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Special Report

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

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

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights This past week, oil ministers from the Kingdom of Saudi Arabia (KSA) and Russia - OPEC 2.0's putative leaders - separately indicated increased comfort with higher prices over the next year or so.1 This suggests they are converging on a common production-management strategy, which accommodates KSA's need for higher prices over the short term to support the IPO of Saudi Aramco, and Russia's longer term desire to avoid reaching price levels where U.S. shale-oil production is massively incentivized to expand. We believe OPEC 2.0's production cuts will be extended to year-end, given signaling by Khalid Al-Falih, KSA's energy minister. As a result, we expect Brent and WTI crude oil prices to average $74 and $70/bbl this year, respectively (Chart Of The Week). These expectations are up from our previous estimates of $67 and $63/bbl, which were premised on curtailed production slowly being returned to market beginning in July. For next year, the extended cuts could lift Brent and WTI to $67 and $64/bbl, up from our previous expectations of $55 and $53/bbl, respectively. Extending OPEC 2.0's production cuts will accelerate OECD inventory draws, which have been faster than expected. Higher prices caused by maintaining the cuts will lift U.S. shale production more than our earlier estimates. Backwardations in both Brent and WTI forward curves will remain steep in this regime, muting the impact of Fed policy on oil prices. Energy: Overweight. We are getting long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls on the back of our updated price forecast. We also are taking profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, which were up 27.4% as of Tuesday's close. Base Metals: Neutral. The U.S. Commerce Department proposed "Section 232" tariffs and quotas on U.S. aluminum and steel imports, following national security reviews. President Trump has until mid-April to respond, and we expect him to go through with one of the three proposed options. Precious Metals: Gold remains range-bound around $1,350/oz, as markets wrestle with the likely evolution of the Fed's rate-hiking regimen. Ags/Softs: Underweight. USDA economists project grain and soybean prices to slowly rise over the next 10 years, according to agriculture.com. Feature Chart Of The WeekBCA Lifts Oil Price Forecasts Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with maintaining OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year, and possibly next. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0's leaders that the world economy can absorb higher prices without damaging demand over the short term is not clear. Markets have yet to receive what we could consider definitive forward guidance from OPEC 2.0 leadership, indicating that recent signaling could be foreshadowing the coalition's new policy. We are raising the odds that it is, and are moving our Brent and WTI forecasts higher for this year and next. Lifting 2018 Brent, WTI Forecasts To $74 And $70/bbl Maintaining OPEC 2.0's production cuts to end-2018 will lift average Brent and WTI crude oil prices to $74 and $70/bbl, respectively, this year, based on our updated supply-demand balances modeling (Chart Of The Week). This is not definitive OPEC 2.0 policy guidance: KSA's and Russia's oil ministers indicated they expect such an outcome in separate statements, and not, as has been the case with previous announcements, at a joint press conference.2 We are assuming the odds strongly favor such an outcome, and give an 80% weight to it. The remaining 20% reflects our previous expectation that OPEC 2.0's production cuts would cease at end-June, and curtailed volumes would slowly be restored over 2H18. Resolving this in favor of the former expectation would lift our price expectations to $76 and $73/bbl for Brent and WTI this year, and $70 and $68/bbl next year. These expectations are up from our previous estimates of $67 and $63/bbl for Brent and WTI prices this year, which were premised on curtailed OPEC 2.0 production slowly returning to market beginning in July, and a subsequent OECD inventory rebuilding. By maintaining production cuts to year-end, supply-demand balances remain tighter, which keeps inventories drawing for a longer period of time (Chart 2). Higher inventories would have increased the sensitivity of oil prices to the USD, which we showed in research on February 8th 2018. With OPEC 2.0's production cuts maintained throughout the year, OECD inventories will be more depleted by year-end (Chart 3). Extending OPEC 2.0's production cuts to end-2018 would result in an additional 130mm bbls reduction to OECD inventories versus our prior modeling. This means Brent and WTI forward curves will be more backwardated than they would have been had the barrels taken off the market at the beginning of 2017 been slowly restored starting in July of this year, as we earlier expected. Chart 2Fundamental Balances Remain In Deficit Longer Chart 3Maintaining Production Cuts Depletes Inventories Even More A steeper backwardation in oil forward curves - i.e., the front of the curve trades premium to the deferred contracts - reduces the USD effects on oil, all else equal. In other words, supply-demand fundamentals dominate the evolution of oil prices when forward curves are more backwardated, and the influence of financial variables -the USD in particular - is muted.3 For next year, we assume the volumes cut by OPEC 2.0 are slowly restored to the market over 1H19, lifting Brent and WTI to $67 and $64/bbl on average, up from our previous expectations of $55 and $53/bbl, respectively.4 Higher Shale Output, Strong Global Demand We expect U.S. shale production increases by 1.15mm b/d from December 2017 to December 2018, and another 1.3-1.4mm b/d during calendar 2019. This dominates non-OPEC production growth this year and next (Chart 4, top panel). Due to the supply response of the shales to higher prices in 2018, global production levels would see a net increase from March 2019 and beyond. Our assumption OPEC 2.0 production cuts will be maintained through 2018 puts our OPEC production assessment 0.14mm b/d below U.S. EIA's estimates (Chart 4, bottom panel). On the demand side, we continue to expect non-OECD (EM) growth to push global oil consumption up by 1.7mm b/d this year and 1.6mm b/d next year, respectively (Chart 5). Non-OECD demand is expected to account for 1.24mm b/d and 1.21mm b/d of this growth in 2018 and 2019, respectively (Table 1). Chart 4U.S. Shales Dominate Non-OPEC Supply Growth Chart 5Non-OECD Demand Growth Continues Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Aramco IPO Driving OPEC 2.0's Short-Term Agenda In previous research, we noted what appeared to be a relatively minor divergence between the goals of KSA and Russia when it comes to the level prices each would prefer over the short term. Recent press reports - unattributed, of course - suggest Saudi Aramco officials prefer a Brent price closer to $70/bbl further along the forward curve (two years out) to support their upcoming IPO.5 This obviously would bolster Aramco's oil-export revenues - some 7mm b/d of its 10mm b/d of production are exported - and income, which shareholders would welcome. However, until this past week, Russia's energy minister, Alexander Novak, was signaling a range of $50 to $60/bbl works better for his constituents, i.e., shareholder-owned Russian oil companies. Novak recently amended his range to $50 to $70/bbl for Brent.6 These positions are not irreconcilable. One is shorter term (2 years forward) and the other is longer term, attempting to balance competitive threats over a longer horizon - e.g., from U.S. shale-oil producers, electric vehicles, etc. This most recent indication the leadership of OPEC 2.0 is comfortable with higher prices over the short term is an indication - at least to us - that these issues are being dealt with in a way that allows markets to incorporate forward guidance into pricing of crude oil over the next two years. Beyond that, however, markets will need to hear an articulated strategy containing a post-Aramco IPO view of the world, so that capital can be efficiently allocated. KSA and Russia are in a global competition for foreign direct investment (FDI), and having a fully articulated strategy re how they will manage their production in fast-changing markets - where, for example, shale-oil approaches becoming a "just-in-time" supply option - will be critical. Signing a formal alliance by year-end would support this, but that, too, will require a level of cooperation that runs deeper than what OPEC 2.0 has so far demonstrated, impressive though it may be. Bottom Line: OPEC 2.0 leadership is signalling production cuts will be maintained for the entire year, not, as we expected, left to expire at end-June with curtailed barrels slowly returned to the market over 2H18. While this does not appear to be official policy of the producer coalition yet, we are revising our price expectations in line with tighter markets this year, lower OECD inventories and continued backwardation in Brent and WTI forward curves. OPEC 2.0's shorter-term agenda, driven by KSA's IPO of Saudi Aramco, and its longer-term agenda - maintaining oil's competitive edge and accommodating U.S. shale-oil production (but not too much) - appear to be getting reconciled. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com  1 OPEC 2.0 is the name we coined for OPEC/non-OPEC coalition led by KSA and Russia, has removed some 1.4 to 1.5mm b/d of oil production from the market beginning in 2017. 2 Please see, "Brent crude settles flat, U.S. oil up on short covering," published by reuters.com on February 15th 2018, in which KSA's oil minister Khalid Al-Falih indicated OPEC would maintain production cuts throughout 2018. See also, "On the air of the TV channel 'Russia 24' Alexander Novak summed up the participation in the work of the Russian investment forum 'Sochi-2018,'" published by Ministry of Energy of the Russian Federation on February 15th 2018. Lastly, please see "Saudi Arabia Is Taking a Harder Line on Oil Prices," published by bloomberg.com on February 19th 2018. 3 We discuss this in "OPEC 2.0 vs. The Fed," which was published on February 8th 2018 by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4 These expectations are highly conditional. Toward the end of this year, KSA and Russia are indicating the OPEC 2.0 coalition will become a more formal organization, with members signing a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "Oil producers to draft long-term alliance deal by end-2018: UAE minister," published by reuters.com on February 15th 2018. 5 Please see "For timing of Aramco IPO, watch forward oil price curve," published by reuters.com on February 19th 2018. 6 Please see reference in footnote 3 and "Russia's Novak says current oil price is acceptable," published by reuters.com on February 15th 2018. 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 This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. 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 Slower global demand growth, coupled with surging production from the U.S. shales and higher OPEC 2.0 production, risks reversing the progress made in draining global commercial oil storage and tanking prices in 2019.1 Our updated balances modelling is in agreement with the backwardation in forward Brent and WTI curves, but, if anything, indicates the backwardation should be more pronounced: We are forecasting Brent and WTI prices next year will average $55 and $53/bbl, respectively, vs. $62.80/bbl and $57.40/bbl average prices for 2019's forward curves. For 2018, we are maintaining our $67 and $63/bbl expectation for Brent and WTI, although our modelling indicates higher prices are a distinct possibility, given our fundamental assumptions of falling supply and rising demand this year (Chart of the Week). Energy: Overweight. We liquidated our May and July Brent and WTI $55 vs. $60/bbl call spreads last week with gains of 110.1% and 129.0%. We will be liquidating our Dec/18 Brent and WTI $55 vs. $60/bbl call spreads at tonight's close; they were up 62.3% and 82.1% as of Tuesday. We remain long Jul/18 vs. Dec/18 WTI (up 47.4%), and long the S&P GSCI (up 8.5%), expecting backwardation. We will get long $55 Brent Puts vs. short $50 Brent Puts in 4Q19 at tonight's close. Base Metals: Neutral. We continue to expect base metals to remain well supported in 1H18 by environmental reforms in China, and supply uncertainty around contract renegotiations at the copper mines. The global expansion underpinning demand will compensate for slower Chinese growth in 2H18. Precious Metals: Neutral. Our long gold portfolio hedge is up 8.5% since inception in May/17. Ags/Softs: Underweight. Soybean markets rallied following last week's USDA WASDE report, but grains fell amid data indicating these markets will remain oversupplied. Feature If there is one truth in commodity markets it is this: The best cure for high prices is high prices, and vice versa. This is being dramatically demonstrated by OPEC 2.0 in its collective action to remove 1.8mm b/d of production from the market following disastrously low prices in 2015 - 16. Higher prices in 4Q17 and 1H18 oil futures are incentivizing a surge in U.S. shale output, and will give OPEC 2.0 comfort in slowly feeding output taken offline at the beginning of 2017 back into the market in 2H18 and 2019 (Chart 2). Higher prices and tightening monetary conditions globally will slow the rate of growth in demand next year (Chart 3). Chart of the WeekFundamentals##BR##Support Oil In 2018 Chart 2Non-OPEC Production##BR##Will Surge Chart 3Strong Consumption Growth In 2018,##BR##Tempered By Higher Prices In 2019 Given these fundamental inputs, we expect to see Brent averaging $55/bbl next year, and WTI averaging $53/bbl next year. Our forecast is highly uncertain, given the actual evolution of prices will, once again, depend on actions taken by OPEC 2.0 and the forward guidance provided by its leadership, KSA and Russia. Our forecast for 2018 - $67/bbl for Brent and $63/bbl for WTI - remains unchanged. If anything, our unconstrained models (Chart of the Week) have more upside risk than our forecast suggests, largely from falling production and surging demand - not to mention unplanned production outages. Looking to the end of 2019 from today, the backwardation we expect is greater than what is being priced into the Brent and WTI forward curves presently. Growth In U.S. Shales Dominates Non-OPEC Gains We are expecting U.S. crude oil production growth will dominate the increase in non-OPEC output in 2018 and 2019 (Chart 2, top panel). U.S. shale-oil output rises by 970k b/d and another 1.18mm b/d, respectively, this year and in 2019. By our reckoning, this will lift total U.S. crude oil production to 10.22mm b/d this year, a record level of output, and to 11.44mm b/d on average next year. Total U.S. crude and liquids output therefore rises from just under 17mm b/d in 2018 to 18.5mm b/d by the end of 2019. If our estimates are correct, the U.S. will join Russia in producing more than 11mm b/d of crude oil next year, and may even exceed it. Russia is expected to raise production slightly. As one of the putative leaders of OPEC 2.0, we expect Russia to maintain its 300k b/d production cut in 1H18, which will keep its overall liquids production steady at ~ 11.17mm b/d through June. In 2H18, Russia will gradually restore production to an average of 11.24mm b/d, reaching 11.4mm b/d by December. For 2019, we expect total Russian liquids production to average 11.35mm b/d, up ~ 140k b/d yoy. OPEC's return will be led by the Cartel's Gulf producers, which are expected to raise crude production 450k b/d this year and 350k b/d next year (Chart 2, bottom panel). Total production in Gulf OPEC states will reach 25.25mm b/d on average in 2019. This will, of course, be dominated by KSA, which we expect will lift crude production to ~ 10.36mm b/d in 2H18 after holding crude output steady at ~ 10mm b/d in 1H18 over-delivering vs. its quota under the OPEC 2.0 Agreement. For 2019, we expect KSA to maintain production above 10.1mm b/d.2 Non-Gulf OPEC producers, on the other hand, will see their production fall 140k b/d this year, and another 240k b/d next year, leaving it at 7.49mm b/d on average in 2019, in our estimation. The contribution of these states to the OPEC 2.0 production cuts has been "managing" their respective decline curves. It is highly unlikely they will see production surge following the expiration of the OPEC 2.0 agreement at the end of this year. Overall, we expect global crude and liquids production to reach 100mm b/d this year, and 102.2mm b/d next year (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Demand Surges This Year, But Slows In 2019 The global economic expansion will lift oil demand above 100mm b/d this year to 100.3mm b/d. This will be led, as always, by non-OECD growth, which we expect to increase 1.24mm b/d this year to 52.8mm b/d (Chart 3, top panel). DM demand - i.e., OECD consumption - will increase 440k b/d this year, to 47.5mm b/d, based on our estimates. Overall global demand rises 1.68mm b/d this year, by our reckoning (Chart 3). We expect tighter financial conditions this year and next will, with the lags typical of monetary policy, slow the rate of growth in oil demand next year. This will be delivered by tightening monetary policy, led by the U.S. Fed, and a mild recession next year, most likely in 2H19. We expect global demand to grow 1.57mm b/d next year, rising to just under 102mm b/d. EM demand will grow 1.21mm b/d, while DM demand will be up 360k b/d next year. Tightening Balances Will Reverse In 2H18 The yeoman effort put forth by OPEC 2.0 in reducing output and draining commercial inventories globally will reach its apotheosis by the end of 1H18 (Charts 4). Thereafter, as production grows and demand begins to slow, our balances indicate inventories will start to grow again (Chart 5). Chart 4Supply-Demand Balances##BR##No Longer Tightening In 2019 ... Chart 5... Leading To##BR##Inventory Accumulation Markets likely will start focusing on the implications of OPEC 2.0 returning production to the market and the surge in shale in 2H18 and during 2019. Non-forecastable events notwithstanding - e.g., a breakdown in Venezuela's production and exports - markets will be looking to OPEC 2.0 leadership for guidance on how the coalition will manage member-state production from 2H18 forward. If the OPEC 2.0 coalition is allowed to dissolve - something we do not expect - and a production free-for-all resumes similar to that of 2015 - 16, another round of supply destruction, brought about by lower prices, likely will ensue. This would greatly restrict E&P and services companies' access to capital, should it occur, and would, once again, imperil the economies of OPEC 2.0. In addition, because such volatility would discourage investment once again, it would set up a powerful price rally in the early 2020s following the attendant collapse in capex and E&P spending, as occurred in the previous down-cycle. We doubt this is the desired outcome of the OPEC 2.0 leadership, particularly KSA, as the Kingdom will be looking to IPO Saudi Aramco later this year to fund its Vision 2030 diversification efforts. We also doubt this is the desired outcome of Russia, given the economic pain it endured in the 2015 - 16 episode. More Frequent OPEC 2.0 Guidance Expected Given these considerations, we expect KSA and Russia to increase the frequency of forward guidance, directing market participants toward a preferred price band. Right now, this looks like a $50 to $60/bbl range - the 2018 forecast given by Russia's Energy Minister Alexander Novak earlier this week.3 It would be incumbent on OPEC 2.0 leadership to guide markets to expect production and inventory responses consistent with such guidance. We think the combination of OPEC 2.0 production restraint and the powerful synchronized global growth already in place puts Energy Minister Novak's guidance out of range for this year, and we are sticking with our forecasts for Brent and WTI. However, beginning in 2H18, a 2019 Brent forecast in Novak's range appears reasonable, based on the fundamentals discussed above. And, our WTI forecast of $53/bbl also is reasonable, given the average marginal cost of producing in the most prolific fields in the U.S. are at or below $50/bbl, according to the Dallas Fed's periodic Energy Survey.4 We believe the massive drawdown in global oil inventories to be the first step in a longer-term strategy by OPEC 2.0 countries. Lower OECD commercial inventory levels will diminish their shock-absorbing capacity, leading to a higher responsiveness of oil prices to supply-demand shocks. This will allow the coalition to exert greater control over oil prices via rapid, flexible storage adjustments and spare capacity management. Therefore, this year's out-of-range prices will be tolerated by Russia and KSA to achieve their optimal level of global inventories. A $50-to-$60/bbl Brent range for OPEC 2.0 would be consistent with a longer-term strategy to maximize the period of time hydrocarbons are the primary transportation fuel in the world. This is the only way to achieve the development goals set out by leaders of various oil-exporting states seeking to diversify the economic underpinnings of these economies. To do so, they have to keep oil-based transportation competitive for decades. Too much volatility - i.e., frequent excursions between very high and very low prices - will severely limit the access to capital these societies need to pull off this diversification. Managing production in a way that limits this volatility and keeps oil competitive in transport markets therefore is critical. Bottom Line: High prices will cause crude oil production to surge this year and next, particularly in the U.S. shales, and demand growth to slow. We expect Brent prices to average $67/bbl this year and $55/bbl next year. WTI prices will average $63/bbl this year and $53/bbl next year. We expect OPEC 2.0 to increase the frequency of its forward guidance - and to follow through on production and inventory adjustment in a manner that supports a desired price range for Brent prices in 2019 and into the 2020s. Right now, that range looks like $50 to $60/bbl. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is a name we coined to describe the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed at the end of 2016 to rein in out-of-control global oil production by cutting production some 1.4 to 1.5mm b/d last year (vs. a target of 1.8mm b/d). The coalition has been remarkably successful in maintaining production discipline in 2017 and extending their deal to the end of 2018 with an option to review quotas in June. We expect OPEC 2.0 to gradually return production taken off the market over the course of 2H18, which will, by next year, most likely reverse the draws seen in global inventories. 2 KSA's production should lift next year as pipeline repairs at its giant Manifa field are completed. Corrosion problems took some 300k of 900k b/d total production offline. In addition, there is another 500k b/d of capacity offline in the Neutral Zone shared with Kuwait. KSA's capacity likely will remain ~ 11.7mm b/d, versus its historical 12.5mm level, but as Energy Intelligence notes, it will have to balance actual production with spare capacity for the next year or so. Please see "A Headache for Aramco," published July 2017 by Energy Intelligence on its website. 3 Please see "CORRECTED-UPDATE 5-Brent oil falls by $1 but demand underpins near $70/barrel," published by uk.reuters.com on January 16, 2018. 4 In its December 2017 Dallas Fed Energy Survey, the Federal Reserve Bank of Dallas reported the WTI price shale operators needed to profitably drill a new well in Texas and Oklahoma averaged $49/bbl (simple, unweighted survey average). The lowest cost was in the Permian Midland formation ($46/bbl) and the highest costs was in so-called Other U.S. (shale) at $55/bbl. 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

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in Summary of Trades Closed in

Special Report

Highlights The Arabic title of this Special Report is "Against Wasta." Wasta roughly translates as reciprocity in formal and informal dealings. It "indicates that there is a middleman or 'connection' between somebody who wants a job, a license or government service and somebody who is in a position to provide it."1 While it has been helpful, it also has led to profound corruption. Feature The political sandstorm ripping through the Kingdom of Saudi Arabia (KSA) - visible in the lifting of the ban on women driving cars earlier this year, and, most recently in the consolidation of military and political power by Crown Prince Mohammed bin Salman (often referred to as "MBS") over the past few weeks - must be seen as prelude to implementing Vision 2030, which will feature an ongoing battle against wasta in KSA. If successful, this could transform a feudal desert kingdom into a modern nation-state.2 When the storm passes, MBS will hold the military and political reins of power in the Kingdom. This will allow the Sudairi branch of the Saud family, led by MBS's father, King Salman, to execute on its Vision 2030 agenda to wean itself from an almost-complete dependence on oil-export revenues. To do so, the Kingdom's leadership must successfully navigate OPEC 2.0's production-cutting deal in the short term, and the IPO of Saudi Aramco in the long term.3 KSA's Leadership Is On A Mission Chart of the WeekMarkets Take KSA News In Stride It's fairly obvious KSA's leadership and Russian President Vladimir Putin are on the same page re extending OPEC 2.0's 1.8mm b/d production-cutting deal to end-2018, given the public statements of MBS and Putin supporting such a measure. While markets have been responsive to this messaging, Russian Energy Minister Alexander Novak is restraining a full-throttled embrace of this expectation, saying a decision to extend the deal might not come at OPEC's November 30 meeting, given the amount of data to be analyzed.4 Markets appear to be taking the recent news - particularly the headlines out of KSA - in stride, as the major safe-haven assets have been remarkably well-behaved (Chart of the Week). In our base case, we continue to expect the OPEC 2.0 deal to be extended to end-June, which will lift Brent and WTI prices to $65 and $63/bbl next year. If we do get an extension of the OPEC 2.0 deal to end-December - and the odds of this appear very high - our 2018 Brent and WTI average-price forecasts could increase by as much as $5/bbl.5 KSA, Russia Have A Transactional Relationship, Not An Alliance The public alignment of the views of the Saudi and Russian leaderships are important over the short term. However, this does not necessarily mean both states have achieved a general alignment of views on everything of common concern to them. The OPEC 2.0 coalition led by KSA and Russia - the two largest oil exporters in the world - is a transactional relationship, not an alliance. The coalition members negotiated a deal to remove 1.8mm b/d of oil from the market in order to drain global inventories, particularly in the OECD. This deal was negotiated under duress - Brent prices threatened to fall through the $20/bbl level at the beginning of 2016 in the wake of the market-share war declared by OPEC at the end of 2014.6 Such an outcome would have imperiled the very survival of the member states (Chart 2). The success of OPEC 2.0 has taken many by surprise: The overwhelming market consensus in the lead-up to the deal getting done was the coalition would never come about, and, if it did, it would never be able to maintain the discipline necessary to follow through on its goal to return OECD inventories to their five-year average. BCA was outside this consensus from the get-go.7 And we continue to expect OPEC 2.0's production discipline to be maintained into next year, with KSA and Russia leading by example (Chart 3). Chart 2Oil-Price Collapse Clobbered Reserves Chart 3OPEC 2.0 Production Discipline Holds As important as the management of OPEC 2.0 is to KSA, Russia and the oil markets, the Kingdom's leadership has a laser focus on its chief long-term goal: the Saudi Aramco IPO. In light of its Vision 2030 agenda, the most important decision the Kingdom's leadership will make will be whether to IPO Aramco on a Western bourse - e.g., the NY Stock Exchange - or whether the initial offering of KSA's crown jewel is placed directly with China's sovereign wealth fund (SWF) and two of that country's largest oil companies. KSA controls this evolution. Decisions made by its leaders will resound in the oil markets for years, if not decades, to come. KSA's Anti-Corruption Campaign And The Aramco Offering The recent arrest of Saudi royals and consolidation of power by the Sudairi branch of the Saud royal family - led by King Salman and his son, MBS - appear to be part and parcel of an anti-corruption campaign laid out in the Vision 2030 document last year. This campaign, like the formation of OPEC 2.0, is being undertaken to support the IPO of Saudi Aramco next year. Proceeds from the IPO will support KSA's diversification away from being almost wholly dependent on oil exports.8 King Salman, MBS and their closest advisors have concluded they must reform the system of wasta if the Kingdom is to offer anything resembling a prosperous future full of opportunity to its restive population, most of which - more than 50% - are members of MBS's 30-something demographic cohort (Chart 4). Chart 4KSA's Under-30 Cohort Needs Jobs The wasta system in the Middle East - like the "old-boy" networks in the West - can be positive, in that it can "lower transaction costs and reduce the problem of asymmetric information if, for example, the use of such connections can place disadvantaged groups or individuals into the workforce who might otherwise not have the same opportunity as others," according to Prof. Ramady. However, such a system can, and has, become corrosive to the evolution of society, and can stunt the evolution toward an innovative, dynamic society and economy. Prof. Ramady notes, "Fighting negative wasta is important for the countries that seek to truly implement a more equal opportunity and entrepreneurial knowledge-based economic base." This discontent with the status quo post-Arab Spring was apparent in 2016, when BCA's Geopolitical Strategy noted KSA was in the early stages of such reforms.9 From everything King Salman and MBS have said and done to date, this appears to be the agenda that is being enacted. The lifting of the ban on women driving in KSA to take effect next year; hosting investors and entrepreneurs in Riyadh in September - the so-called Davos in the Desert presentations; even the recent mass arrests and consolidation of power are part and parcel of this reform.10 Early indications of this agenda could be seen in April 2015, when KSA lowered the value of projects requiring approval by the Council of Ministers to SR100 million from SR300 million ($27 million from $80 million). The collapse in oil prices from more than $100/bbl in 2014 likely drove this decision, but, as Prof. Ramady notes, "the intention of the Saudi government was clear: that even 'small' projects (by Saudi standards) could now be scrutinised to avoid 'hidden costs' and corruption." Following the April 2015 reforms, King Salman told the Kingdom's Anti-Corruption Committee "that his government would have zero tolerance for corruption in the country and that he and other members of the royal family are not above the law and that any citizen can file a lawsuit against the king, crown prince or other members of the royal family. These were some of the strongest statements to be made by a Saudi monarch on the issue of combating corruption and nepotism." (Emphasis added.)11 The Aramco IPO The way KSA monetizes its crown jewel will have a profound effect on the evolution of the country's institutions and the oil markets. MBS's implementation of the anti-corruption campaign laid out by his father, King Salman, suggests an IPO on a western bourse is in the offing. Such a listing would impose regulatory and transparency requirements on Aramco that are fully consistent with the royal family's words and deeds since King Salman took power in January 2015. Monetizing 5% of what could potentially be the largest oil-producing and -refining enterprise in the world - the only asset capable of funding the transformation of an entire country of 32mm people - on a bourse that requires even a minimal level of transparency for investors means the government of KSA could demand similar transparency from every other firm and individual in the Kingdom. It gives the government license, so to speak, to develop and enforce the rule of law, consistent with King Salman's remarks to the Anti-Corruption Committee. This will resonate with the younger KSA elites, many of whom are tech-savvy, educated in the West and in MBS's 30-something cohort. This would be a huge gamble on the future and the Kingdom's ability to transform itself into an open monarchy. Success would transform a feudal kingdom into a modern nation-state with an enfranchised population that can advance based on entrepreneurial innovation and merit. The rule of law and transparency in business and governmental dealings would replace wasta, privilege and corruption. It also could expose the royal family to a palace coup, as Marko Papic, BCA's Chief Geopolitical strategist, notes in his most recent report "The Middle East: Separating The Signal From The Noise," which we cite above. The stakes couldn't be higher. Listing on a Western bourse also would position Saudi Aramco squarely in the market and central to it, executing on its plan to become the dominant global oil refiner, and funding the Kingdom's diversification away from near-total dependence on oil exports. Lastly, it would allow KSA to retain its geopolitical optionality - playing competing global interests off each other when negotiating alliances and commercial deals. Implications Of An Aramco Private Placement If the Aramco shares are privately placed with China's SWF and the country's two largest oil companies, the pressure to reform likely would be lessened, as the Chinese government typically does not make reform demands on governments of resource-rich countries in which it is investing.12 Assuming China's SWF and/or the oil companies participating in its bidding consortium received a seat(s) on the Aramco board, China certainly would gain greater assurance over its crude oil and refined product supplies going forward. This is a critical concern with domestic production falling and demand for crude oil increasing (Chart 5). And it would give China an eventual interest in using military power to protect its investments in KSA, thus advancing and supporting its long-term evolution as a superpower.13 It also would, in all likelihood, expand the membership of the club trading oil in yuan, which now includes Russia and Iran, to KSA and its GCC allies and Iraq by 2020, if not sooner. This would represent ~ 39mm b/d of production (Chart 6), and 23mm b/d of exports. BP estimates just over 42mm b/d of crude oil are traded globally, meaning this petro-yuan producing coalition would account for 55% of total exports.14 Chart 5China Needs To Offset Declining Production Chart 6A Petro-yuan Would Be Formidable At some 9mm b/d, China accounts for ~ 21% of global crude oil imports. The combination of OPEC 2.0's crude production and exports with China's import volumes could make the OPEC 2.0 + 1 - the "+1" being China - the most potent force in the oil trading markets, if such a coalition can find a way to balance the competing interests of the world's largest exporters (KSA and Russia) with those of the world's largest importer (China). It also would put the petro-yuan bloc firmly in China's geopolitical orbit, allowing it to expand its sphere of influence deeply into the Persian Gulf, and the global oil market. Bottom Line: The recent turmoil in KSA must be seen as the opening moves in the transformation of a feudal desert kingdom into a modern nation-state. The evolution of the transformation is critically dependent on decisions made by KSA's leadership. How this breaks will profoundly affect the global oil markets and the Kingdom itself particularly in regard to how oil is priced - USD vs. yuan - and the effect new trading blocs have on market structure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Ramady, Mohamed A., ed. (2016), "The Political Economy of Wasta: Use and Abuse of Social Capital Networking," Springer International Publishing Switzerland. Ramady is a professor of Finance and Economics at King Fahd in Dhahran, Saudi Arabia. The introduction of the book starts by quoting the proverb: To accept a benefit is to sell one's freedom. 2 Please see "The Middle East: Separating The Signal From The Noise," published November 15, 2017, in BCA Research's Geopolitical Strategy, for a full analysis of these issues. 3 OPEC 2.0 is our moniker for the OPEC and non-OPEC coalition of oil producers led by KSA and Russia, which agreed to remove 1.8mm b/d of oil production from the market at the end of last year. 4 Please see "Russia's Novak: Oil cut pact extension decision not necessarily at Nov meeting," published November 2, 2017, by reuters.com. Elevating the level of uncertainty as to when the OPEC 2.0 pact will be unwound is exactly the sort of forward guidance OPEC 2.0 leaders would need to convey to markets in order to backwardate the forward oil-price curve - i.e., keep longer-dated prices below prompt prices. A backwardated forward curve means U.S. shale producers realize lower prices on longer-dated hedges, which restrains the number of rigs they can deploy in the field. On Wednesday, Reuters also reported as spokesman for Rosneft, Russia's largest oil company, foresees difficulty in the wind-down of OPEC 2.0's production cuts - and the return to unrestrained production. Mikhail Leontyev said, "Speaking about the company's concerns, first of all it was about how to prepare for suspending measures to restrict production. This is a serious question. Sooner or later, of course, these measures will be lifted," Leontyev said. "Now or later, that's a separate question. It's a serious challenge, for which one needs to prepare." Roseneft is responsible for 40% of Russia's oil output; it is 50% owned by the Russian government. Please see "Russia's Rosneft says managing exit from OPEC+ deal is a serious challenge," published by reuters.com on November 15, 2017. 5 Please see "Oil Forecast Lifted As Markets Tighten," published by BCA Research's Commodity & Energy Strategy, October 19, 2017. It is available at ces.bcaresearch.com. Worth noting is the fact that should OPEC 2.0 not extend the expiry of the production-cutting deal markets likely would sell off quickly. This is because the leadership of the coalition - MBS and President Putin - have publicly embraced such a move; not doing so would be a disappointment to markets. Our modelling in the article cited here indicates the cuts have to be extended at least to end-June 2018, if the OPEC 2.0 goal of reducing OECD commercial oil inventories to their 5-year average levels is to be achieved. Also worth noting, if we do see the OPEC 2.0 cuts extended to end-2018, we likely will be widening our implied Brent vs. WTI spread to $4/bbl, given the transportation bottlenecks that are likely to emerge in the event of a further lift in U.S. prices: Pipeline infrastructure in the most productive shales, particularly the Permian Basin, cannot get oil to export facilities as quickly as it is produced. Please see "Transportation constraints and export costs widen the Brent-WTI price spread," published in the U.S. EIA's This Week in Petroleum series November 8, 2017. 6 We discuss this at length in our 2017 outlook. Please see "2017 Commodity Outlook: Energy," published by BCA Research's Commodity & Energy Strategy December 8, 2016. See also our "2016 Commodity Outlook: Neutral Across the Board," published December 17, 2016, for a detailed discussion of pricing dynamics as this time. Both are available at ces.bcaresearch.com. 7 Please see the 2017 Outlook referenced above in footnote 6. 8 KSA officials believe the company is worth $2 trillion, based on their expectation a 5% IPO of the company would generate $100 billion. 9 Please see "Saudi Arabia's Choice: Modernity Or Bust," the May 2016 issue of BCA Research's Geopolitical Strategy. It is available at gps.bacresearch.com. 10 Please see "Saudi Arabia plans to build futuristic city for innovators," published October 24, 2017, by phys.org. 11 Please see footnote 1, p. ix. 12 Please see "Exclusive - China offers to buy 5 percent of Saudi Aramco directly: sources," published by reuters.com October 16, 2017. 13 We examined this in depth in our report entitled "OPEC 2.0: Fear and Loathing in Oil Markets," published by BCA Research's Commodity & Energy Strategy on April 27, 2017. It is available at ces.bcaresearch.com. 14 Please see https://www.bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy/oil/oil-trade-movements.html. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Special Report

Highlights Middle Eastern geopolitics will add upside risk to our bullish oil view, but not cause a drastic supply shock; Saudi Arabia is at last converting from a feudal monarchy to a modern nation-state; The greatest risk is domestic upheaval, motivating Saudi internal reforms and power consolidation; Abroad, the Saudis are constrained by military weakness, relatively low oil prices, and U.S. foreign policy; Geopolitical risk premia are seeping back into oil prices, but OPEC 2.0 and the Saudi-Iranian détente are still intact. Feature Geopolitical and political turbulence in Saudi Arabia kicked into high gear in November, with Crown Prince Mohammad bin Salman apparently turning the Riyadh Ritz-Carlton into a luxury prison for members of the royal family.1 At the same time, rumors are swirling that the bizarre resignation of Lebanese Prime Minister Saad Hariri, allegedly orchestrated by Saudi Arabia, is a potential casus belli. In this scenario, Lebanon would become a proxy war for a confrontation between Sunni Gulf monarchies led by Saudi Arabia (aided by Israel) and their Shia rivals, led by Iran and its proxy Hezbollah. To our clients around the world we say, "please take a deep breath." In this report, we intend to separate the signal from the noise. The Middle East has been a theater of paradigm shifts since at least 2011.2 Not all of them are investment relevant. In this report, we conclude that: Changes under way in the Middle East are the product of impersonal, structural forces that have been in place since the U.S. pulled out of Iraq in 2011; Saudi Arabia is engaged in belated, European-style nation-building, a volatile process that will raise tensions in the country and the region; Saudi Arabia remains constrained by a lack of resources and military capabilities, and unclear alliance structures. Iran, meanwhile, benefits from the status quo. As such, no major war with Iran is likely in the short term, although proxy wars could intensify. In the short term, we agree that the moves by Saudi leadership will increase tensions domestically and in the region. However, over the long term, the evolution of Saudi Arabia from the world's last feudal monarchy into a modern nation-state should improve the predictability of Middle East politics. Regardless of our view, one thing is clear: Saudi Arabia has an incentive to keep oil prices at the current $64 per barrel, or higher, as domestic and regional instability looms. As such, we believe that risks to oil prices are to the upside, but a global growth-constraining geopolitical shock to oil supply is unlikely. The Paradigm Shift: Multipolarity "Tikrit is a prime example of what we are worried about ... Iran is taking over [Iraq]."3 -- Prince Saud al-Faisal, Saudi Foreign Minister, to U.S. Secretary of State John Kerry, March 5, 2015 Pundits, journalists, investors, and Middle East experts all make the same mistake when analyzing the region: they assume it exists on "Planet Middle East." It does not. The Middle East is part of a global system and its internal mechanic is not sui generis. Its actors are bit players in a much bigger game, which involves nuclear powers like the U.S., China, and Russia. Yes, the whims and designs of Middle East leaders do matter, but only within the global constraints that they are subject to. The greatest such constraint has been the objective and observable withdrawal of the U.S. from the Middle East, emblematized by a dramatic reduction of U.S. troops in the region (Chart 1). The U.S. went from stationing 250,000 troops in 2007 to mere 36,000 in 2017. The withdrawal was not merely a manifestation of President Barack Obama's dovish foreign policy. Rather, it was motivated by U.S. grand strategy, specifically the need to "pivot to Asia" and challenge China's rising geopolitical prowess head on (Chart 2). Chart 1U.S. Geopolitical Deleveraging Chart 2China's Ascendancy Challenges The U.S. As we expected, President Donald Trump has not materially increased the U.S. presence in the region since taking office.4 His efforts to eradicate the Islamic State have largely built on those of his predecessor. While he has rhetorically changed policy towards Iran, and taken steps to imperil the nuclear deal by decertifying it, he has not abrogated the deal. The U.S. president can withdraw from the nuclear deal without congressional approval, yet President Trump has merely passed the buck to Congress, which has until the end of the year to decide whether to re-impose sanctions. For Saudi Arabia, U.S. rhetoric and half measures do not change the fact that Iraq is now devoid of American troops and largely in the Iranian sphere of influence. Following the 1991 Gulf War, Saudi Arabia enjoyed the best of both worlds for two decades: a Sunni-dominated but weakened Iraq serving the role of an impregnable buffer between itself and the much more militarily capable Iran. Since Iraq's paradigm shift in the wake of American invasion, the buffer has not only vanished but has been replaced by a Shia-dominated, Iranian-influenced Iraqi state (albeit still relatively weak). Unsurprisingly, Saudi military spending as a share of GDP nearly doubled from the 2011 U.S. withdrawal to 2015, and in absolute terms has risen from $48.5 billion in 2011 to $63.7 billion in 2016, revealing a deep concern in Riyadh that its northern border has become nearly indefensible (Chart 3). Chart 3Saudis React To U.S. Withdrawal Meanwhile, Baghdad's heavy-handed political and military tactics produced an immediate reaction from the Sunni population.5 Militant Sunni insurgent groups, with material support from unofficial (and probably official) channels in Saudi Arabia and wider Gulf monarchies, began to fight back. Violence escalated and soon melded with the emerging civil war in Syria, which by early 2013 had taken on a sectarian cast as well. This led to the emergence of the Islamic State, which grew out of the earlier Sunni insurgence against the U.S. in the Al Anbar governorate. The military success of the Islamic State in 2014 against the inexperienced and demoralized Iraqi Army forced Baghdad to lean even more heavily on domestic Shia militias, and Iran, for survival. Islamic State militants reached the outskirts of Baghdad in September 2014 and were only beaten back by a combination of hardline Shia militias and Iranian advisers and irregular troops. From the Saudi perspective, this direct intervention by the Iranian military in Iraq was the final straw. Most jarring to the Saudis was the fact that the Americans acquiesced to the Iranian presence in Iraq and even collaborated with Iran. In fact, the overt presence of Iranian military personnel in Syria and Iraq drew no rebuke from the U.S. Some American officials even seemed to praise the Iranian contribution to the global effort against the Islamic State. Meanwhile, the nuclear negotiations continued undisturbed, right down to their successful conclusion in July 2015. Bottom Line: Global multipolarity and the rise of China has forced America's hand, and the dramatic withdrawal of military assets from the Middle East is the direct consequence. Saudi Arabia has suffered a dramatic reversal of geopolitical fortunes, with its crucial geographic buffer, Iraq, now dominated by its strategic rival, Iran. Saudi Arabia "Goes It Alone," And Fails Miserably "Saudi Arabia will go it alone."6 -- Mohammed bin Nawwaf Bin Abdulaziz Al Saud, Saudi ambassador to the U.K., December 17, 2013 To counter growing Iranian influence across the region and its strategic isolation, Saudi Arabia relied on five general strategies, all of which have failed: Map 1Saudi Arabia's Shia-Populated Eastern Province Is A Crucial Piece Of Real Estate Asymmetric warfare: Saudi Arabia has explicitly and implicitly supported radical-Islamist Sunni militant groups around the region. Some of these groups were either directly linked to, or vestiges of, al-Qaeda. The Islamic State, which received implicit support from Saudi Arabia in its early days of fighting president Bashar al-Assad in Syria, eventually turned against Saudi Arabia itself. Its agents claimed multiple mosque attacks in the Shia-populated Eastern Provinces (Map 1), attacks intended to incite sectarian violence in this key oil-producing Saudi area. Saudi officials also became alarmed at a large number of Saudi youth who went to fight with Islamic State fighters across the region, some of whom are now back in the country (Chart 4). "Sunni NATO": Talk of a broad, Sunni alliance against Iran has not materialized. Despite the Saudis' best efforts, the main Sunni military powers - Egypt and Pakistan - have remained aloof of its regional efforts to isolate Iran. The best example is the paltry contribution of its Sunni peers to the ongoing war in Yemen, where anti-government Houthi rebels are nominally allied with Iran. Pakistan contemplated sending a brigade of 3,000 troops to the Saudi-Yemen border earlier this year, but has refused to join the fight directly. Egypt sent under 1,000 troops early in the war, but none since. Talk of a 40,000 Egyptian deployment to the Yemen conflict earlier this year has not materialized. If Pakistan and Egypt are unwilling to help Saudi Arabia against the Houthis, why would they be interested in directly confronting a formidable military power like Iran? Direct warfare: When supporting militants and spending money on allies did not work, Saudi Arabia decided to try its hand at direct warfare. In February 2015, it began airstrikes against the Houthi rebels in Yemen. The war, which costs Saudi Arabia over $70 billion a year, has gone badly for Saudi Arabia.7 Despite two years of intensive involvement by Saudi Arabia and its GCC allies, the capital Sanaa remains in Houthi hands. As far as we are aware, there has been no real Saudi ground troop commitment to the conflict. K-street: Despite its best efforts, and the vast resources spent on lobbyists in Washington, Saudi Arabia could not prevent the U.S. détente with Iran. What the Saudis failed to appreciate was multipolarity, i.e. how the U.S. pivot to Asia would affect Washington's policy toward the Middle East.8 Oil prices: At the fateful November 2014 OPEC meeting, Saudi Arabia refused to cut oil production in the face of falling prices, instead increasing production (Chart 5). Since late 2016, however, Saudi Arabia has reversed this aggressive bid for market share and orchestrated oil production cuts with Russia and OPEC states. Chart 4The Islamic State Movement Threatens Saudi Arabia Chart 5Saudis Surged Production Into Falling Prices Each and every one of the above strategies has failed. The last one is the most spectacular: Saudi Arabia was forced to backtrack from its oil production surge and negotiate with long-time geopolitical rival Russia, which was courting the Saudis to relieve its budget pressures from low oil prices. Saudi Arabia not only accepted the need to work with Russia, but also acquiesced to Russia's geopolitical demands for détente in the ongoing Syrian Civil War. The latter will force Saudi Arabia at least tacitly to accept the continued leadership of President al-Assad in Syria. Furthermore, Saudi intervention in Yemen has gone nowhere. Pundits who claim that the Saudis are on the verge of a major military engagement in ______ (insert Middle East country), should carefully study the effectiveness of the Saudi military in Yemen. After over two years of Saudi bombardment, the Houthis are further entrenched in the country. Meanwhile, Saudi Arabia's Sunni allies have not committed many ground troops to the effort, save for Sudan, which is impoverished and has no choice but to curry favor with its largest foreign donor. Bottom Line: The past six years have taught the Saudi leadership a series of hard lessons. Saudi Arabia cannot "go at it alone." On the contrary, the rise of the Islamic State - a messianic political entity claiming religious superiority to the Saudi kingdom - has alarmed the Saudi leadership and awoken it to a truly existential risk: domestic upheaval. Nation-Building, Saudi Style "What happened in the last 30 years is not Saudi Arabia. What happened in the region in the last 30 years is not the Middle East. After the Iranian revolution in 1979, people wanted to copy this model in different countries, one of them is Saudi Arabia. We didn't know how to deal with it. And the problem spread all over the world. Now is the time to get rid of it."9 -- Saudi Crown Prince Mohammed bin Salman, October 24, 2017 European nation-states developed over the course of five hundred years, from roughly the end of the Hundred Years' War between England and France to the unification of Italy and Germany in the mid-nineteenth century. Fundamentally, these efforts were about centralizing state power under a single authority by evolving the governance system away from feudal monarchy toward a constitutional, bureaucratic, and national system. The defining feature of feudalism was the separation of feudal society into three "estates": the clergy, the nobility, and the peasantry. The first two estates - the clergy and the nobility - had considerable rights and privileges. The king, who was above all three estates, nonetheless had to curry favor with both in order to raise taxes and wage wars. The state was weak and often susceptible to foreign influence via interference in all three estates. Saudi Arabia is one of the world's last feudal monarchies and it does not have five hundred years to evolve. Still, the best model for what is going on inside Saudi Arabia today is the European nation-building of the past. In brief, recent Saudi policies - from foreign policy assertiveness to domestic reforms - are intended to centralize power and evolve Saudi Arabia into a modern nation-state. Three parallel efforts, modeled on European history from the last millennia, are under way: Curbing the "first estate": Saudi Arabia has begun to curb the power of the religious establishment. In April 2016, it severely curbed the powers of the hai'a - the country's religious police. They no longer have the power to arrest. Instead, they have to report violations of Islamic law to the secular police; and they are only allowed to work during office hours.10 The state has even arrested a prominent cleric who opposed the change in hai'a powers, and has dismissed many other conservative clerics since King Salman came to power. Curbing the "second estate": The detention of members of the Saudi royal family at the Ritz Carlton is part of an ongoing effort to curb the powers of the "landed aristocracy" and bring it under the control of the ruling Sudairi branch of the royal family.11 This is not just palace intrigue, but a necessary step in harnessing the financial resources of the state, which are currently dispersed amongst roughly 2,000 members of the "second estate." Rallying the "third estate": Nationalism was used by European leaders of the nineteenth century to rally the plebs behind the state-building efforts of the time. Similarly, King Salman and his son, Crown Prince Mohammad bin Salman, are building a Saudi national identity. To do so, they are appealing to the youth, which makes up 57% of the country's population (Chart 6), as well as emphasizing the existential threat that Iran poses to the kingdom. Chart 6Still A Young Country We do not see these efforts as merely the reckless agenda of an impulsive thirty year-old, as Crown Prince Mohammad bin Salman is often derisively portrayed by his opponents. We see genuine strategy in every policy that has been initiated by Saudi leadership since King Salman took over in January 2015. Several efforts are particularly notable. Vision 2030: A Major Salvo Against The "First Estate" As we indicated in May 2016, we consider the Saudi "Vision 2030" reform blueprint to be a serious document.12 While its plan to address Saudi economic constraints is overly ambitious and vague, there are nonetheless several prominent themes that reveal the preferences of Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. As if on cue, the Saudi leadership announced that it would soon end its policy of forbidding women to drive. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. We were right to emphasize these three themes back in May 2016 as it is now obvious that King Salman and his son Mohammad bin Salman are following the prescriptions of their Vision 2030. What explains their reformist zeal? Over half of the Saudi population of almost 30 million is below 35 years of age. The youth population is facing difficulty entering the labor force, with unemployment above 30% (Chart 7). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart 8). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,13 and Twitter has the highest level of penetration in Saudi Arabia of any other country in the region.14 Chart 7A Potential National Security Risk Chart 8Saudi Youth Is As Internet Savvy As Others The idea that the royal family can take on the religious establishment on behalf of the youth seems far-fetched. Skeptics point out that the conservative Sunni Wahhabi religious movement lies at the foundation of the Saudi state. However, commentators who take this mid-eighteenth-century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, but Westerners may even overstate the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.15 Although Saudi Arabia has not appeared in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart 9). In addition, Saudis identify with values of self-expression over values of survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart 9Saudi Arabia: More Modern Than You Think The Weekend At The Ritz: The "Second Estate" Is Put On Notice The ongoing effort to curb the power of the Saudi "second estate" is not just about court intrigue and political maneuvering. Without harnessing the economic resources of the wider Saudi aristocracy, the state would succumb to debilitating capital outflows. If the Saudi "second estate" decided to "vote" against King Salman and his son with their "deposits" - and flee the country - the all-important currency peg would collapse. Despite a pickup in oil prices, Saudi Arabia's currency reserves are falling rapidly and could soon dip below the total amount of local-currency broad money (Chart 10). Beneath that point, confidence among locals and foreigners in the currency peg could shatter, leading to massive capital flight, which was clearly a very serious problem as of end-2016 (Chart 11). Chart 10KSA: Forex Reserves Depleting Chart 11KSA: Capital Outflows Persist The peg of the Saudi riyal to the U.S. dollar is not just an economic tool. It is a crucial social stability anchor for an economy that imports nearly all of its basic necessities. De-pegging would lead to a massive increase in import costs and thus a potential political and social crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years. However, this is only the case if capital outflows do not pick up and oil prices continue to stabilize. The Russia-OPEC deal is in place to ensure the latter. The "weekend at the Ritz" is meant to ensure the former. But doesn't the crackdown against the wealth of 2,000 royal family members represent appropriation of private property? Not in the minds of King Salman and his reformist son. In fact, if the financial wealth of the royal family is used to fill the coffers of the Saudi sovereign wealth fund, there is no reason why members of the Saudi "second estate" cannot benefit from its future investment returns and essentially "clip coupons" for a living. In fact, prior to the anti-corruption crackdown against the "second estate," Saudi officials hosted a completely different event at the Ritz Carlton: a gathering of top international investors for a conference called "Davos in the Desert." Judging by the conversations we had with a number of participants at that event, the point was not to encourage investments in Saudi Arabia. Rather, it was to secure the services of top international managers as Saudi Arabia ramps up the investment activities of its Public Investment Fund (PIF). Investors should therefore consider the first weekend at the Ritz as the launch of a new international investment vehicle by Saudi officials and the second weekend at the Ritz as its capitalization by the wider "second estate." We expect that fighting corruption will remain a major domestic policy thrust going forward. A recent academic study, for example, takes on the difficult job of eradicating wasta - the concept that each favor or privilege in Saudi society flows through middlemen or connections.16 The volume has been edited by Mohamed A. Ramady, professor of Finance and Economics at King Fahd University in Dhahran, Saudi Arabia, and is undoubtedly supported by the royal family. Moreover, King Salman and his son have the example of Chinese President Xi Jinping's impressive power consolidation via anti-corruption campaign right in front of them and are unlikely to have embarked on this course with the expectation that it would be a short process. Iran As An Existential Threat: Harnessing The "Third Estate" Real reform is always and everywhere difficult, otherwise the desired end-state would already be the form. For the Saudi leadership, attacking both the first and second estate presents considerable risks. It is appropriate, therefore, to believe that a palace coup may be attempted against King Salman and his son.17 International tensions with Iran are a particularly useful strategy to distract the opposition and paint all domestic dissent as treasonous. This is not to say that Saudi Arabia does not face considerable strategic challenges from Iran. As mentioned, Iranian influence in Iraq is particularly threatening to Saudi Arabia as it gives Tehran influence over a key strategic buffer that also produces 4.4 million barrels of crude per day. Furthermore, Iran supported the 2011 uprising in Shia-majority Bahrain against the Saudi-allied al-Khalifa monarchy; it at least nominally supports the Houthi rebels in Yemen; it has directly intervened in Syria on behalf of President al-Assad; and it continues to support Hezbollah in Lebanon. It is safe to say that, since 2011, Iran has been ascendant in the Middle East and has surrounded Saudi Arabia with strategic threats on all points of the compass. But to what extent is the Saudi rhetoric on Lebanon, Bahrain, Yemen, and Qatar a real threat to the stability in the Middle East? We turn to this question in our next section. Bottom Line: Saudi Arabia's domestic intrigue is far more logical than pundits and the media make it out to be. King Salman and his son, Crown Prince Mohammad bin Salman, are trying to build a modern nation state from what is today the world's last feudal monarchy. To do so, they have to enlist the support of the third estate - the country's large youth population - and curb the powers of its first and second estates - the religious establishment and the landed aristocracy. The process will be filled with risks and volatility, but is ultimately necessary for the long-term stability of the kingdom. Regional Risk Of War Is Overstated "[I am] positive there will be no implications coming out of this dramatic situation at all."18 -- Secretary of Defense James Mattis, asked about the Qatar crisis and the fight against ISIS, June 5, 2017 As this report goes to publication Saudi Arabia has accused Iranian-allied Hezbollah of forcing Lebanese Prime Minister Saad Hariri to run for his life. Hariri resigned while visiting Saudi Arabia. Although he claims that he is not being held against his will by Saudi authorities, his resignation is highly suspect. Saudi officials have also called a failed missile attack on Riyadh's airport, allegedly launched by Houthi rebels in Yemen, as a possible "act of war" by Iran. Meanwhile, Bahrain's Saudi-allied government has accused Iran of destroying an oil pipeline via terrorist action. The region's rumor mill - one of the most productive in the world - is in overdrive. What are the chances of increased proxy warfare between Saudi Arabia and Iran? We think that there is a good chance that Saudi Arabia will step up its military activity in the ancillary parts of the Middle East. In particular, we could see renewed Saudi military campaigns in Yemen and Bahrain. In isolation, these campaigns would add a temporary risk premium to oil prices. But given that Iran has no intention to become directly involved in either, we would expect Saudi moves to be largely for show. Over the long term, we do not see a direct confrontation between Iran and Saudi Arabia for three reasons. First, Saudi military capabilities are paltry and the kingdom has failed to secure the support of the wider Sunni world for its "Sunni NATO." We have already mentioned Saudi military failures in Yemen. Anyone who thinks that Saudi Arabia is ready to directly confront Iran must answer two questions. First, how does the Saudi military confront a formidable foe like Iran when it cannot dislodge Houthis from Yemen? Second, if Saudi Arabia is itching for a real conflict with Iran, why is it not saber-rattling in Iraq, a far more strategic piece of real estate for Saudi Arabia than any of the other countries where it accuses Iran of meddling? Chart 12Correlation Between Oil Prices And Military Disputes Second, oil prices remain a constraint to war. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 12). Political science research shows that the relationship is not spurious. Chart 13 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.19 While oil prices have recovered from their doldrums from two years ago, they are also a far cry from their pre-2014 highs. In fact, by our calculation, oil prices are still below the Saudi budget break-even price of oil, despite its best efforts to implement austerity (Chart 14). Chart 13More Oil Revenue = More Aggression Chart 14Saudi Spending Binge Raised Oil Breakevens Third, Saudi Arabia has failed to secure a clear security commitment from the U.S. While the Trump administration is far more open to supporting Saudi Arabia than the Obama administration, it still criticized the Saudi decision to ostracize Qatar. Secretary of Defense James Mattis made a visit to Qatar in September to offer American support. In a shocking reversal to over half-a-century of geopolitics, King Salman went to Moscow this October to deepen geopolitical relations with Russia.20 The visit included several business deals in the realm of energy and a significant promise by Saudi Arabia to purchase Russian arms in the future, including the powerful S-400 SAM system. Saudi Arabia is the world's third-largest arms importer and uses purchases as a tool of diplomacy, but has never purchased weapons from Russia in a significant way in the past. While many pundits have pointed to the Saudi-Russian détente as a sign of strength, we see it as a sign of weakness. It illustrates that Saudi Arabia is diversifying its security portfolio away from the U.S. It is doing so because it has to, not because it wants to. As U.S. petroleum imports continue to decline due to domestic shale production, Saudi Arabia is compelled to find new allies (Chart 15). The plan to hold an initial public offering for Aramco, and to target sovereign Chinese entities as major bidders for Aramco assets, fits this pattern as well. Chart 15Saudi Arabia Has To Diversify Its Security ##br##Portfolio As U.S. Oil Imports Decline However, diversifying the geopolitical security portfolio to include Russia and China will not mean that Saudi Arabia will have a blank check to wage direct war against Iran. Both Russia and China have considerable diplomatic and economic interests in Iran and are as likely to restrain as to enable Saudi ambition. Finally, talk of a Saudi-Israeli alliance against Hezbollah in Lebanon is as far-fetched as a direct Saudi-Iranian confrontation. Israel won the 2006 war against Hezbollah, but at a high cost of 157 soldiers killed and 860 wounded.21 The Israeli public grew tired of the one month campaign, showing political limits to offensive war. Furthermore, twelve years later, Hezbollah is even more deeply entrenched in Lebanon. Unless Saudi Arabia is willing to provide ground troops for the effort (see Yemen discussion above), it is unclear why Israel would want to enter the morass of Lebanese ground combat on behalf of Riyadh. Bottom Line: Constraints to Saudi offensive military action remain considerable: paltry military capability, fiscal constraints imposed by low oil prices, and a lack of clear support from the U.S. While rhetorical attacks on Iran serve the strategic goal of nation-building, we do not expect a major war between oil-producing states that would significantly raise oil prices over the medium term. The rhetoric and posturing will increase volatility and temporarily push up prices from time to time. Investment Implications Of Saudi Nation-Building First, on the question of OPEC 2.0, our baseline case is for the 1.8 million barrel-per-day production cuts to be extended through June 2018, drawing OECD inventories down toward their five-year average and creating the conditions for Brent and WTI prices to average $65 per barrel and $63 per barrel respectively next year.22 Moreover, both Crown Prince Mohammad bin Salman and Russian President Vladimir Putin have endorsed extensions through end-2018. These comments add bullish upside risk to prices, though they also alter perceptions and thus raise the short-term downside risk if no extension is agreed this month (which we think is the least likely scenario). Second, as to broader geopolitical risks in the Middle East, we believe they are rising yet again in the short and medium term, after the relative calm of 2017.23 We could see Saudi officials decide to ramp up military operations in Yemen or revive them in neighboring Bahrain. However, we do not see much of a chance of serious conflict in Lebanon or Qatar. The former would require an Israeli military intervention, which is unlikely given the outcome of the 2006 war. The latter would require American acquiescence, which is unlikely given the vital U.S. strategic presence in the country's Al Udeid military base. Nonetheless, even temporary military operations in any of these locales could add a geopolitical risk premium to oil markets. For example, the 2006 Lebanon-Israel War, which had no impact on oil production, generated a significant jump in oil prices (Chart 16). Chart 16Even The 2006 Israel-Lebanon War Produced A Risk Premium... Over the long term, how should investors make sense of the complicated Middle East geopolitical theater? Our rule of thumb is always to seek out the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. For a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications, we would need to see it have an impact on at least two of the following three factors: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni versus Shia. When we consider the security dilemma between Iran and Saudi Arabia, Iraq and the Eastern Province in Saudi Arabia are two regions critical to global oil supply. Tellingly, neither has played a role in the recent spate of tensions between the two countries. Saudi Arabia has been very careful not to increase tensions with Iran in Iraq. In fact, the Saudi leadership has reached out to Iraqi Prime Minister Haider al-Abadi, who was received by King Salman in October in the presence of U.S. Secretary of State Rex Tillerson. How should investors price domestic political intrigue in Saudi Arabia? In the long term, any failure of King Salman and his son to reform the country would be negative for internal stability, with risks to oil production if social unrest were to increase. In the short and medium term, however, even a palace coup would likely have no lasting impact on oil prices as it would be highly unlikely that an alternative leadership would imperil the kingdom's oil exports. On the contrary, a coup against King Salman could lead to lower oil prices if the new leadership in Riyadh decided to renege on their oil production cuts with Russia. The bottom line is that the geopolitical risk premium is likely to rise. The evolution of Saudi Arabia away from a feudal monarchy requires the suppression of the kingdom's first and second estates, a dangerous business that will likely be smoothed by nationalism and saber-rattling. Risks to oil prices, therefore, are to the upside. However, given the considerable constraints on Saudi Arabia's military and foreign policy capabilities, we do not foresee global growth-constraining oil supply risks in the Middle East. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The latest news from Riyadh is that the nearby Courtyard by Marriott Hotel may have been enlisted by the Saudi authorities for the crackdown, in addition to the Ritz Carlton. If true, we can only imagine the horrors that the prisoners are subject to! 2 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, and BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 3 Please see "Iran 'taking over' Iraq, Saudis warn, blaming U.S. refusal to send troops against ISIS," The National Post, dated March 5, 2015, available at nationalpost.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 5 Iran's influence in Iraq grew almost immediately following the American military withdrawal. Iraq's Shia Prime Minister, Nouri al-Maliki, wasted no time revealing his allegiance to Iran or his sectarian preferences. Baghdad issued an arrest warrant for the Sunni Vice President Tariq al-Hashimi literally the day after the last American troops withdrew from the country, signaling to the Sunni establishment that compromise was not a priority. Persecution of the wider Sunni population soon followed, with counter-insurgency operations in Sunni populated Al Anbar and Nineveh governorates. 6 Please see Mohammed bin Nawwaf bin Abdulaziz al Saud, "Saudi Arabia Will Go It Alone," New York Times, dated December 17, 2013, available at nytimes.com. 7 Please see Bruce Riedel, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 8 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 9 Please see Martin Chulov, "I will return Saudi Arabia to moderate Islam, says crown prince," The Guardian, dated October 24, 2017, available at www.theguardian.com. 10 Something tells us that most violations of Islamic law are likely to be committed after hours! 11 The Sudairi branch of the Saud dynasty refers to the issue of Saudi Arabia's founder Abdulaziz Ibn Saud with Hassa bint Ahmed Al Sudairi, one of Ibn Saud's wives and a member of the powerful Al Sudairis clan. The union produced seven sons, the largest faction out of the 45 sons that Ibn Saud fathered. As the largest grouping, the sons - often referred to as the "Sudairi Seven" - were able to consolidate power and unite against the other brothers. In addition to the current King Salman, the other member of the Sudairi faction who became a king was Fahd, ruling from 1982 to 2005. 12 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 2016, available at gps.bcaresearch.com. 13 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is highly unlikely to be used for religious education. It is highly likely to be used by teenagers for ... well, use your imagination. 14 Please see "Social Media In Saudi Arabia - Statistics And Trends," TFE Times, dated January 12, 2017, available at tfetimes.com; "Saudi social media users ranked 7th in the world," Arab News, November 14, 2015, available at arabnews.com. 15 The World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge: Cambridge UP, 2005). For more information, please see http://worldvaluessurvey.org. 16 Please see Mohamed A. Ramady, ed., The Political Economy Of Wasta: Use and Abuse of Social Capital Networking (New York: Springer, 2016). 17 It would not be the first such coup in Saudi history. King Saud was deposed in 1962 by his brother, King Faisal. 18 Please see Nahal Toosi and Madeline Conway, "Tillerson: Dispute Between Gulf States And Qatar Won't Affect Counterterrorism," dated June 5, 2017, available at www.politico.com. 19 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 20 Please see BCA Energy Sector Strategy and Geopolitical Strategy Special Report, "King Salman Goes To Moscow, Bolsters OPEC 2.0," dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see "Mideast War, By The Numbers," Associated Press, August 17, 2006, available at www.washingtonpost.com. 22 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," dated October 19, 2017, available at ces.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com.

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades