped together are highly correlated with oil volatility in the post-GFC period. We expect this to continue going forward, as oil inventories are drawn down globally to meet consumer demand for refined petroleum products like gasoline, diesel fuel, chemicals and plastics. The drawdown in global inventories shows up in a backwardated oil-price forward curve, which reflects the increasing inelasticity of supply.3 This means prices have to adjust more frequently and sharply to equilibrate available supply with demand, producing higher volatility in oil prices (Chart 4). Chart 4Implied Volatilities Will Rise As OECD Storage Falls Using principal components analysis (PCA), we find a high pairwise correlation between oil and bond volatility since 2010. The first principal component (PC) of all grades of corporate and junk bonds grouped together varies strongly with oil volatility, with a correlation of 0.80. Importantly, this component explains 91% of the variability in the group (Chart 5).4 EM bond spreads for smaller issuers like Chile, Peru, Hungary, Poland, Turkey, Indonesia, Mexico, Colombia, and Malaysia are also heavily influenced by greater variability of oil prices, with the first PC of this group highly correlated with oil volatility. Chart 5Oil Volatility Leads To Bond Volatility It comes as no surprise that our U.S. Bond Strategy group, headed by Ryan Swift, has found that lower-quality corporate bonds (i.e., junk) have a high correlation with oil volatility, as do lower-quality corporate spreads (Chart 6). As Ryan noted in a recent report: "there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa. ... The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads."5 Chart 6Higher Oil Vol = Wider Junk Spreads Oil Volatility Leads To Credit Spread Widening Thus, the oil price spike that we are expecting in 2019 should make corporate bond investors more cautious on the outlook for credit spread and expected returns. BCA's bond strategists have already been expecting to shift to an underweight stance on U.S. corporate debt sometime in 2019 as the Fed moves to a restrictive monetary stance and investors begin to cut U.S. growth expectations and anticipate increased future credit downgrades and defaults. A sharp upward move in oil prices in 1Q19 may prove to be the trigger for that shift to a more bearish outlook on credit. Could An Oil Price Spike Change The Fed's Current Thinking? The combination of an oil price spike and a stronger USD that we anticipate would present a considerable headwind to EM economic growth. Econometric modelling work done by BCA Commodity & Energy Strategy shows that there is a strong correlation between EM growth and U.S. inflation (see Box 1).6 Correlation is not causation, of course, but there is a plausible mechanism for that correlation through the USD, which impacts both EM growth and U.S. inflation. Box 1 Modeling The Links Between The USD, EM & Inflation The two risks we highlight in this Special Report - an oil-price shock in 1Q19 that occurs while the Fed is tightening - have profound implications for EM economies, which makes them particularly important for fixed-income markets globally.7 The near-term effects of an oil-supply shock that quickly sent prices above $100/bbl will hit EM consumers particularly hard. Many governments relaxed or removed fuel subsidies shielding consumers from high oil prices following the OPEC-engineered oil-price collapse of 2014 - 16, which saw Brent crude oil prices - the global benchmark - fall from more than $110/bbl in 1H14 to close to $25/bbl in early 2016.8 An oil-price spike would consume a far larger share of EM households' disposable income now, and would reduce aggregate demand. The second risk - tightening of the Fed's monetary policy - is more complicated. The U.S. economy separated itself from the rest of the world with strong growth this year, partly aided by fiscal stimulus. As a result, the U.S. economy is operating beyond full employment, and wages are growing smartly. This growth allows the Fed to tighten monetary policy, which likely produces four policy-rate rate hikes this year, and, per our House view, four next year. On the back of the Fed's rates-normalization policy, the U.S. trade-weighted dollar appreciated ~ 8% this year. We expect continued strength next year. As the dollar strengthens, EM trade volumes slow. This is partly a result of rising local-currency costs ex U.S., as most commodities are priced in USD. Trade volumes - particularly imports - are closely tied to EM incomes: The World Bank estimates the income elasticity of trade in EM economies averaged 1.5% from 2000-07 p.a., and 1.2% from 2010-17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period.9 Falling trade volumes correspond with weakening or falling income in EM economies. Part of this likely is explained by the expansion and deepening of Global Supply Chains (GSCs) over the past two decades, which fueled the rapid rise in trade of intermediate goods globally, and EM incomes in the process.10 To examine the impact of a rising dollar on EM income, we estimated a regression for the level of EM import volumes using an ensemble of models for the broad trade-weighted index (TWIB) USD as an explanatory variable.11 Our modeling indicates that a 1% increase in our USD TWIB ensemble translates into a 0.33% decline in EM import volumes (Chart 7).12 Chart 7Strong Dollar Dampens EM Trade Volumes Downward Trend In EM Trade Will Continue As USD Strengthens ... Next, we wanted to take these results and have a closer look at inflation, since, as noted above, wage and price pressures have been transmitted globally through GSCs for the better part of the 21st century. This is a phenomenon that accelerates as GSCs are broadened and deepened. More precisely, we wanted to examine the global aspects of local inflation in DM and EM economies.13 To do this, we look at the level of the U.S. Consumer Price Index (CPI) as a function of EM import volumes. Our modeling indicates that a 1% change in the level of EM import volumes as a function of the USD TWIB translates to a change (in the same direction) in the level of U.S. CPI of between 0.15% and 0.25% - estimated over the post-GFC period (2010 to now). This reflects both the direct and indirect effects of EM incomes on domestic inflation in the U.S. (Chart 8): Chart 8U.S. CPI Vs EM Import Volumes U.S. CPI Vs EM Import Volumes A stronger USD lowers expected U.S. inflation by reducing the cost of imports. EM disposable income growth slows as the USD rises, because the local-currency costs of imports rise and consumes more of available household budgets. Our modeling isolates the common deterministic trend between the U.S. CPI and EM import volumes from the cyclical variations. In fact, these two variables expressed in levels exhibit a strong and stable common trend.14 The U.S. trade-weighted dollar index has already appreciated 8% this year, with more upside likely in the next 6-12 months (Chart 9).15 This would widen the existing sharp divergence between a strong U.S. economy and weaker non-U.S. growth, putting even more upward pressure on the USD. This would represent an additional tightening of U.S. monetary conditions on top of the Fed rate hikes that have already occurred since late 2015. Chart 9Expect Continued USD Appreciation BCA's bond strategy services have described a concept known as the "Fed Policy Loop" to explain the link between global growth divergences, a rising USD, financial market volatility and eventual shifts in the Fed's hawkish bias. Such a move occurred in late 2015/early 2016, when the Fed had to delay additional increases beyond the initial 25bp rate hike of the current tightening cycle because of a soaring USD and global financial market instability (Chart 10). Chart 10Is The Fed Policy Loop: Watch U.S. Credit Spreads The current backdrop shares some characteristics with that episode, in terms of growth divergences (top panel), USD strength and wider EM credit spreads (second panel). The missing piece today is a large widening of U.S. credit spreads, and U.S. credit market underperformance versus Treasuries (third panel). The U.S. economy is in a much healthier place now compared to three years ago, which is why credit spreads have remained much better behaved in 2018. The global backdrop is also far less disinflationary, with the global output gap now closed and inflation expectations drifting back towards pre-crisis levels consistent with central bank inflation targets (Chart 11). Investors should focus on U.S. corporate bond spreads for signs that a stronger USD is starting to impact U.S. corporate profits and future U.S. growth expectations. This would be the most likely potential trigger for the Fed to pause on its current tightening path, as occurred in early 2016 (bottom panel). Importantly, we firmly believe that the Fed's hurdle for backing off the rate hikes from a tightening of financial conditions is much higher now because the U.S. economy is stronger today. A "garden variety" equity market correction, without much widening of corporate spreads, will not be enough. Investment Implications What we have laid out in this report is a risk to the current BCA house views on global duration exposure (stay below-benchmark) and global credit exposure (stay neutral, but favoring the U.S. over Europe and EM) - a supply-driven spike in oil prices, combined with additional increases in the USD fueled by Fed tightening. The potential trigger for that oil spike is largely geopolitical, stemming from the likely loss of oil supply from Iran via U.S. sanctions and Venezuela through economic collapse. The timing of either outcome is difficult to pin down precisely, but sometime in the first quarter of 2019 is our current best guess for when oil prices reach $100/bbl. The key variables to watch will be the U.S. dollar. If it stays stable, then the impacts on global growth and U.S. inflation from the oil spike could be more modest. If the USD surges higher, then the negative impact on non-U.S. growth will eventually spill back into the U.S. economy. The combination of more volatile oil prices and a stronger USD would be a likely trigger for a surge in U.S. bond volatility and wider corporate bond spreads. Eventually, this could move the Fed to pause on its rate hike cycle and, at least temporarily, end the current bond bear market. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Our full oil-price forecast is available in the September 20, 2018, issue of BCA Commodity & Energy Strategy, in a report titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. We will be updating our oil-price forecast next week. 2 Please see the IMF's World Economic Outlook for October 2018, which can be found here https://www.imf.org/en/Publications/WEO/ 3 Backwardation is a term of art in commodity markets used to describe an inverted forward curve - i.e., prompt prices for commodities delivered in the very near future trade higher than prices for commodities delivered further out in time. This is the market's way of signaling supplies are tight; storage holders are being incentivized to release oil in inventory via higher prices for prompt delivery. The opposite of this is referred to as a contango market (prompt prices are lower than deferred prices). Contango markets reflect well-supplied markets, as supply that cannot be immediately used must be stored for later use. In recent research, we were able to extend findings from academic studies that showed a non-linear relationship between oil volatility and the slope of the forward curve - highly backwardated and contango forward curves are accompanied by higher volatility in oil prices, due to the physical constraints on storage in such markets. 4 Principal components analysis (PCA) is a statistical technique used to reduce the most important information contained in a large number of correlated variables into a smaller number of common factors that explains the larger set. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk," dated October 9, 2018, available at usbs.bcaresearch.com. 6 EM trade volumes - particularly imports - are a key variable we use to track EM income levels. The World Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. Please see "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 10 of the 11 post-WW2 recessions in the U.S. were preceded by an oil-price spike. Since 1970, the combination of an oil-price spike and a Fed rate-hiking cycle resulted in recession. Please see "Oil-Supply Shock, Risking U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy on September 13, 2018. It is available at ces.bcaresearch.com. 8 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse." 9 We discuss this in "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Global value chains and the increasingly global nature of inflation," by Raphael Auer, Claudio Borio, Andrew Filardo, published online April 28, 2017, by VOX, the CEPR Policy Portal. 11 We average estimates from five different USD regressions using monetary policy variables, commodity prices and momentum indicators. The period covered is the post-GFC (2010 to now). 12 The regression we estimate includes a trend variable, which allows us to separate out the cyclical aspects of trade (i.e., imports) alone. 13 Please see "The globalisation of inflation: the growing importance of global value chains," by Raphael Auer, Claudio Borio and Andrew Filardo, which was published by the Bank For International Settlements in January 2017. 14 We believe this reflects "hidden variables" that simultaneously drive U.S. inflation and EM incomes such as global growth and global money/credit growth. The coefficient range we report - 0.15% to 0.25% - controls for this. For a discussion of "hidden variables," please see Clive Granger's 2003 Nobel Lecture entitled "Time Series Analysis, Cointegration, and Applications." 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ...Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com.

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights So What? Go long Brent / short S&P 500. The risk of a recession in 2019 is underappreciated. Why? The likelihood is increasing of a geopolitically-induced supply-side shock that pushes crude prices above $100 per barrel in the coming 6-12 months. Oil supply disruptions in Iran, Iraq, and Venezuela represent the primary source of risk. Historically, the combination of Fed rates hike and an oil price spike has preceded 8 out of the last 9 recessions. Also... A recession in 2019, ahead of the 2020 election, would set the stage for a confrontation between Trump and the Fed, adding fuel to market volatility. Feature Geopolitical tensions are brewing from the Strait of Hormuz to the Strait of Malacca. As we go to press, news is breaking that a Chinese naval vessel almost collided with the USS Decatur as the latter conducted "freedom of navigation" operations within 12 nautical miles of Gaven and Johnson reefs in the Spratly Islands. Given the trade tensions between China and the U.S., this alleged maneuver by the Chinese vessel suggests that Beijing is not backing off from a confrontation. Our view remains that Sino-American trade tensions can get a lot worse before they get better. The latest incident, which builds on a series of negative gestures recently in the South China Sea, suggests that both sides are combining longstanding geopolitical tensions with the trade war. This will likely encourage brinkmanship and further degrade U.S.-China relations. Yet China-U.S. tensions are not the only concern for investors in 2019. Another crisis is brewing in the Middle East, with the potential to significantly increase oil prices over the next 12 months. U.S. households may have to deal with a double-whammy next year: higher costs of imported goods as the U.S.-China trade war rages on and a significant increase in gasoline prices. In this report, we discuss this dire outlook. The Folly Of Recession Forecasting In mid-2017, BCA Research published two reports, one titled "Beware The 2019 Trump Recession" and another titled "The Timing Of The Next Recession."1 Both argued that if the Federal Reserve kept raising rates in line with the FOMC dots, then monetary policy would move into restrictive territory by early 2019 and increase the likelihood of recession thereafter. We subsequently adjusted the timing of our recession forecast to 2020 or beyond, based on a more positive assessment of the U.S. economy. In this report, we explore a risk to the BCA House View on the timing of the next recession. As BCA's long-time Chief Economist Martin Barnes has said, predicting recessions is a mug's game. There have been eight recessions in the past 60 years (excluding the brief 1980-81 downturn) and the Fed failed to forecast all of them (Table 1). Table 1Fed Economic Forecasts Versus Outcomes The Atlanta Fed produces a recession indicator index which is designed to highlight the odds of recession based on trends in recent GDP data. At the moment, the indicator is at a historically sanguine 2.4%. Unfortunately, low readings are not a reliable cause for optimism. The 1974-75, 1981-82, and 2007-09 recessions were all severe and the Atlanta Fed's recession indicator had a low reading of 10%, 1.6%, and 7.7%, respectively - just as the recession was about to begin (Chart 1). Chart 1The Market Is Not Expecting A Recession The 1974-75 recession is instructive, given the numerous parallels with the current environment: Energy Geopolitics: The 1973 oil crisis caused a massive spike in crude prices. This point is especially pertinent since the 1973 oil embargo is widely viewed as an important contributor to the 1974-75 recession. Real short rates had risen and the yield curve had inverted long before oil prices spiked, so recession was almost inevitable even without the oil price move. But the oil spike made the recession much deeper than otherwise. Protectionism: President Nixon imposed a 10% across-the-board tariff on all imports into the U.S. in 1971 to try to force trade partners to devalue the U.S. dollar. Dislocation: Competition from newly industrialized countries - Japan and the East Asian tigers in particular - laid waste to the steel industry in the developed world. Polarization: President Nixon polarized the nation with both his policies and behavior, leading to his resignation in 1974. Given the exogenous and geopolitical nature of oil supply shocks, today's recession indicators are missing a critical potential headwind to the economy. A geopolitically induced oil-price shock could create more pain than the economy is able to handle. Why An Oil Price Shock? America's renewed foray into the politics of the Middle East will unravel the tenuous equilibrium that was just recently established between Iran and its regional rivals. The U.S.-Iran détente that produced the signing of the 2015 Joint Comprehensive Plan of Action (JCPA) created conditions for a precarious balance of power between Israel and Saudi Arabia on one side, and Iran and its allies on the other side. This equilibrium led to a meaningful change in Tehran's behavior, particularly on the following fronts: The Strait of Hormuz: Tehran ceased to rhetorically threaten the Strait as soon as negotiations began with the U.S. (Chart 2). Since then, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities remain unchanged.2 Iraq: Iran directly participated in the anti-U.S. insurgency in Iraq. Tehran changed tack after 2013 and cooperated closely with the U.S. in the fight against the Islamic State. In 2014, Iran acquiesced to the removal of the deeply sectarian, and pro-Iranian, Prime Minister Nouri al-Maliki. Bahrain and the Saudi Eastern Province: Iran's material and rhetorical support was instrumental in the Shia uprisings in Bahrain and Saudi Arabia's Eastern Province in 2011 (Map 1). Saudi Arabia had to resort to military force to quell both. Since the détente with the U.S. in 2015, Iranian support for Shia uprisings in these critical areas of the Persian Gulf has stopped. Chart 2Geopolitical Crises And Global Peak Supply Losses Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Put simply, the 2015 nuclear deal traded American acquiescence toward Iranian nuclear development in exchange for Iran's cooperation on a number of strategically vital regional issues. By unraveling that détente, President Trump is upending the balance of power in the Middle East and increasing the probability that Iran retaliates. Since penning our latest net assessment of the U.S.-Iran tensions in May, Iran has already retaliated.3 Our checklist for "kinetic" conflict has now risen from zero to at least 15%, if not higher (Table 2). We expect the probability to rise once the U.S. starts implementing the oil embargo in November. This will dovetail our Iran-U.S. decision tree, which sets the subjective probability of kinetic action by the U.S. against Iran at a baseline of 20% (Diagram 1). Table 2Will The U.S. Attack Iran? Diagram 1Iran-U.S. Tensions Decision Tree Bottom Line: The premier geopolitical risk to investors in 2019 is that President Trump's maximum pressure tactic on Iran spills over into Iraq, causing a loss of supply from the world's fifth-largest crude producer.4 We expect the U.S. oil embargo against Iran to remove between 1 million and 1.5 million barrels per day from the market. In addition, the loss of Iraqi production due to sabotage could be anywhere between 500,000 and 3.5 million barrels per day. Added to this total is the potential loss of Venezuelan exports due to the deteriorating situation there. When our commodity team combines all of these factors, they generate a worst-case scenario where the price of crude rises to $110 per barrel in 2019 or higher (Chart 3). And this scenario assumes that EMs do not reinstitute energy subsidies (and therefore their consumption falls faster than if they do reinstitute them). Chart 3Worst-Case Scenario Propels Oil Price Toward 0/Barrel The Ayatollah Recession We believe that the midterm election is a dud from an investment perspective, no matter the outcome. However, the election does matter as a hurdle that, once cleared, will allow President Trump to renew his "maximum pressure" tactic against China, Iran, and perhaps domestic tech corporations.5 Iran is a critical risk in this strategy. If President Trump applies maximum pressure on Iran, then a reduction in crude exports from Iran, Iranian retaliation in Iraq, and the simultaneous loss of Venezuelan supplies could combine to increase the likelihood of U.S. recession in 2019. Readers might recall that no sitting president has gotten re-elected during a recession. Why would Trump pursue a policy that risks his re-election chances in 2020? Surely he would deviate from his maximum pressure tactic if faced with the prospect of a recession. However, it is folly to assume that policymakers are perfectly rational, or fully informed. American presidents are some of the most unconstrained policymakers in the world, given both the hard power of the United States and the constitutional lack of constraints on the president when it comes to national security. Trump may believe, for instance, that the 660 million barrels of crude in America's Strategic Petroleum Reserve can offset the impact of sanctions against Iran.6 Or he may believe that he can force OPEC to supply enough oil to offset the Iranian losses. The problem for President Trump is that Iran is not led by idiots. Iranian policymakers understand that the best way to reduce American pressure is to induce an oil price spike in the summer of 2019 that hurts President Trump's re-election chances, forcing him to back off. As such, sabotaging Iraqi oil exports, which mainly transit through the port of Basra - a city highly vulnerable to Shia-on-Shia violence that is already a risk to the country's stability - would be an obvious target. An oil price spike would serve as a negotiating tool against the U.S., and the additional revenue would help replace what Iran loses due to the embargo. Tehran and Washington will therefore play a game of chicken throughout 2019, and there is a fair probability that neither side will swerve. President Trump may be making the same mistake as many predecessors have made, assuming that the Iranian regime is teetering at a precipice and that a mere nudge will force the leadership to negotiate. Oil price shocks and recessions have a historical connection. In a recent report, our commodity strategists highlighted that a spike in oil prices preceded 10 out of the past 11 recessions in the U.S. since 1945 (Table 3). Admittedly, not all spikes were followed by recession. The combination of an oil price spike and Fed rate hikes has produced a recession 8 out of 9 times.7 If oil prices rose to $100 per barrel in the coming 6-12 months, there will be several negative macro consequences. In particular, gasoline prices will rise back toward $4 per gallon (Chart 4). Retail gasoline prices have already increased by more than 50% since they bottomed in February 2016. So how much more upside can the U.S. private sector take? Table 3History Of Oil Supply Shocks Chart 4A Source Of Pressure For Consumers The Household Sector Consumer confidence is currently near all-time highs, which tends to signal that the path of least resistance is flat or down (Chart 5). Household gasoline consumption has already declined in response to higher oil prices since the middle of 2017. Given that gasoline demand is relatively inelastic, consumers may already be near their minimum consumption level. Chart 5Nearing All-Time Highs Instead, households will experience a decline in their disposable income. This will come on the back of both higher gasoline prices and an increase in the prices of other goods and services, as the oil spike spills across sectors. U.S. households - and most likely those in other markets - are stretched to the limit already. A recent Fed survey found that 40% of U.S. households do not have the funds needed to meet an unexpected $400 cost in any given month.8 Such an unexpected expense would require them to either sell possessions, borrow, or cut back on other purchases. Chart 6Most Americans Cannot Cut Saving To Spend Left with few other options, households would react to their lower disposable income by reducing demand for other goods and services. This dent in consumer spending would bring down aggregate demand, leading to slower employment growth and even less income and spending. Households could save less to maintain their current purchasing levels, given the recent rise in the savings rate (Chart 6). But this is unlikely. Although the household savings rate has increased in recent years, we have previously argued that a material part of the increase was driven by small business-owner profits. These owners have much higher levels of income than the median consumer. For Americans living paycheck-to-paycheck, it would be difficult to reduce a savings rate that is already close to, or below, zero. Higher oil prices will also hurt growth in Europe and Japan, economies that are already struggling to gain economic momentum after grappling with a weaker growth impulse from China. In addition, EM economies that took the opportunity to reform their oil subsidies amid lower oil prices post-2014 will have to grapple with a much larger shock to consumers than usual. The Corporate Sector In theory, what consumers lose from rising oil prices, producers of crude can gain in stronger revenue. This is especially important in the U.S. as domestic energy production has increased significantly over the past 10 years. Nonetheless, the oil and gas extraction sector accounts for just 1.1% of GDP and 0.1% of total employment. The marginal propensity to spend out of every dollar of income is lower for producers than consumers. Moreover, if consumer confidence fell and consumer spending weakened, non-energy capex would decline as businesses reassessed household demand and held off from making investment decisions. Small business confidence is at record highs, and as with consumer confidence, vulnerable to downward revisions (Chart 7). Chart 7Dizzying Heights Chart 8Only One Way To Go (Down) Profit margins remain at a highly elevated level and also have only one way to go (Chart 8). If high oil prices should combine with rising borrowing costs and upward pressure on wages (which could develop in this macro environment) the result would be a triple hit to margins (Chart 9). Of course, rising wages would give consumers some offset to higher oil prices, so the question will be the net effect of all variables. And if the dollar bull market continues, as our FX team believes it will, the combination of higher oil prices and a strong USD would hurt U.S. companies with international exposure. The debt load held by the U.S. corporate sector would turn this bad dream into a nightmare. Many American companies have spent the past 10 years increasing leverage to buy back equity (Chart 10). Companies with high debt would need to revise down their profit expectations, with potentially devastating consequences. Elevated debt levels also increase the likelihood of financial market stress if bond investors get worried and spreads begin to widen significantly. Chart 9Rising Pressures On Earnings? Chart 10Large Corporate Debts According to all measures, U.S. stocks are at or near their all-time valuation peaks. Investors have also priced in a significant amount of optimism for profit growth (Chart 11). These expectations would be subject to quick revision if our oil shock scenario plays out. In other words, investor expectations for profit margins are not sufficiently factoring the triple hit of higher oil prices, higher interest rates, and higher wages. Chart 11The Market Has High Hopes An additional geopolitical risk on the horizon for 2019 is the creeping "stroke of pen" risk from potential regulation of technology enterprises. This is unrelated to an oil price spike (other than that it would be an effect of U.S. policy) but could nonetheless combine with rising energy prices to sour investors' mood.9 Bottom Line: An oil price spike above $100 would produce negative consequences for the U.S. household and corporate sectors. Given the supply-side nature of the price shock, it would not be accompanied by the usual decline in USD, and could therefore hurt the foreign profits of U.S. corporations as well. If investors must also deal with mounting regulatory pressures on FAANG stocks, they could face a perfect storm. Given the high probability of such an oil price shock, why isn't a 2019 recession BCA's House View, rather than merely a risk to it? Because it is difficult to say how high oil prices need to rise to cause a recession. For example, 1973 both marked a permanent move up in oil prices and saw oil prices triple. In 2019 terms, that would mean an oil price above $200, a far less probable scenario than $100-$110. Nevertheless, the combination of elevated oil prices and the price impact on consumer goods of the U.S.-China trade war could combine to create a nightmare scenario for consumers. But it is impossible to gauge the level of both required to push the U.S. into a recession. Second, there are many ways in which today's macro environment is different from that in 1974. In the 1970s the inventory cycle was a key factor in the business cycle, with excesses building up ahead of recessions, forcing output cutbacks as demand weakened. That is no longer the case in today's world of just-in-time inventory management. Also, inflation was a much bigger problem back then, requiring tougher Fed action. On the other hand, debt burdens were much lower. Investment Implications To be clear, none of the usual recession indicators that BCA Research uses are flashing red at this time. The point of this analysis is to illustrate a credible, exogenous scenario that cannot be revealed through the usual data-driven recession forecasting methods. What happens if a recession does occur ahead of the 2020 election? How would President Trump react to a recession induced by his foreign policy adventurism in the Middle East? By doing what every other president would do: finding someone else to blame. In this case, we would put high odds on the Federal Reserve becoming the target of President Trump's fury. Ahead of 2020, the Fed and its independence may very well become an election issue.10 This could spell serious trouble for the Fed, which is at a massive disadvantage when it comes to explaining to voters why central bank independence is so important. The Fed had great difficulty managing public opinion regarding its extraordinary measures to combat the Great Recession - its attempts at public outreach largely failed. Compare the number of Trump's Twitter followers to that of the Fed's (Chart 12). Chart 12The Fed's PR Abilities Are Limited Though most of our clients and colleagues will probably disagree, we do not see central bank independence as a static quality. It was bestowed upon central banks by politicians following widespread inflation fears throughout the 1970s and 1980s, although in the U.S. the current tradition goes back to the 1951 Treasury Accord that restored the independence of the Fed. Our colleague Martin Barnes penned a report on the politicization of monetary policy in 2013.11 His conclusion is that political meddling in monetary affairs is less pernicious than economic performance. The Fed will incur Trump's ire, in other words, but it will be its failure to generate economic growth that causes a break in independence. We are not so sure. The next recession is likely to be a mild one for Main Street given the lack of real economic bubbles. But given the slow recovery in real wages over the past decade and the general angst of the populace towards governing elites, even a mild recession that merely reminds voters of 2008-2009 could produce deep anxiety and significant public reactions. Further, the idea of "independent," non-politically accountable institutions is going out of style. President Trump - and other policymakers in the developed world - have specifically targeted the "so-called experts" and "institutions." President Trump has attacked America's foreign policy architecture, NATO, the WTO, and a slew of supposedly outdated norms and practices for being "out of touch" with the electorate. This policy has served him well thus far. If our nightmare scenario of an oil price-induced recession plays out, the immediate implication for investors will be a sharp downturn in risk assets. As such, we are recommending that investors hedge their portfolios with a long Brent / short S&P 500 trade. Alternatively we would recommend going long U.S. energy / short technology stocks. A longer-term, and perhaps even more pernicious implication, would be the end of the era of central bank independence and a full politicization of the economy. Laissez-faire capitalist system would give way to dirigisme. In the process, the U.S. dollar and Treasuries would be doomed. Jim Mylonas, Global Strategist Daily Insights & BCA Academy jim@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 3 Please see BCA Research Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018 and "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com. 6 The Strategic Petroleum Reserve currently covers 100 days of net crude imports, or 200 days of net petroleum imports, and can be tapped for reasons of political timing as well as international emergencies. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," dated September 13, 2018, available at bcaresearch.com. 8 Please see the U.S. Federal Reserve, "Report on the Economic Well-Being of U.S. Households in 2017," May 2018, available at federalreserve.gov. 9 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com. 10 Please see BCA Daily Insights, "Politics And Monetary Policy," dated August 22, 2018, and "The Battle Of The Press Conferences: Trump Versus Powell," dated September 27, 2018, available at dailyinsights.bcaresearch.com. 11 Please see BCA Special Report, "The Politicization Of Monetary Policy: Should We Care?" dated April 15, 2013, available at bca.bcaresearch.com. Geopolitical Calendar

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot Chart 19The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities Appendix A Chart IIMarket Outlook: Bonds Appendix A Chart IIIMarket Outlook: Currencies Appendix A Chart IVMarket Outlook: Commodities Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The risk of unplanned oil-production outages is rising. One or more such events will severely test OPEC 2.0's spare capacity in a supply-constrained market (Chart of the Week).1 As things now stand, OPEC 2.0 spare capacity - if it is available - and a likely U.S. SPR release of 500k b/d in 1Q19 will not cover expected production losses, if markets are hit with another unplanned outage from Libya or Iraq.2 Demand destruction via higher prices will have to balance markets. Oil markets are tightening (Chart 2). Falling supply and stable demand will produce a 1mm b/d physical deficit into 1H19, forcing continued OECD inventory draws (Chart 3). The dominant scenario in our forecast includes a supply shock arising from lost Iranian and Venezuelan exports, which triggers price-induced demand destruction. We raised the odds of Brent prices hitting $100/bbl by 1Q19, and our 2019 forecast to $95/bbl on the back of these factors. Unplanned outages would lift prices higher. Energy: Overweight. The long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls we recommended last week are up an average 33.8%, as of Tuesday's close. Base Metals: Neutral. Our foreign-exchange strategists expect the USD to correct further. This will be bullish for copper, which is up ~ 10% since Sept. 11. Precious Metals: Neutral. The USD correction will support gold in the short term. Technically, gold appears to be forming a pennant, which could be short-term bullish. Ags/Softs: Underweight. Corn prices are benefiting from strong exports, according to USDA data. Accumulated exports for the current crop year are up 27% vs last year in the week ending Sept. 13. Chart of the WeekUnplanned Oil-Production Outage Risks Up, OPEC 2.0's Spare Capacity Down Chart 2Physical Oil Deficit Returns##BR##To Oil Market Next Year Chart 3Fundamentals Support##BR##Strong Prices Feature Oil markets are approaching a moment of truth. OPEC 2.0's spare capacity likely will be put to the test in 1Q19, as Iranian export volumes continue to fall, and other threats to production - Venezuelan losses, and increasing sectarian tension in Iraq and Libya - come to the fore. As the Chart of the Week demonstrates, spare capacity in the traditional OPEC states is low and falling: The U.S. EIA's most recent estimate of OPEC spare capacity is 1.7mm b/d this year and 1.3mm next year, well below the 2.3mm b/d average of 2008 - 2017. For its part, Russia - the other putative leader of OPEC 2.0 - likely only has ~ 200k b/d of spare capacity to ramp. On a relative basis, OPEC spare capacity is even more stretched: This year, the EIA expects it to average 1.7% of global demand. By next year, it is expected to fall to 1.3%, or ~ 1.3mm b/d. This will be lower than the spare capacity reported for 2008 (1.6%), when OPEC (mostly KSA) found itself struggling to meet surging EM demand, and well below the 2.6% average for 2008 - 2017. Spare capacity is very close to levels last seen in 2016, when low prices resulted in supply destruction. In the wake of the oil-price rout of 2014 - 16, capex collapsed as did maintenance spending needed to keep production steady y/y. This can be seen in the relentless decline in OPEC production ex GCC and the stagnation in other states unable to grow output (Chart 4 and Chart 5). Indeed, as prices hit their nadir in 1Q16, sovereign wealth funds (SWFs) in OPEC and non-OPEC states were being liquidated to cover gaping holes in producers' fiscal accounts. This partly explains the growing incidence of unplanned outages, and our contention OPEC spare-capacity claims are highly suspect (Chart of the Week). Chart 4OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5Outside Of A Very Few Regions, Oil Production Has Struggled U.S. Remains Adamant On Shutting Down Iran's Exports The Trump administration's goal is to reduce Iranian oil exports to zero via the sanctions it will impose beginning November 4 from ~ 2.5mm b/d back in April, when the U.S. sanctions were announced. However, as the EIA data indicates, achieving this goal would leave markets seriously short oil. Indeed, the Washington-based Center for International Strategic Studies (CSIS) noted in late August, "realistically, there is simply not enough readily available spare oil production capacity in the world to replace the loss of all Iranian barrels (some 2.4 mm b/d), coupled with the potential for further reductions in Venezuela, Libya, Nigeria, and elsewhere."3 Our modeling includes 1.25mm b/d of lost Iranian and Venezuelan exports, continued y/y losses in non-core OPEC (Chart 4), constrained U.S. production growth, and stagnate supply growth outside a handful of states able to lift their output (Chart 5). We do not believe OPEC 2.0 spare capacity is sufficient to cover these losses and one or two additional unplanned outages in Iraq or Libya, or anywhere for that matter. In addition, a 500k b/d release of U.S. SPR after the price goes above $90/bbl in 1Q19 will contain the supply shock we expect slightly, but will not completely reverse it. We have long believed KSA's ability to maintain production above 10.5mm b/d for an extended period is suspect, despite its claims it can ramp to its capacity of 12mm b/d.4 We are carrying KSA's current production at 10.4mm b/d in our balances estimates, roughly the level it self-reported to OPEC last month. To be clear, we are not saying KSA's production cannot be increased - perhaps to 10.7mm b/d - but we are dubious it can get to its claimed 12mm b/d capacity, or that it can sustain 10.7mm b/d indefinitely. It is important to note any short-term increase in OPEC 2.0's production will come out of spare capacity available to meet unplanned outages, or deeper-than-expected Venezuelan losses next year. Lastly, unplanned outages in a market already stretched by tighter supply will accelerate the rate of demand destruction via higher prices. This also would accelerate the arrival of a U.S. recession brought about by an oil-price shock, all else equal.5 Iran's Hand Is Strengthening You'd never know it from the declarations of President Trump and U.S. Treasury Secretary Steve Mnuchin - both of whom are adamant in their professed desire to see Iranian oil exports fall to zero - but the U.S. has been attempting to engage Iran in treaty discussions to limit the country's ballistic-missile capabilities and nuclear-development program.6 Not surprisingly, Iranian officials have shown no interest in such discussions. This is a remarkable turn of events, but not unexpected. At some point, it likely became apparent to the Trump administration the global oil markets are on a trajectory for significantly higher prices, as our analysis and forecasts indicate. It also likely is apparent to administration officials that oil prices - and gasoline prices, in particular, which matter most to U.S. voters - will be surging just as the 2020 presidential campaign gets underway next summer. Along with our colleague Marko Papic, who runs BCA's Geopolitical Strategy, we believe that, from a game-theoretic perspective, the approach from the U.S. actually strengthens Iran's hand. Given its history with the previous round of sanctions, and the economic hardships they imposed, the government in Iran likely believes it can ride out 12 to 18 months of renewed sanctions. It is not unrealistic to entertain the possibility Iranian politicians take the bet that sharply higher gasoline prices in the U.S. by 2H19 will give Democrats in U.S. presidential and congressional races - which kick off next summer - a powerful issue with which to campaign against President Trump and the GOP. Bottom Line: There is a non-trivial chance that OPEC 2.0 spare capacity will prove insufficient to cover the losses in Iranian and Venezuelan exports we foresee in the very near term. Should this prove to be the case, the odds that Brent crude oil prices exceed our $95/bbl forecast for next year are high. We believe Iran's political hand could be strengthened, if it rebuffs overtures by the Trump administration to negotiate a treaty to replace the executive agreement with former U.S. president Obama that limited its nuclear program. We recommended getting long Brent call spreads last week to position for the higher prices we are forecasting for next year. Specifically, we recommended getting long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls. As of Tuesday's close, these positions were up 33.8% on average vs their opening levels last Thursday. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Upside Risks Dominate BCA's Oil Price Forecast," published by BCA Research's Commodity & Energy Strategy October 26, 2017, and "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. Both are available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed in November 2016, following the price collapse brought on by OPEC's market-share war launched in November 2014. Please see last week's Commodity & Energy Strategy lead article, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. In that article we note that, in addition to the highly visible export losses in Iran due to U.S. sanctions and continued deterioration in Venezuelan production, the EIA reduced its estimate of U.S. production growth by 201k b/d in 2019, and the IEA reduced its estimate of Brazilian output this year by 260k b/d. 3 Please see "Whither the Oil Market? Headlines and Tariffs and Bears, Oh My..." published by csis.org August 29, 2018. We are closely following a just-proposed workaround to U.S. sanctions on Iranian oil exports made by the High Representative of the EU, Federica Mogherini, at the UN General Assembly meeting in New York on Tuesday. Ms. Mogherini proposed setting up a special-purpose vehicle that would allow importers in the EU, China and Russia to continue purchasing Iranian oil crude. The SPV would transact in euros, yuan, and roubles, so as to avoid processing transactions through the Society for Worldwide Interbank Financial Telecommunication SWIFT system in Brussels. The SWIFT system is dominated by USD transactions, and the U.S. Treasury has high visibility into transactions made using the system, given USD-denominated transaction like oil purchases and sales must ultimately be cleared through a U.S. bank or intermediary. Iran already takes yuan for its oil, and this mechanism would allow it to purchase goods and services denominated in these currencies. If technical details of the proposed system can be worked out, the SPV could facilitate increased Iranian exports under the U.S. sanctions regime. This would cause us to lower our estimate of lost exports from that country from our baseline assumption of 1.25mm b/d. Please see "Why India Will Struggle to Join Iran's Sanctions Busters," published by bloomberg.com on September 26, 2018. 4 We are not the only ones dubious of KSA's ability to ramp production. Please see "Can Saudi Arabia pump much more oil," published by reuters.com July 1, 2018. 5 In our House view, a recession in the U.S. does not arrive until 2H20. We have argued an oil-supply shock, particularly during a Fed tightening cycle, typically presages a recession in the 6 - 18 months following the shock. Please see Commodity & Energy Strategy lead article, "Odds of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. 6 Please see "U.S. seeking to negotiate a treaty with Iran," published September 19, 2018, by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

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