Persian (Gulf)

Bank Credit Analyst

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds Chart 25QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels...   Chart 36A…And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Highlights When we flagged the increasing likelihood of higher volatility a few weeks ago, we did not expect the Trump Administration's granting of waivers on sanctions against Iranian oil exports, which ultimately led to the oil-price meltdown.1 Neither, it seems, did the market, as the surge in Brent and WTI implied volatilities attests (Chart of the Week). Chart of the WeekOil-Price Volatility Surges As Markets Process Conflicting News In one fell swoop, the Trump Administration's volte-face on Iran oil-export sanctions transformed the threat of an oil-price spike to $100/bbl in 1Q19 into a price rout. Whether that persists depends on how OPEC 2.0 responds to sharply higher short-term supply. Our updated supply - demand balances and price forecast are highly conditional on our expectation OPEC 2.0 will reduce output in response to the 1mm+ b/d or so of oil put back into the market early next year because of waivers. Inventories globally are at risk of swelling once again, if OPEC 2.0 does not cut output. OPEC 2.0's interests will conflict with the Trump Administration's agenda. Going into OPEC 2.0's December 6 meeting in Vienna, we lowered our 2019 Brent expectation $82/bbl, and continue to expect WTI to trade $6/bbl below that. We expect volatility to persist. Energy: Overweight. Natgas futures raced above $4.00/MMBtu on the NYMEX as the U.S. heating season kicked off with inventories of 3.2 TCF - 16% below their five-year average, and the lowest since 2005, according to EIA data. Base Metals: Neutral. China's benchmark copper treatment and refining charges are expected to remain on either side of $82.25/MT next year, as concentrate supply tightens slightly, Metal Bulletin's Fastmarkets reported. Precious Metals: Neutral. The Fed is on course to lift the fed funds range 25bp to 2.25% - 2.50% at its December meeting, which will keep gold under pressure. Ags/Softs: Underweight. The USDA's latest ending stocks estimates for the 2018/19 crop year came in below trade expectations for corn and wheat - at 1.74 billion and 949mm bushels, respectively, vs. expectations of 1.78 billion and 969mm, according to agriculture.com. Soybean estimates came in at 955mm vs. an expected 906mm bushels. Feature Brent and WTI crude oil prices air-dropped from a high of $86.10/bbl in early October to a Wednesday low of $65.01/bbl as we went to press. This was a 24% drop in a little more than a month, reflecting the difficulty markets experienced recalibrating supply - demand balances in the wake of the Trump Administration's volte-face on Iranian export sanctions, which took effect last week. Over the past weeks, markets appear to be pricing the return of more than 1mm b/d of Iranian exports in 1Q19, on the back of these waivers for importers of Iranian crude. The full extent of the additional volumes that will be allowed back on the market still is unknown. Lacking certain information, market participants have to assume the waivers will dramatically expand short-term supplies, which already had been boosted by OPEC 2.0 and U.S. producers, in the lead-up to sanctions (Table 1).2 The sell-off on the back of the waivers did, however, dissipate some of the risk premium we identified in prices in October, and brought price more in line with actual balances (Chart 2).3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 2Oil Risk Premium Dissipates Prior to the granting of waivers, markets were girding for sanctions-induced losses of as much as 1.7mm b/d. Now markets could see a far lower supply loss of 500k b/d in Iranian exports. This lower loss of exports from Iran reduced expected prices by $10/bbl in 1H19, vs. our previous expectation of $85/bbl for 1H19 using our ensemble forecast (Chart 3). For market participants hedging or trading based on the expectation of higher losses of Iranian exports, the granting of waivers creates even more "new-found" and unanticipated supply. In a simulation with the waivers extended to end-2019, average 2019 Brent prices fall to $75/bbl vs. $82/bbl using our current assumptions. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 In our estimation, "finding" this much supply via waivers amounts to a supply shock. This was compounded by surging U.S. crude and liquids production, which is boosting oil and product exports from America. Uncertain Balances, Volatile Prices Waivers are not the only factor contributing to price volatility. Fears of weaker global demand come up repeatedly - particularly as regards Asia in general, and China in particular.4 Those fears are not showing up in actual demand. In our balances estimates, we expect demand growth of 1.46mm b/d next year, down slightly from our previous estimate, given realized oil consumption remains strong (Chart 4 and Table 1). Supporting data - e.g., EM import volumes - continue to indicate incomes are holding up. Chart 4Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 On the supply side, references to an apparent disagreement between the Kingdom of Saudi Arabia (KSA) and Russia - the leaders of OPEC 2.0 - over the need to cut 1mm b/d of production next year, to keep inventories from once again swelling as they did in 2014 - 2016, compounding risks.5 While it appears KSA has carried the day on the need to cut production, that could change at OPEC 2.0's December meeting in Vienna. Output from OPEC 2.0's weakest member states - i.e., Libya and Nigeria - remains strong. Even Venezuela's rate of decline slowed some. Therefore, even without the waivers, KSA and its Gulf Arab allies would have had to reduce output to make room for these states, which are desperately trying to rebuild war-torn infrastructure. In addition to the OPEC 2.0 output surge, U.S. production has been unexpectedly strong, as have U.S. crude and refined product exports (Chart 5). The EIA - in an adjustment that surprised its analysts - revised its U.S. production estimate for October by 400k b/d vs. September's estimate to 11.4mm b/d. Production in the Big 4 shale plays - Permian, Eagle Ford, Bakken, Niobrara - is proving to be even stronger as well (Chart 6). U.S. shale output will be just under 8mm b/d by December, months ahead of schedule. The infrastructure buildout in the Permian will no doubt absorb this production and the subsequent growth in shale output by ~1.35mm b/d next year easily. Chart 5U.S. Production, Exports Surge Chart 6U.S. Shale Production Will Surge U.S. producers do not have an interest in managing their production. OPEC 2.0 does, however. We expect KSA and its Gulf Arab allies to reduce production in December and keep it low until the recently formed overhang brought on by the waivers to Iranian sanctions clears. This means OECD inventory levels will once again be a key variable for OPEC 2.0 in its production management decisions (Chart 7). Chart 7Once Again, OECD Stocks Are OPEC 2.0's Policy Variable We assume KSA will mobilize 800k to 1mm b/d of cuts in the coalition's production at least through 1H19. KSA already has said it will reduce exports by 500k b/d in Dec18, and that could be extended to Jun19. We also expect the rest of the Gulf Arab producers to follow suit, and cut back on the production increases they brought on line at President Trump's urging. By 2H19, the waivers will have expired, but U.S. shale output will be surging and newly built pipelines will be filling. We have been carrying lower 2H19 OPEC 2.0, particularly KSA, production estimates in anticipation of this increased production and exports from the U.S. (Table 1). OPEC 2.0 + 1? President Trump apparently wants to continue to have a say in OPEC 2.0's policy deliberations, as he obviously did in the run-up to U.S. mid-term elections earlier this year. In response to persistent messaging from President Trump, KSA, Russia and their allies surged production ~ 750k b/d in July - November over their 1H18 output, in preparation for the U.S. sanctions against Iran. In addition to pushing for higher production, the U.S. has taken a more activist approach to boosting oil production among U.S. allies, possibly ahead of another attempt to impose sanctions on Iran when the current waivers expire next year in June, assuming the 180-day wind-down begins in January. For example, the U.S. has taken a more active role in re-starting exports of oil from Iraq's semi-autonomous Kurdish province - some 400k b/d, which would flow to Turkey and on to Western consumers. Without higher production from Iraq and others in OPEC 2.0, the Iran waivers almost surely will have to be extended when they expire. As we have shown in our research, Brent prices mostly likely would push toward $100/bbl without a substantial increase in spare capacity within OPEC 2.0.6 President Trump gives every impression he and his administration now share our assessment, as the FT noted: "US president Donald Trump said this week he was 'driving' oil prices down and that he had granted waivers to some of Iran's customers as he did not want to see '$100 a barrel or $150 a barrel' crude."7 BCA's Geopolitical Strategy notes the waivers also send two very important messages to KSA: "First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output."8 Forecasting supply-demand fundamentals and, therefore, prices in this environment is extremely difficult, as it involves reconciling conflicting goals between the Trump Administration and OPEC 2.0. If President Trump prevails and KSA increases output - against its own best interests, given it requires higher prices to fund its budget - then prices will be lower for longer, once again. We are inclined to believe President Trump's alarm bells start sounding when oil prices are approaching the $85/bbl level. This also is the price level KSA needs to fund its fiscal obligations. For this reason, we expect KSA and its Gulf allies to reduce output in the near term until the waivers-induced overhang clears. Depending on how quickly they act, this could be done in fairly short order. Bottom Line: Volatility likely will persist as global markets absorb an unexpected supply surge resulting from the Trump Administration's last-minute volte-face on Iranian export sanctions, which is compounded by the supply ramp undertaken by OPEC 2.0 ahead of sanctions being imposed, and surging U.S. production gains. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published on October 25, 2018. It is available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the OPEC - non-OPEC producer coalition formed at the end of the price collapse of 2014 - 16 to get control over global output and bring down swollen crude oil and refined product inventories. The coalition meets December 6 in Vienna to consider formalizing the union as a production-management cartel. 3 Our price-decomposition model's residual term is our proxy for the risk premium in oil prices. This is the red bar in Chart 2. Please see discussion in "Risk Premium In Oil Prices rising; KSA Lifts West Coast Export Capacity," which is cited above. 4 Please see "Asia's weakening economies, record supply threaten to create oil glut," published November 14, 2018, by uk.reuters.com. 5 Please see "OPEC and Russia Prepare for Clash Over Oil Output Cuts," published online by the Wall Street Journal November 9, 2018. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published on September 20, 2018, and "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," published September 27, 2018. Both are available at ces.bcaresearch.com. 7 Please see "Iraq close to deal to restart oil exports from Kirkuk," published by the Financial Times November 9, 2018. 8 Please see BCA Research's Geopolitical Strategy Weekly Report "Insights From The Road - Constraints And Investing," published on November 14, 2018. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights So What? The Trump administration is focusing on re-election in 2020, which could push the recession call into 2021. Why? The midterms were investment-relevant, just not in the way most of our clients thought. We are downgrading our alarmism on Iran; Trump is aware of his constraints. But investor optimism regarding the trade war may be overdone. China has contained its capital outflows, which suggests Beijing will be comfortable with more CNY/USD downside. A new GPS mega-theme: Bifurcated Capitalism! Watch carefully for any upcoming trade action on semiconductors. Feature There is no better feeling than hearing from our clients that we got a call wrong because we misjudged the constraints of the Trump administration by focusing too much on its preferences. Why? Because it means that clients are keeping us honest by employing our most important method: constraints over preferences. This is one of the takeaways from a quarter filled with meetings with our clients in the Midwest, Toronto, Amsterdam, Rotterdam, The Hague, Frankfurt, Berlin, Auckland, Melbourne, Sydney, Dubai, Abu Dhabi, and sunny Marbella, Spain! In this report, we discuss several pieces of insight from our clients. Midterms Are Investment Relevant Generally speaking, few of our clients agreed with our assessment that the midterm elections were not investment-relevant. The further away from the U.S. we traveled, the greater the sense among investors that equity markets influence U.S. politics: both the upcoming takeover of the House of Representatives by the Democratic Party and the odds of trade war intensification. We strongly disagree with this assessment. Both periods of equity market turbulence this year were preceded by a rising U.S. 10-year yield, not any particularly damning trade war chatter (Chart 1). In fact, the intensification of the trade war this summer occurred amidst a fairly buoyant S&P 500! Meanwhile, the odds of a Democratic takeover of the House were priced in well before the October equity decline began. Chart 1Yields, Not Trade, Matter For Stocks Generally speaking, even midterms that produce gridlock have led to a relief rally (Chart 2). This time could be the same, especially because the likely next Speaker of the House, Nancy Pelosi, has signalled that the main policy goal for 2019 would be infrastructure spending. In her "victory" speech following the election, Pelosi mentioned infrastructure numerous times (impeachment, zero times). Chart 2Stocks Are Indifferent To Midterm Results Democratic Representative Peter DeFazio, likely head of the House of Representatives committee overseeing transportation, has already signalled that he will ask for "real money, real investment."1 DeFazio has previously proposed a $500bn infrastructure plan, backed by issuance of 30-year Treasuries and raising fuel taxes. He has rejected the February 2017 Trump proposal, which largely relied on raising private money for the job. Would President Trump go with such a plan? Maybe. In early 2018, he stunned lawmakers by saying that he supported hiking the federal gasoline tax by 25 cents a gallon (the federal 18.4 cent-a-gallon gasoline tax has not been hiked since 1993). He has since confirmed that "everything is on the table" to achieve an infrastructure deal. Several clients from around the world pointed out that both Democrats and President Trump have an incentive to make a deal. President Trump wants to avoid the deeply negative fiscal thrust awaiting him in 2020 (Chart 3). Given the House takeover by the Democrats, it is tough to imagine that new tax cuts are the means for Trump to avoid the "stimulus cliff." As such, another round of stimulative fiscal spending may be the only way for him to avoid a late-2020 recession (although the latter is currently the BCA House View). Chart 3Can Trump And Pelosi Reverse... Democrats, on the other hand, have an incentive to ditch "Resistance" and embrace policy-making. Yes, hastening the recession in 2020 would be the Machiavellian play, but President Trump would be able to blame Democrats for the downturn - since they will necessarily have had to participate in planning an infrastructure bill only to sink it. They also learned the lesson from the January 2018 government shutdown, which backfired at the polls and forced Senate Democrats to come to an agreement quickly on a two-year stimulative budget deal. What about the GOP fiscal conservatives? They don't necessarily need to come on board. The House is held by Democrats. And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given that infrastructure is popular, that the president will be pushing it, and that the GOP-controlled Senate agreed with the budget bill in January, we think that even more Republican Senators can go along with an infrastructure plan. Another big takeaway from the midterms is that the GOP suffered deep losses in the Midwest. President Trump's party lost ten out of twelve races in the region (Table 1). The two most representative contests were the loss of Republican Wisconsin Governor and one-time rising presidential star Scott Walker, and the victory of the left-wing and über-protectionist Democratic Senator Sherrod Brown of Ohio. Table 1Massive Republican Losses Across The Midwest Senator Brown won his contest comfortably by 6.4% in a state that Trump carried by 8.13%. The appeal of Brown to the very blue-collar voters that Trump himself won is obvious. On trade, there is no daylight between the left-wing Brown and President Trump. Meanwhile, Walker, an establishment Republican who built his reputation on busting public-sector unions, could not replicate Trump's success in Wisconsin. Several of our clients suggested that the GOP performance in the Midwest was poor because of the aggressive trade rhetoric. But that makes little sense. Republicans did not run Trump-style populists in the Midwest, to their obvious detriment. Democrats have always claimed to be for "fair trade" rather than "free trade." And we know, empirically, that Trump saw a key swing of turnout in 2016 in these states, largely thanks to his protectionist rhetoric (Chart 4). Chart 4Trump Owes The Midwest The Presidency President Trump cannot take Michigan, Pennsylvania, and Wisconsin lightly. His performance in 2016 was extraordinary, but also tight. The Democrats will win these states if Trump does not grow voter turnout and support, according to demographic projections - and they lost them by less than a percentage point of white voters (Map 1). As such, we think that Democrats will talk tough on trade and try to reclaim their union and blue-collar voters, while President Trump has to double down on an aggressive trade posture towards China. Map 1Can 'White Hype' Work In 2020? Trump's Margins Are Small The midterms are investment relevant after all, but not in the way some might think. The Democratic takeover of the House, and the resultant gridlock, will potentially avert the "stimulus cliff" in 2020. This ought to support short-term inflation expectations and thus allow the Fed to stay-the-course. For markets, this could be unsettling given the correlation between yields and downturns in 2018. For the dollar, this should be supportive. The odds of an infrastructure deal are good, above 50%, with the key risk being a Democratic House focused on impeaching Trump. Such a bill would augur even higher levels of fiscal spending through 2020, possibly prolonging the business cycle, and setting up an even wider budget deficit when the next recession hits (Chart 5). Chart 5Pro-Cyclical Policy Has To Continue Meanwhile, the shellacking in the Midwest ought to embolden the president to go even harder against China on trade. Rather than the upcoming Xi-Trump meeting in Buenos Aires, the key bellwether of this thesis is whether Trump signals afterwards that he will implement the tariff rate hike on January 1, 2019 (and whether he announces a third round of tariffs). Bottom Line: Go long building products and construction material stocks. Stay short China-exposed S&P 500 companies. The 10-year yield may end the year even closer to 3.5% when the market realizes that the odds of an infrastructure deal are higher than previously thought. The political path of least resistance in the U.S. continues to point towards greater profligacy. Trump Is Aware Of His Constraints In The Middle East Throughout 2018, we have flagged U.S.-Iran tensions as the risk for 2019. In early October, we went long Brent / short S&P 500 as a hedge against this risk, a trade that we closed for a 6% gain last week. During our meetings with clients this quarter, however, several astute observers pointed out that in our own analyses we have stressed the geopolitical and political constraints to President Trump. First, we have argued that the original 2015 nuclear deal signed by President Obama had a deep geopolitical logic, allowing the U.S. to pivot to Asia and stare down China by geopolitically deleveraging the U.S. from the Middle East. If President Trump undermined the détente with Iran, he would be opening up a two-front conflict with both China and Iran, diluting his administration's focus and capabilities. Second, we noted that a rise in oil prices could precipitate an early recession and push up gasoline prices in 2019, a probable death knell for any president's re-election prospects. Our clients were right to ask: Why would President Trump face down these constraints, given the high cost that he would incur? We did not have a very good answer to this question. It is difficult to understand President Trump's preferences for raising tensions against Iran beyond the fact that he promised to do so in his campaign, appears to want to undermine all of President Obama's policies, and turned to Iran hawks to head his foreign policy. Are these preferences worth the risk of a recession in 2019? Or worth the risk of triggering yet another military conflict in the Middle East over a country that only 7% of Americans consider is the 'greatest enemy' (Chart 6)? Chart 6Americans Don't Perceive Iran As 'The Greatest Enemy' Given that the administration has offered exemptions to the oil embargo to eight key importers, it now appears that President Trump is well aware of his geopolitical and domestic constraints. The combined imports of Iranian oil by these eight states is ~1.4mm b/d. While we do not have the detail of the volumes that will be allowed under the waivers, it is likely that these Iranian sales will recover some of the ~1mm b/d of exports lost already (Chart 7). Chart 7Waivers Will Restore Iranian Exports For 180 Days What does this mean for investors? On one hand, it means that the risk of oil prices spiking north of $100 per barrel have substantively decreased. On the other hand, however, it also means that the Trump administration agrees with BCA's Commodity & Energy Strategy view that oil markets remain tight and that OPEC 2.0's spare capacity may be a constraint to future production increases. Bottom Line: The risks of an oil-price-shock-induced 2019 recession have fallen. However, oil prices may yet surge in 2019 to the $85-95 level (Brent) on the back of supply risks in Venezuela and Iran, especially if Saudi Arabia and Russia prove unable to expand production much beyond their current levels. Most of our clients in the Middle East shared the skepticism of our commodity strategists that Saudi Arabia would be able to increase production much higher than current levels in 2019. However, the view was not unanimous. Risks Of Saudi Arabia Going Rogue Have Declined Clients in the Middle East were convinced that the murder of journalist Jamal Khashoggi would have no impact on Saudi oil production decisions. However, the insight from the region is that the incident has probably ended the "blank cheque" that the Trump administration initially gave Riyadh on foreign policy. For global investors, this may not have a major impact. But it may have been at least part of the administration's reasoning behind giving embargo exemptions to such a large number of economies. The incident has likely forced Saudi Arabia to adjust its calculus on three issues: Qatar: The Saudi-Qatari split never made much sense in the first place. It was initially endorsed by President Trump, who may not have understood the strategic value of Qatar to the United States. Defense Secretary James Mattis almost immediately responded by reaffirming the U.S. commitment to the Persian Gulf country which hosts one of the most strategic U.S. air bases in the world. Yemen: The U.S. has now openly called on Saudi Arabia to end its military operations in Yemen. We would expect Riyadh to acquiesce to the request. Iran: With the U.S. giving major importers of Iranian oil exemptions, the message is twofold. First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output. Could Saudi Arabia break with the U.S.? Not a chance. The U.S. is the Saudis' security guarantor. As such, it is up to Saudi Arabia to acquiesce to American foreign policy goals, not the other way around. While we think that President Trump ultimately succumbed to geopolitical and political constraints when he decided to take the "phoney war" approach to Iran, he may have been nudged in that direction by Khashoggi's tragic murder. Bottom Line: A major risk for investors in 2019 was that the Trump administration would treat Saudi preferences for a major confrontation with Iran as its own interests. Such a strategy would have destabilized the global oil markets and potentially have unwound the 2015 U.S.-Iran détente that has allowed the U.S. to focus on China. However, the death of Khashoggi has marginally hurt President Trump domestically - given that it makes him look soft on Saudi Arabia, an unpopular stance in the U.S. Moreover, the administration has come to grips with the risks of a dire oil shock should Iran retaliate. The shift in U.S. policy vis-à-vis Saudi Arabia will therefore refocus the Trump administration on its own priorities, not that of its ally in the Middle East. Trade War Is All About CNY/USD In The Short Term... Clients in Australia and New Zealand are the most sophisticated Western investors when it comes to China. The level of macro understanding of the Chinese economy and the markets in these two countries is unparalleled (outside of China itself, of course). We therefore always appreciate the insights we pick up from our clients Down Under. And they are convinced that the massive capital outflow from China has clearly ceased. The flow of Chinese capital into Auckland, Melbourne, and Sydney real estate has definitely slowed, and anecdotal evidence appears to be showing up in the price data (Chart 8). Separately, this intel has been confirmed by clients from British Columbia and California. Chart 8Pacific Rim Home Prices Rolling Over The reality is that China has successfully closed its capital account. How else can we explain that a 4.7% CNY/USD depreciation in 2015 precipitated a $483 billion outflow of forex reserves, whereas a 10.1% depreciation this year has not had a major impact (Chart 9)? Chart 9On Balance, China Is Experiencing Modest Outflows To be fair, forex reserves declined by $34bn in October, but that is still a far cry from the panic in 2015. Our other indicators suggest that the impact on capital seepage is muted this time around, largely due to the official crackdown on various forms of capital outflows: Quarterly data (Chart 10) reflecting the change in foreign exchange reserves minus the sum of the current account balance and FDI, indicate that while net inflows have remained negative, they are still a far cry from 2015 levels. Chart 10Far Cry From 2016 Crisis Import data (Chart 11) no longer show the massive deviation between Chinese national statistics and IMF figures. Imports from Hong Kong (Chart 12), specifically, are now down to normal levels, with the fake invoicing problem having quieted down for now. Chart 11No More Confusion Regarding Imports Chart 12Fake Invoicing Has Been Curbed Growth rate of foreign reserves (Chart 13) is not clearly contracting yet, and has been positive this year. Chart 13Severe FX Reserve Drawdown Has Ended Chinese foreign borrowing (Chart 14) is down from stratospheric levels, which limits the volume of potential outflows. Chart 14China's Foreign Lending Has Eased And the orgy of M&A and investment deals in the U.S. (Chart 15) has ended. Chart 15M&A Deals Have Eased Bottom Line: Anecdotal and official data suggest that capital outflows are in check despite their recent uptick. This could embolden Chinese leaders to continue using CNY/USD depreciation as their primary weapon against President Trump's tariffs, especially if the global backdrop is not collapsing. An increase of the 10% tariff rate to 25% on January 1 could, therefore, precipitate further weakness in the CNY/USD. The announcement of a third round of tariffs covering the remainder of Chinese imports could do the same. This would be negative for global risk assets, particularly EM equities and currencies. ... In the Long Term, Bifurcated Capitalism Our annual pilgrimage to Oceania included our traditional meeting with The Smartest Man In Oceania The Bloke From Down Under.2 He shares our belief that the long-term result of the broader Sino-American geopolitical conflict will be a form of Bifurcated Capitalism. His exact words were that "countries may soon have to choose between being in the Amazon or Alibaba camp," a great real-world implication of our mega-theme. Australian and New Zealand clients are particularly sensitive to the idea that the world may soon be split into spheres of influence because both countries are so high-beta to China, while obviously retaining their membership card in the West. Our suspicion is that both will be fine as they export mainly a high-grade and diversified range of commodities to China. Short of war, it is unlikely that the U.S. will one day demand that New Zealand stop its dairy exports to China, or that Australia stop iron ore and LNG exports. Countries exporting semiconductors to China, on the other hand, could face a choice between enforcing a future embargo or incurring the wrath of their closest military ally. The Bloke From Down Under has pointed out that, given China's dependency on semiconductor technology, a U.S. embargo of this critical tech could be comparable to the U.S. oil embargo against Japan that precipitated the latter's attack on Pearl Harbor. Chart 16China Accounts For 60% Of Global Semiconductor Demand The global semiconductor market reached $354 billion in 2016, with China accounting for 60% of total consumption (Chart 16). Despite the country's insatiable appetite for semiconductors, no Chinese firm is among the world's top 20 makers. This is why Beijing's "Made in China 2025" plan has focused so much on semiconductor capability (Chart 17). The goal is for China to become self-sufficient in semiconductors, gaining 35% share of the global design market. Chart 17China's High-Tech Protectionism A key feature of Bifurcated Capitalism will be impairment of investment in high-tech that has dual-use applications in military. Semiconductors obviously make that list. Another key feature would be investment restrictions in such high-tech sectors, particularly the kind of investments and M&A deals that China has been looking for in the U.S. this decade. Further, clients in California are very concerned about the U.S.'s proposed export controls, which would cut off access to China and wreak havoc on the industry. The Trump administration has already signalled that it will restrict Chinese inbound investment. Congress passed, with a large bipartisan majority, an expanded review system, the Foreign Investment Risk Review Modernization Act (FIRRMA). The law has expanded the purview of the Committee on Foreign Investment in the United States (CFIUS), a secretive interagency panel nominally under control of the Treasury Department that can block inbound investment on national security grounds. CFIUS, at its core, has always been an entity focused on China. While the Treasury Department initially signalled it would take as much as 18 months to adopt the new FIRRMA rules, Secretary Mnuchin has accelerated the process. The procedure now will expand review from only large-stake takeovers to joint ventures and smaller investments by foreigners, particularly in technology deemed critical for national security reasons. This oversight began on November 10 and will allow CFIUS to block foreigners from taking a stake in a business making sensitive technology even if it gives the foreign investors merely a board seat. Countries of "special concern" will inherently receive heightened scrutiny, and a country's history of compliance with U.S. law, as well as cybersecurity and American citizens' privacy, will be considerations. A new interagency process led by the Commerce Department will focus on refurbishing export controls so as to protect "emerging and foundational technologies." Such impediments to capital flows are likely to become endemic and expand beyond the U.S. We may be seeing the first steps in the Bifurcated Capitalism concept that one day comes to dominate the global economy. Entire countries and sectors may become off-limits to Western investors and vice-versa for Chinese market participants. At the very least, companies whose revenue growth is currently slated to come from expansion in overseas markets may see those expectations falter. At its most pessimistic, however, Bifurcated Capitalism may precipitate geopolitical conflict if it denies China or the U.S. critical technology or commodities. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see David Shepardson, "Democrats to push for big infrastructure bill with 'real money' in 2019," Reuters, dated November 7, 2018, available at reuters.com. 2 At the time of publication, the said investor was unable to secure the permission of his wife for the "The Smartest Man" moniker. Geopolitical Calendar

Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Chart 6... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market.   Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms\ Chart 9Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights So What? Donald Trump's reelection depends on the timing of the next recession. Why? The midterm elections will not determine Trump's reelection chances. Rather, the timing of the next recession will. BCA's House View expects it by 2020. Otherwise, President Trump is favored to win. Trump may be downgrading "maximum pressure" on Iran, reducing the risk of a 2019 recession. Trade war with China, gridlock, and budget deficits are the most investment-relevant outcomes of U.S. politics in 2018-20. Feature The preliminary results of the U.S. midterm elections are in, with the Democrats gaining the House and failing to gain the Senate, as expected. Our view remains that the implications for investors are minimal. The policy status quo is now locked in - a gridlocked government is unlikely to produce a major change in economic policy over the next two years. While the election is to some extent a rebuke to Trump, this report argues that he remains the favored candidate for the 2020 presidential election - unless a recession occurs. A Preliminary Look At The Midterms First, the preliminary takeaways from the midterms, as the results come in: The Democrats took the House of Representatives, with a preliminary net gain of 27 seats, resulting in a 51%-plus majority, and this is projected to rise to 34 seats as we go to press Wednesday morning. This is above the average for midterm election gains by the opposition party, especially given that Republicans have held the advantage in electoral districting. Performance in the Midwest, other swing states, and suburban areas poses a threat to Trump and Republicans in 2020. Republicans held the Senate, with a net gain of at least two seats, for a 51%-plus majority. Democrats were defending 10 seats in states that Trump won in 2016. While Democrats did well in the Midwest, these candidates had the advantage of incumbency. On the state level, the Democrats gained a net seven governorships, two of them in key Midwestern states. The gubernatorial races were partly cyclical, as the Republicans had hit a historic high-water mark in governors' seats and were bound to fall back a bit. However, the Democratic victory in Michigan and Wisconsin, key Midwestern Trump states, is a very positive sign for the Democrats, since they were not incumbents in either state and had to unseat incumbent Governor Scott Walker in Wisconsin. (Their victory in Maine could also help them in the electoral college in 2020.) The governors' races also suggest that moderate Democrats are more appealing to voters than activist Democrats. Candidate Andrew Gillum's loss in Florida is a disappointment for the progressive wing of the Democratic Party.1 With the House alone, Democrats will not be able to push major legislation through. In the current partisan environment it will be nigh-impossible to reach the 60 votes needed to end debate in the Senate ("cloture"), and even then House Democrats will face a presidential veto. They will not be able to repeal Trump's tax cuts, re-regulate the economy, abandon the trade wars, resurrect Obamacare, or revive the 2015 Iranian nuclear deal. Like the Republicans after 2010, they will be trapped in the position of controlling only one half of one of the three constitutional branches. The most they can do is hold hearings and bring forth witnesses in an attempt to tarnish Trump's 2020 reelection chances. They may eventually bring impeachment articles against him, but without two-thirds of the Senate they cannot remove him from office (unless the GOP grassroots abandons him, giving senators permission to do so). U.S. equities generally move upward after midterm elections - including midterms that produce gridlock (Chart 1A & Chart 1B). However, the October selloff could drag into November. More worryingly, as Chart 1B shows, the post-election rally tends to peter out only six months after a gridlock midterm, unlike midterms that reinforce the ruling party. Chart 1AMidterm U.S. Elections Tend To Be Bullish... Chart 1B... But Markets Lose Steam Six Months Post-Gridlock However, the 2018 midterms could be mildly positive for the markets, as they do not portend any major new policies or uncertainty. Trump's proposed additional tax cuts would have threatened higher inflation and more Fed rate hikes, whereas House Democrats will not be able to raise taxes or cut spending alone. Bipartisan entitlement reform seems unlikely in 2018-20 given the acrimony of the two parties and structural factors such as inequality and populism. An outstanding question is health care, which Republicans left unresolved after failing to repeal Obamacare, and which exit polls show was a driving factor behind Democratic victories. Separately, as an additional marginal positive for risk assets, the Trump administration has reportedly granted eight waivers to countries that import Iranian oil. We have signaled that Trump's "maximum pressure" doctrine poses a key risk for markets due to the danger of an Iran-induced oil price shock. A shift toward more lax enforcement reduces the tail-risk of a recession in 2019 (Chart 2). Of course, the waivers will expire in 180 days and may be a mere ploy to ensure smooth markets ahead of the midterm election, so the jury is still out on this issue. Chart 2Rapid Increases In Oil Prices Tend To Precede Recessions This brings us to the main focus of this report: what do the midterms suggest about the 2020 election? Bottom Line: The midterm elections have produced a gridlocked Congress. Trump can continue with his foreign policy, most of his trade policy, his deregulatory decrees, and his appointment of court judges with limited interference from House Democrats. The only thing the Democrats can prevent him from doing is cutting taxes further. He tends to agree with Democrats on the need for more spending! While the U.S. market could rally on the back of this result, we do not see U.S. politics being a critical catalyst for markets going forward. On balance, a gridlocked result brings less uncertainty than would otherwise be the case, which is positive for markets in the short term. The Midterms And The 2020 Election There is a weak relationship at best between an opposition party's gains in the midterms and its performance in the presidential election two years later. Given that the president's party almost always loses the midterms - and yet that incumbent presidents tend to be reelected - the midterm has little diagnostic value for the presidential vote, as can be seen in recent elections (Chart 3A & Chart 3B). Chart 3AMidterm Has Little Predictive Power For Presidential Popular Vote ... Chart 3B... Nor For Presidential Electoral College Vote Nevertheless, historian Allan Lichtman has shown that since 1860, a midterm loss is marginally negative for a president's reelection chances.2 And for Republicans in recent years, losses in midterm elections are very weakly correlated with Republican losses of seats in the electoral college two years later (Chart 4). Chart 4Republican Midterm Loss Could Foreshadow Electoral College Losses Still, this midterm election does not give any reason to believe that Trump's reelection chances have been damaged any more than Ronald Reagan's were after 1982, or Bill Clinton's after 1994, or Barack Obama's after 2010. All three of these presidents went on to a second term. A midterm loss simply does not stack the odds against reelection. Why are midterm elections of limited consequence for the president? They are fundamentally different from presidential elections. For instance, "the buck stops here" applies to the president alone, whereas in the midterms voters often seek to keep the president in check by voting against his party in Congress.3 Despite the consensus media narrative, the president is not that unpopular. Trump's approval rating today is about the same as that of Clinton and Obama at this stage in their first term (Chart 5). This week's midterm was not a wave of "resistance" to Trump so much as a run-of-the-mill midterm in which the president's party lost seats. Its outcome should not be overstated. Bottom Line: There is not much correlation between midterms and presidential elections. The best historians view it as a marginal negative for the incumbent. This result is not a mortal wound for Trump. Chart 5President Trump Is Hardly Losing The Popularity Contest 2020: The Recession Call Is The Election Call The incumbent party has lost the White House every single time that a recession occurred during the campaign proper (Chart 6).4 The incumbent party has lost 50%-60% of the time if recession occurred in the calendar year before the election or in the first half of the election year. Chart 6A 2020 Recession Is Trump's Biggest Threat This is a problem for President Trump because the current economic expansion is long in the tooth. In July 2019, it will become the longest running economic expansion in U.S. history, following the 1991-2001 expansion. The 2020 election will occur sixteen months after the record is broken, which means that averting a recession over this entire period will be remarkable. BCA's House View holds that 2020 is the most likely year for a recession to occur. The economy is at full employment, inflation is trending upwards, and the Fed's interest rate hikes will become restrictive sometime in 2019. The yield curve could invert in the second half of 2019 - and inversion tends to precede recession by anywhere from 5-to-16 months (Table 1). No wonder Trump has called the Fed his "biggest threat."5 Table 1Inverted Yield Curve Is An Ominous Sign The risks to this 2020 recession call are probably skewed toward 2021 instead of 2019. The still-positive U.S. fiscal thrust in 2019 and possibly 2020 and the Trump administration's newly flexible approach to Iran sanctions, if maintained, reduce the tail-risk of a recession in 2019. If there is not a recession by 2020, Trump is the favored candidate to win. First, incumbents win 69% of all U.S. presidential elections. Second, incumbents win 80% of the time when the economy is not in recession, and 76% of the time when real annual per capita GDP growth over the course of the term exceeds the average of the previous two terms, which will likely be the case in 2020 unless there is a recession (Chart 7). Chart 7Relative Economic Performance Could Give Trump Firepower The above probabilities are drawn from the aforementioned Professor Allan Lichtman, at American University in Washington D.C., who has accurately predicted the outcome of every presidential election since 1984 (except the disputed 2000 election). Lichtman views presidential elections as a referendum on the party that controls the White House. He presents "13 Keys to the Presidency," which are true or false statements based on historically derived indicators of presidential performance. If six or more of the 13 keys are false, the incumbent will lose. On our own reading of Lichtman's keys, Trump is currently lined up to lose a maximum of four keys - two shy of the six needed to unseat him (Table 2). This is a generous reading for the Democrats: Trump's party has lost seats in the midterm election relative to 2014; his term has seen sustained social unrest; he is tainted by major scandal; and he is lacking in charisma. Yet on a stricter reading Trump only has one key against him (the midterm). Table 2Lichtman's Thirteen Keys To The White House* What would it take to push Trump over the edge? Aside from a recession (which would trigger one or both of the economic keys against him), he would need to see two-to-four of the following factors take shape: a serious foreign policy or military failure, a charismatic Democratic opponent in 2020, a significant challenge to his nomination within the Republican Party, or a robust third party candidacy emerge. In our view, none of these developments are on the horizon yet, though they are probable enough. For instance, it is easy to see Trump's audacious foreign policy on China, Iran, and North Korea leading to a failure that counts against him. Thus, as things currently stand, Trump is the candidate to beat as long as the economy holds up. What about impeachment and removal from office prior to 2020? As long as Trump remains popular among Republican voters he will prevent the Senate from turning against him (Chart 8). What could cause public opinion to change? Clear, irrefutable, accessible, "smoking gun" evidence of personal wrongdoing that affected Trump's campaigns or duties in office. Nixon was not brought down until the Watergate tapes became public - and that required a Supreme Court order. Only then did Republican opinion turn against him and expose him to impeachment and removal - prompting him to resign. Chart 8Trump Cannot Be Removed From Office All that being said, Trump tends to trail his likeliest 2020 adversaries in one-on-one opinion polling. Given our recession call, we would not dispute online betting markets giving Trump a less-than-50% chance of reelection at present (Chart 9). The Democratic selection process has hardly begun: e.g. Joe Biden could have health problems, and Michelle Obama, Oprah Winfrey, or other surprise candidates could decide to run. The world will be a different place in 2020. Bottom Line: The recession call is the election call. If BCA is right about a recession by 2020, then Trump will lose. If we are wrong, then Trump is favored to win. Chart 9A Strong Opponent Has Yet To Emerge Is It Even Possible For Trump To Win Again? Election Scenarios Is it demographically possible for Trump to win? Yes. In 2016 BCA dubbed Trump's electoral strategy "White Hype," based on his apparent attempt to increase the support and turnout of white voters, primarily in "Rust Belt" battleground states. While Republican policy wonks might have envisioned a "big tent" Republican Party for the future, demographic trends in 2016 suggested that this strategy was premature. Indeed, drawing from a major demographic study by the Center for American Progress and other Washington think tanks,6 we found that a big increase in white turnout and support was the only 2016 election scenario in which a victory in both the popular vote and electoral college vote was possible. In other words, while "Minority Outreach" have worked as a GOP strategy in the future, Donald Trump's team was mathematically correct in realizing that only White Hype would work in the actual election at hand. This strategy did not win Trump the popular vote, but it did secure him the requisite electoral college seats, notably from the formerly blue of Wisconsin, Michigan, and Pennsylvania. Comparing the 2016 results with our pre-election projections confirms this point: Trump won the very swing states where he increased white GOP support and lost the swing states where he did not. Pennsylvania is the notable exception, but he won there by increasing white turnout instead of white GOP support.7 Can Trump do this again? Yes, but not easily. Map 1 depicts the 2016 election results with red and blue states, plus the percentage swing in white party support that would have been necessary to turn the state to the opposite party (white support for the GOP is the independent variable). In Michigan, a 0.3% shift in the white vote away from Republicans would have deprived Trump of victory; in Wisconsin and Pennsylvania, a 0.8% shift would have done the same; in Florida, a 1.5% change would have done so. Map 1The 'White Hype' Strategy Narrowly Worked In 2016 Critically, the country's demographics have changed significantly since 2016 - to Trump's detriment. The white eligible voting population in swing states will have fallen sharply from 81% of the population to 76% of the population by 2020 (Chart 10). Chart 10Demographic Shift Does Not Favor Trump Thus, to determine whether Trump still has a pathway to victory, we looked at eight scenarios, drawing on the updated Center for American Progress study. The assumptions behind the scenarios in Table 3 are as follows: Status Quo - This replicates the 2016 result and projects it forward with 2020 demographics. 2016 Sans Third Party - Replicates the 2016 result but normalizes the third party vote, which was elevated that year. Minority Revolt - In this scenario, Hispanics, Asians, and other minorities turn out in large numbers to support Democrats, even with white non-college educated voters supporting Republicans at a decent rate. The Kanye West Strategy - Trump performs a miracle and generates a swing of minority voters in favor of Republicans. Blue Collar Democrats - White non-college-educated support returns to 2012 norms, meaning back to Democrats. Romney's Ghost - White college-educated support returns to 2012 levels. White Hype - White non-college-educated support swings to Republicans. Obama versus Trump - White college-educated voters ally with minorities in opposition to a surge in white non-college-educated voters for Republicans. Table 3Assumptions For Key Electoral Scenarios In 2020 The results show that Trump's best chance at remaining in the White House is still White Hype, as it is still the only scenario in which Trump can statistically win a victory in the popular vote (Chart 11). Another pathway to victory is the "2016 Sans Third Party" scenario. But this scenario still calls for White Hype, since a third party challenger is out of his hands (Chart 12).8 Chart 11'White Hype' May Be Only Way To Secure Both Popular And Electoral College Vote...   Chart 12... Although Moving To The Center Could Still Yield Electoral College Vote However, the data show that Trump cannot win merely by replicating his white turnout and support from 2016, due to demographic changes wiping away the thin margins in key swing states. He needs some additional increases in support. These increases will ultimately have to be culled from his record in office - which reinforces the all-important question of the timing of recession, but also raises the question of whether Trump will move to the center to woo the median voter. In the "Kanye West" and "Romney's Ghost" scenarios, Trump wins the electoral college by broadening his appeal to minorities and college-educated white voters. This may sound far-fetched, but President Clinton reinvented himself after the "Republican Revolution" of 1994 by compromising with Republicans in Congress. The slim margins in the Midwest suggest that the probability of Trump shifting to the middle is not as low as one might think. Especially if there is no recession. Independents remain the largest voting block - and they have not lost much steam, if any, since 2016. Moreover, the number of independents who lean Republican is in an uptrend (Chart 13). Without a recession, or a failure on Lichtman's keys, Trump will likely broaden his base. Chart 13Trump Shows Promise Among Independents Bottom Line: Trump needs to increase white turnout and GOP support beyond 2016 levels in order to win 2020. Demographics will not allow a simple repeat of his 2016 performance. However, he may be able to generate the requisite turnout and support by moving to the center, courting college-educated whites and even minorities. His success will depend on his record in office. Investment Implications What are the implications of the above findings for 2018-20 and beyond? The Rust Belt states of Michigan, Pennsylvania, and Wisconsin will become pseudo-apocalyptic battlegrounds in 2020. The Democrats must aim to take back all three to win the White House, as they cannot win with just two alone.9 They are likely to focus on these states because they are erstwhile blue states and the vote margin is so slim that the slightest factors could shift the balance - meaning that Democrats could win here without a general pro-Democratic shift in opinion that hurts Trump in other key swing states such as Florida, North Carolina, or Arizona. The "Blue Collar Democrat" scenario, for instance, merely requires that white non-college-educated voters return to their 2012 level of support for Democrats. Joe Biden is the logical candidate, health permitting, as he is from Pennsylvania and was literally on the ballot in 2012! Moreover, these states are the easiest to flip to the Democratic side via the woman vote. In Michigan, a 0.5% swing of women to the Democrats would have turned the state blue again; in Pennsylvania that number is 1.6% and in Wisconsin it is 1.7% (Table 4). These are the lowest of any state. Women from the Midwest or with a base in the Midwest - such as Michelle Obama or Oprah Winfrey - would also be logical candidates. Table 4Women Voters May Hold The Balance The Democrats could also pursue a separate or complementary strategy by courting African American turnout and support, especially in Florida, Georgia, and North Carolina. But it is more difficult to flip these states than the Midwestern ones. With the Rust Belt as the fulcrum of his electoral strategy and reelection, Trump has a major incentive to maintain economic nationalism over the coming two years. Trump may be more pragmatic in the use of tariffs, and will certainly engage in talks with China and others, but he ultimately must remain "tough" on trade. He has fewer constraints in pursuing trade war with China than with Europe. For the same Rust Belt reason, the Democrats, if they get into the Oval Office, will not be overly kind to the "butchers of Beijing," as President Clinton called the Chinese leadership in the 1992 presidential campaign (after the 1989 Tiananmen Square incident). Hence we are structurally bearish U.S.-China relations and related assets. Interestingly, if Trump moves to the middle, and tones down "white nationalism" in pursuit of college-educated whites and minorities, then he would have an incentive to dampen the flames of social division ahead of 2020. The key is that in an environment without recession, Trump has the option of courting voters on the basis of his economic and policy performance alone. Whereas if he is seen fanning social divisions, it could backfire, as Democrats could benefit from a sense of national crisis and instability in a presidential election. Either way, culture wars, controversial rhetoric, identity politics, unrest, and violence will continue in the United States as the fringes of the political spectrum use identity politics and wedge issues to rile up voters.The question is how the leading parties and their candidates handle it. What about after 2020? Are there any conclusions that can be drawn regardless of which party controls the White House? The two biggest policy certainties are that fiscal spending will go up and that generational conflict will rise. On fiscal spending, Trump was a game changer by removing fiscal hawkishness from the Republican agenda. Democrats are not proposing fiscal responsibility either. The most likely areas of bipartisan legislation in 2018-20 are health care and infrastructure - returning House Speaker Nancy Pelosi mentioned infrastructure several times in her election-night speech - which would add to the deficit. The deficit is already set to widen sharply, judging by the fact that it has been widening at a time when unemployment is falling. This aberration has only occurred during the economic boom of the 1950s and the inflation and subsequent stagflation beginning in the late 1960s (Chart 14). The current outlook implies a return of the stagflationary scenario. In the late 1960s, the World War I generation was retiring, lifting the dependent-to-worker ratio and increasing consumption relative to savings. Today, as Peter Berezin of BCA's Global Investment Strategy has shown, the Baby Boomers are retiring with a similar impact. Chart 14The Deficit Is Blowing Out Even Without A Recession Trump made an appeal to elderly voters in the midterms by warning that unfettered immigration and Democratic entitlement expansions would take away from existing senior benefits. By contrast, Democrats will argue that Republicans want to cut benefits for all to pay for tax cuts for the rich, and will try to activate Millennial voters on a range of progressive issues that antagonize older voters. The result is that policy debates will focus more on generational differences. Mammoth budget deficits - not to mention trade war - will be good for inflation, good for gold, and a headwind for U.S. government bonds and the USD as long as the environment is not recessionary. The greatest policy uncertainties are health care and immigration. These are the two major outstanding policy issues that Republicans and Democrats will vie over in 2018 and beyond. While President Trump could achieve something with the Democrats on either of these issues with some painful compromises, it is too soon to have a high conviction on the outcome. But assuming that over the coming years some immigration restrictions come into play and that some kind of public health care option becomes more widely available, there are two more reasons to expect inflation to trend upward on a secular basis. Also on a secular basis, defense stocks stand to benefit from geopolitical multipolarity, especially U.S.-China antagonism. Tech stocks stand to suffer due to the trade war and an increasingly bipartisan consensus that this sector needs to be regulated.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   1 Furthermore, victories on the state level, if built upon in the 2020 election, could give the Democrats an advantage in gerrymandering, i.e. electoral redistricting, which is an important political process in the United States. 2 Please see Allan J. Lichtman, Predicting The Next President: The Keys To The White House 2016 (New York: Rowman and Littlefield, 2016). 3 Please see Joseph Bafumi, Robert S. Erikson, and Christopher Wlezien, "Balancing, Generic Polls and Midterm Congressional Elections," The Journal of Politics 72:3 (2010), pp. 705-19. 4 Please see footnote 2 above. 5 Please see Sylvan Lane, “Trump says Fed is his ‘biggest threat,’ blasting own appointees,” The Hill, October 16, 2018, available at thehill.com. 6 Please see Rob Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, dated April 14, 2018, available at www.americanprogress.org. 7 In several cases, he did not have to lift white support by as much as we projected because minority support for the Democrats dropped off after Obama left the stage. 8 Interestingly, however, this scenario would result in an electoral college tie! Since the House would then vote on a state delegation basis, it would likely hand Trump the victory (and Pence would also win the Senate). 9 However, if they win Pennsylvania plus one electoral vote in Maine, they can win the electoral college with either Michigan or Wisconsin.

Mounting supply-side uncertainty will keep the risk premium in oil prices - and volatility - elevated after U.S. export sanctions against Iran kick in November 4 (Chart of the Week). Chart of the WeekOil-Price Risk Premium Will Continue To Increase These sanctions likely will remove 1.0 - 1.5mm b/d of Iranian exports, and absorb the combined spare capacity of the Kingdom of Saudi Arabia (KSA) and Russia (Chart 2) in the process. Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put the supply-side risks sharply in focus. Chart 2Lost Iranian Exports Could Exceed KSA's and Russia's Spare Capacity OPEC 2.0's production increases last month calmed markets.1 All the same, it is worth noting they occurred just before a widely expected U.S. Strategic Petroleum Reserve (SPR) release coinciding with refinery turnarounds, and one-off Asian demand shocks. On the back of these supply boosts, and an upward revision to U.S. shale output (see below), and a slight decrease in our expected demand growth next year, we lowered our 2019 Brent forecast to $92/bbl from $95/bbl. We now expect Brent prices to peak in April 2019. WTI will trade $6/bbl lower (Chart 3). Our forecasts are conditioned on Iranian export losses of 1.25mm b/d, and Venezuelan losses of just over 450k b/d. A loss of 1.7mm+ b/d of Iran exports, as Platts Analytics expects, or a Venezuela collapse, means an unplanned outage anywhere will take prices above $100/bbl. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 Highlights Energy: Overweight. The IMF downgraded global GDP growth expectations from 3.9% to 3.7% p.a. this year and next. This reduced our base case demand growth for 2019 slightly, to 1.5mm b/d from 1.6mm b/d previously. Base Metals: Neutral. Global copper stocks stand at half their late April peak - the lowest level since late 2016, on the back of restrictions on Chinese scrap imports. Precious Metals: Neutral. Palladium traded to record levels above $1,140/oz this week, as persistent physical deficits into 2020 are priced into the market. Ags/Softs: Underweight. The USDA's Crop Progress Report showed soybean harvests accelerating: 53% of the crop was harvested as of last week, below the 2013 - 17 average of 69%, but well above the previous week's 38% level. Feature U.S. Treasury Secretary Steve Mnuchin is convinced global oil markets have fully priced in the loss of Iranian crude oil exports arising from the re-imposition of export sanctions by the U.S. November 4. Speaking with Reuters over the weekend, he said, "Oil prices have already gone up, so my expectation is that the oil market has anticipated what's going on in the reductions. I believe the information is already reflected in the price of oil."2 We are not so sure. The price-decomposition model shown in the Chart of the Week is a bottom-up fundamental model that assesses how changes in OPEC and non-OPEC supplies, global demand and inventories contribute to overall price changes, as new information becomes available regarding these variables. These variables are shown in Chart 4 and Table 1.3 Chart 4BCA Global Oil Supply-Demand Balances The "residual" term in the model covers everything not explained by these fundamental variables.4 We believe the unexplained effect on prices in the residuals reflects market participants' perception of riskiness - either to supply or demand - given the big fundamental drivers of price are accounted for in the other variables. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) Close inspection reveals the residual term has been increasing as we approach the deadline for the re-imposition of U.S. sanctions on Iran. And the fact is, estimates of the loss in Iranian exports are widely dispersed - from less than 1mm b/d to 1.7mm b/d by tanker trackers like Platts Analytics. As Chart 2 shows, export losses at the high end of this range would absorb almost all of the world's spare capacity - the 1.3mm b/d the U.S. EIA estimates for OPEC (most of it held by KSA, plus whatever other Gulf Arab producers can muster). Russia, which is producing at a record of ~ 11.4mm b/d, likely has ~ 250k b/d of spare capacity at its disposal. With the increase in global demand largely being covered by U.S. shales, which are constrained to ~ 1.3mm b/d of growth p.a. until 2H19, when we expect production to increase at a 1.44mm b/d annual rate, this leaves the global market perilously exposed to any and all unplanned production outages. Any deterioration in Venezuela's production, which we expect to fall to 865k b/d on average in 2019 (versus 1.3mm b/d on average this year), or an unplanned loss in exports from historically unstable states like Nigeria and Libya - where we raised our production estimates to 1.75mm b/d and 1.05mm b/d in line with OPEC survey data - almost surely will spike prices above $100/bbl.5 OPEC 2.0 Got Lucky OPEC 2.0 - the producer coalition led by KSA and Russia - picked a fortuitous moment to increase production this past month. OPEC, led by KSA, lifted crude and liquids production 140k b/d in September, while Russia's production rose 150k b/d. It is worth noting these output increases occurred just before a widely expected U.S. SPR release in October - November, which overlapped with refinery maintenance (turnaround) season in the U.S. Midwest refiners were expected to take 300k to 460k b/d of capacity offline in September and October, a relatively high level of maintenance, while Gulf Coast refiners were expected to take 430k to 535k b/d down.6 Both events raise the supply of crude relative to demand, and reduce inventory drawdowns. In addition, one-off Asian demand shocks - an earthquake and typhoon in Japan - dented demand. KSA lifted its production to 10.5mm b/d in September, bringing average 3Q18 production to 10.4mm b/d versus a bit more than 10mm b/d in 1H18. Russia's crude and liquids output rose to 11.45mm b/d in 3Q18 versus 11.2mm b/d in 1H18. The higher production calmed markets somewhat. OPEC 2.0 effectively got a two-month assist from the U.S. refinery turnarounds and a U.S. SPR release, just as markets were fretting prices would breach $90/bbl earlier this month.7 These production boosts will allow OECD inventories to rebuild somewhat going in to the Northern Hemisphere's winter (Chart 5). Nonetheless, OPEC 2.0 has begun tearing into spare capacity with these output increases. Chart 5OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild KSA Talks Markets Lower... While the U.S. SPR release and inventory builds associated with U.S. turnarounds progressed, KSA's Energy Minister Khalid al-Falih was reassuring markets the Kingdom can ramp production to 11mm b/d, and even 12mm b/d if needs be. KSA has been increasing rig counts in 2H18 as Brent prices rise, but we remain highly dubious KSA can ramp production to 11mm b/d - let alone 12mm b/d - and sustain it for any meaningful length of time (Chart 6). Chart 6KSA Increasing Rig Counts, After Price-Induced Slowdown The likelihood KSA can significantly boost production before the end of 1H19 became even more doubtful, following reports the Kingdom and Kuwait were having difficulty agreeing on restarting Neutral Zone production. We've downgraded our assessment that 350k b/d of Neutral Zone production will be returned to the market beginning in 2Q19 to a 50% likelihood, following reports KSA and Kuwaiti officials are diverging on operational control of the production. Apparently, the two states also differ on geopolitical issues in the Gulf, as well - e.g., the Qatar blockade lead by KSA, and Iran policy.8 While core Gulf Arab producers are raising output, we expect the non-Gulf members of the Cartel continue to see output decline (Chart 7). Indeed, with the exception of the core OPEC Gulf Arab producers, U.S. shale operators and Russia, the rest of the world is barely keeping its output level (Chart 8). Chart 7Non-Gulf OPEC Output Continues to Decline Chart 8Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia ...And Shores Up Export Capacity Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put global supply-side risks sharply in focus. KSA has added 3 mm b/d of oil export capacity to the Red Sea coast of the Kingdom, with an upgrade to its Yanbu crude oil terminal. Prior to the expansion, Yanbu terminal's export capacity was 1.3mm b/d; it was used mainly for refined products and petrochemicals shipments, due to its relative proximity to refineries in Yanbu, Rabigh, Yasref, Jeddah and Jazan. Shipping via the Red Sea port allows KSA to move crude to Asia through the Bab el-Mandeb Strait to the south, which at times is threatened by Yemen's Houthi militia, and the north to Western markets through the Suez Canal. In addition, KSA's national oil company, Aramco, says it intends to restore operations at al-Muajjiz crude oil terminal, which has been out of operation since Iraq's invasion of Kuwait in 1990. Aramco intends to integrate the Muajjiz terminal into the Yanbu facilities to expand Red Sea export capacity from ~ 8 mm b/d to some 11.5 mm b/d. KSA's total export capacity is scheduled to reach 15mm b/d by year-end. These expansions give KSA the option to reroute all of its ~ 7mm b/d exports through the Red Sea, in the event the Strait of Hormuz is closed by Iran. However, this option could be limited by pipeline infrastructure. The current capacity of the East - West crude pipeline is 5mm b/d, although Aramco signalled its intention to boost capacity to 7mm b/d by end-2018. No announcements indicating this was on schedule or completed could be found. Global Demand Holds Up The IMF downgraded its global GDP growth expectation from 3.9% p.a. to 3.7% this year and next. This reduced our base case demand growth for 2019 to 1.5mm b/d from 1.6mm b/d. Even so, we note that oil prices for EM consumers in local-currency terms are at or close to post-GFC highs (Charts 9A and9B). A number of EM governments relaxed or removed subsidies on fuel prices following the oil-price collapse of 2014 - 16, which means consumers in these states are feeling most or all of the effect of higher prices directly for the first time in the modern era (beginning in the 1960s, when OPEC became the dominant producer cartel in the market).9 Chart 9ALocal-Currency Cost Of Oil In Select EM Economies Chart 9BLocal-Currency Cost Of Oil In Select EM Economies As we've noted previously, high fuel costs (in local-currency terms) coupled with high absolute prices deliver a double-whammy to EM consumers, which are the driving force in global oil-demand growth. In fact, 1.1mm b/d of the 1.5mm b/d of demand growth we expect next year in our base case is accounted for by EM growth. In our scenarios analysis, we assume every $10/bbl jump in prices above $90/bbl destroys 100k b/d of EM demand. This lowers the unconstrained oil-price trajectory, and reduces our base case growth estimate of 1.5mm b/d next year to 1.3mm b/d (Chart 10). Chart 10An Oil-Supply Shock Would Lower Demand An oil-supply shock that seriously erodes EM demand would - in the course of months, we believe - translate into a disinflationary impulse into DM markets. This could force the Fed to change course and dial its rates-normalization policy back, as we recently noted.10 Bottom Line: Volatility will remain elevated following the re-imposition of sanctions against Iran's oil exports next month. OPEC 2.0's fortuitously timed production increases - coincident with a scheduled U.S. SPR release and refinery turnarounds - will be absorbed by markets once turnaround season ends in the U.S. Global spare capacity is insufficient to cover Iranian export losses at the high end of market expectations, if Venezuelan production falls more than expected or that state collapses. Any unplanned outage anywhere will quickly push prices through $100/bbl, necessitating further U.S. SPR releases. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by KSA and Russia. This coalition likely will be formalized at the December 7 OPEC meeting in Vienna via treaty. This has been alluded to over the past year, most recently in an interview given to Tass, the Russian state-owned news agency. Please see "Saudi energy minister Al-Falih speaks to TASS on OPEC+, oil prices and Khashoggi," published by TASS, October 22, 2018. 2 Please see "Mnuchin says it will be harder for Iran oil importers to get waivers," published by uk.reuters.com October 21, 2018. 3 The Federal Reserve Bank of New York publishes a similar price-decomposition model weekly in its "Oil Price Dynamics Report," which is available online. 4 We can assume USD effects will be reflected in demand and supply at the margin - i.e., a stronger USD reduces demand by raising the local-currency costs of oil, and increases supply by lowering the local-currency costs of production, and vice versa. Uncertainty as to the USD's trajectory adds to overall uncertainty in the model. 5 This likely would trigger withdrawals from the U.S. SPR, or the EU's strategic petroleum reserves, but that will take time to implement. Both Libya and Nigeria likely will hold elections next year: Nigeria in February, Libya possibly on December 10, but more likely next year following passage of a UN resolution to extend the mandate of its political mission there to September 15, 2019. Civil unrest in Libya has been increasing, as ISIS fighters increase the tempo of operations on the ground. 6 Please see "Falling into refiner Turnaround Season & Maintenance outlook," published by Genscape August 23, 2018. 7 This occurs at a fortuitous time in the U.S. election cycle, as mid-terms will be held November 6, two days after Iran sanctions kick in. We expected an SPR draw ahead of midterms; please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018. It is available at: ces.bcaresearch.com. 8 Please see "Oil output from Saudi, Kuwait shared zone on hold as relations sour," published by uk.reuters.com October 18, 2018. 9 The U.S. Federal Reserve is in the process of a rates-normalization cycle, which likely will keep the USD appreciating against EM currencies into next year. Our House view calls for five additional hikes between December and the end of 2019. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018, for further discussion. ces.bcaresearch.com. 10 We discuss this at length in a Special Report published last week with BCA Research's entitled "Man Bites Dog: Could Sharply Rising Oil Prices Lead To Lower Global Bond Yields in 2019?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017 Summary Of Trades Closed In 2017

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 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

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Chart 4... Even Those That Produce Gridlock What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Chart 5B...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Chart 9Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling Chart 15Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Chart 20 Geopolitical Calendar