Softs

Bank Credit Analyst

Highlights Given that rising crop yields have been the main vehicle through which global supply of agricultural commodities grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. The impact of climate change will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The implications of climate change on agriculture producers are non-uniform. Low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. Expect greater volatility in agriculture prices as the frequency of weather events will raise uncertainty. Feature The steady expansion of global population and rising per-capita calorie consumption has directly translated to growing demand for agricultural products of all types. However, these demand-side pressures increasingly will be met with disruptions to global supply of agricultural commodities, as the impact of climate change raises uncertainty. In any given year, the aggregate decisions of farmers all over the world – i.e., the choice of which crops to plant and how much acreage to dedicate to each crop – determine the supply and market prices of ags. In this competitive market, each farmer attempts to maximize his or her welfare by planting the crops that are expected to yield the greatest profit. Chart 12010/11 Shock Highlights Ag Vulnerability To Weather The collective action of these producers in reaction to perceived demand generally leads to stable prices, especially for staple commodities such as grains and oilseeds, which differ from industrial commodities in that they are not highly correlated with global business cycles. Demand trends are long-term and slow moving, and typically do not result in abrupt price pressures, as farmers have time to adjust and adapt to changing consumer preferences. Unforeseen, weather-induced supply-side shocks, therefore, are the main source of sudden price changes in ag markets. Such a shock was dramatically on display during the drought-induced crop failures in major grain and cereal producing regions in the most recent global food crisis of 2010/11. While this massive supply shock was not the first of its kind (Chart 1, on page 1), it highlighted the vulnerability of ag markets to weather risks and specifically the evolving environment under climate change. A 2019 study quantifies the impact of shifting weather patterns on the agricultural market, finding that year-to-year changes in climate factors during the growing season explain 20%-49% of change in corn, rice, soybean, and wheat yields, with climate extremes accounting for 18%-43% of this variation.1 In theory, the impact can manifest in several ways, sometimes contradictory: Extreme weather events: An increase in the frequency and intensity of droughts or floods which threaten to wipe out crops or reduce yields, creating unpredictable supply shocks. The gradual rise in temperature: Each crop has cardinal temperatures – defined by the minimum, maximum and optimum – that determine its boundaries for growth. Increases in temperatures induced by global warming may push the boundary, reducing yields in some regions. Changes in precipitation patterns: In many areas precipitation is projected to increase – both in short bursts and over longer periods. This will lead to greater soil erosion resulting in deterioration in the quality of soil. In other regions, precipitation will decrease, and drought is expected to become more frequent.2 Moreover, the interaction of these factors – along with other region-specific variables – will amplify the impact on crops: Rising temperatures and greater precipitation will result in greater amounts of water in the atmosphere, producing increased water vapor and greater cloud cover. This will reduce solar radiation, and will harm crop productivity. Elevated atmospheric carbon dioxide and CO2 fertilization: Greater CO2 concentrations brought on by continued growth in air pollution are positive for crops as they stimulate photosynthesis and plant growth. However, the impact differs across crops with plants such as soybeans, rice and wheat set to benefit relatively more than plants such as corn.3 Moreover, elevated atmospheric CO2 levels can help crops respond to environmental stresses and reduce yield losses due to ozone and crop water loss through partial stomatal closure and a reduction in ozone penetration into leaves. Temperature changes and the magnitude and intensity of precipitation impact soil moisture and surface runoff. Indirect effects of climate change – weeds, pests and pathogens – also present challenges as they require changes to management practices and may raise farming costs required. The impact of climate change on agriculture markets is already evident in increasing intensity and frequency of extreme weather events. The confluence of these factors, and the region- and crop-specific nature of these variables, makes it impossible to estimate the impact of evolving climate conditions on ag products with great accuracy. Nevertheless, our research suggests that the impact of climate change on ag markets will create opportunities in this evolving and highly uncertain market. Abrupt Shocks Amid Gradual Warming: The Long And Short View The impact of climate change on agriculture markets is already evident in the increasing intensity and frequency of extreme-weather events such as heatwaves, floods, and droughts. Charts 2A, 2B, and 2C, illustrate the impact of major weather events in crop-producing regions of the U.S. on yields, production and acreage for the crop year in which the events took place. Chart 2AExtreme Weather Events Reduce U.S. Corn Supplies … Chart 2B… Soybean Supplies … Chart 2C… And Wheat Supplies In A Big Way Chart 3Climate-Induced U.S. Supply Shocks Associated With Price Spikes   While the individual losses are a function of the magnitude of the event, the events highlighted translate to a 16%, 10%, and 7% decline in corn, soybean, and wheat yields, respectively. These supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. Given that the U.S. is a major global supplier of these crops, extreme weather events and the subsequent supply reductions lead to non-negligible price pressures (Chart 3). While crop conditions thus far have failed to deteriorate in trend (Chart 4), greater frequency and intensity of weather events raise the probability of a decline in overall crop and could lower supply.   Chart 4Crop Conditions Have Generally Held Up Expanding the analysis to other major crop-producing regions of the world, we find that once again, extreme-weather events are associated with a decline in yields and production in the corresponding crop year (Chart 5). This exercise also indicates that the impact of droughts is significantly more pronounced than the impact of floods.4 While the weather-induced supply shocks described above are unpredictable, abrupt, and have an immediate impact on output and prices, the gradual warming of temperatures is a slow-moving process. Consequently, the impact will manifest in the form of gradual changes that are difficult to capture and quantify, especially given the mitigating effect of CO2 fertilization – i.e., higher yields resulting from higher CO2 in the atmosphere. Nonetheless, rising temperatures will become a serious risk in crop-planting regions both in the U.S. and globally (Chart 6). While rising temperatures are expected to bring about increasingly more wide-ranging supply disruptions (Chart 7), the net impact over the coming decade is not a clear negative. Chart 5Weather Events, Especially Droughts, Hurt Global Supplies Chart 6Rising Global Temperatures Will Pose A Serious Risk … Chart 7… Especially Above The 2°C Mark One study expects the positive impact of CO2 fertilization on yields to overwhelm the negative effect of rising temperatures over the coming decade (Table 1). Elsewhere, studies forecast different responses, with some predicting incremental yield gains over the coming decade before temperatures rise to levels that overwhelm the benefits of greater CO2. Similarly, according to the FAO’s assessment, the net negative impact of climate change on global crop yields will only become apparent with a high degree of certainty post-2030.5 Table 1Estimates For The Response Of Global Average Crop Yields To Warming And CO2 Changes Over The Next Decades Bottom Line: Given that rising crop yields have been the main vehicle through which global ag supply grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. Supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. The impact will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The Winners … And Losers Rising temperatures are expected to result in a negligible impact on ag markets over the coming decade; yet this finding is not uniform across all regions. The FAO study cited above finds that by 2030, the projected impact on crop yields will be slightly net negative in developing countries. However, in developed countries, the effect will be net positive. In terms of global supply, the impact of climate change over the coming decade is expected to remain relatively contained, affecting certain regions at various times without causing major global disruptions. That said, as global warming and extreme weather persist, the ramifications will begin to extend beyond individual regions, and will cause supply shocks on a global scale. In part, this can be explained by a greater potential for net reductions in crop yields in warmer, low-latitude areas and semi-arid regions of the world.6 This non-uniform impact will create relative winners and losers. Producers located in temperate regions – where climate change does not yet pose as serious a threat – are set to profit from their increased role in global supply. Conversely, tropical regions are much more vulnerable to climate change. This is especially true for those whose economies are highly dependent on agriculture (Chart 8). Chart 8Agricultural Economies In Tropical Regions Are Most Vulnerable On net, the overall economies of DM countries – which generally are not economically dependent on agriculture and are located in northern regions – will be relatively more insulated from the impact of climate change on the agriculture sector. Aside from the impact on producers, the implications on consumers are also region-dependent. Clearly the direct impact of climate change on global agriculture will be higher food prices, which directly impacts the food component of inflation generally. As a result, consumers who spend a large share of their income to food – generally consumers in lower income countries – will be hardest hit (Chart 9). Chart 9Higher Food Prices Disproportionately Hurt Consumers In Lower Income Countries In theory, a food supply shock is transitory, and given that food is usually excluded from core inflation gauges targeted by central banks, monetary policy should not react to these price spikes. All the same, aside from this direct impact on inflation, food inflation can also pass-through into other components of the CPI basket, for example through wage pressures or inflation expectations. This would lead to a more persistent impact on core inflation, forcing policy makers to react to these transitory forces, complicating the monetary policy response function for these countries. Given that inflation expectations are less well-anchored in lower income economies and that food makes up a larger share of consumption expenditures in these economies, they are most vulnerable to weather-induced food shocks. Chart 10Subsidies Partially Insulate Against International Shocks In countries where food prices are highly subsidized, the impact of higher global food prices will not immediately translate to higher domestic prices. This explains why there is no one-to-one relationship between global food prices and domestic food prices (Chart 10). Instead, the higher prices are absorbed by the governments, resulting in an expansion in government expenditures. This distorts the local food market, as it prevents demand from adjusting to the higher prices, and could potentially result in an undershoot in inventories that makes global markets even more vulnerable to further supply shocks. Bottom Line: The implications of climate change on ag producers are non-uniform. While higher-latitude regions are set to benefit, at least in the short-run, low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. On the consumer side, individuals who spend a large share of their income on food are set to suffer most. While consumers in countries that subsidize the crops will be protected from the immediate inflation risk, they may feel a delayed impact due to an increase in budget expenditures needed to cover the larger import bill. Mitigation Efforts While the potential impact of climate change on the agriculture sector can be large, it will be at least partially managed through adoption of mitigation policies (Diagram 1). Diagram 1Adaptation Reduces Vulnerability A key question in determining the extent of this behavior is whether warming temperatures and the increased occurrence and intensity of extreme events will be sufficient to justify a major acceleration of investment in agriculture. These efforts would range from simple management changes on the part of farmers to technological advances that raise the productivity of farming or reduce the vulnerability of farmers to climate change. For example, farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates (Chart 11). The earlier planting has also been accompanied by a longer growing season with the average number of days in the season increasing. Farmers are also adapting by altering their decisions on which crops to plant. For example, since soybean and corn are planted in many of the same regions of the U.S., farmers often plant more soybeans than corn when experiencing weather shocks. Chart 11Weather Events, Especially Droughts, Hurt Global Supplies The agriculture sector is also using more efficient machinery that can plant and harvest crops much faster as well as developing heartier seeds and more potent fertilizers. In turn, farmers will alter their decision making by selecting crop varieties or species that are more resistant to heat and drought. Or they will change fertilizer rates, amounts and timing of irrigation, along with other water-management techniques. Farmers also are making wider use of integrated pest and pathogen management techniques, in order to raise the effectiveness of pest, disease, and weed control. Given that the number of firms in the agriculture sector are fewer in developed markets than in the rest of the world, management decisions can be more easily implemented in the former. Farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates. On the other hand, emerging market countries where ag output is driven by numerous individual farmers will have a more difficult time implementing policies. Individual farms may not have the means to support themselves, which raises the potential impact of climate change. What is more, climate-change mitigation efforts may require projects, programs, or funds set aside by the government to support these efforts. This is more likely to occur in wealthier developed countries. Bottom Line: Adaptation and mitigation measures on the part of farmers have the potential to reduce the impact of climate change. That said, farmers in richer countries with the funds and institutions in place to support the ag sector likely will fare better. Investment Implications Over the coming decade, the ramifications of climate change are likely to be contained to a regional level. Although global supply will be vulnerable to regional disruptions, the impact will, in part, be mitigated by inventories, which have been rising for years. These stocks will create a buffer against unpredictable supply shocks (Chart 12). Chart 12Higher Inventories Needed To Buffer Against Unpredictable Shocks However, given that the global soybean market resembles an oligopoly with Brazil, the U.S., and Argentina accounting for 81% of global supply, global soybean prices will be more vulnerable to supply events in these regions than other crops (Chart 13). Chart 13Soybeans Most Vulnerable To Shocks Affecting Major Producers At the other end of the spectrum, global wheat markets will be relatively more insulated from isolated weather events impacting any one major producer as each of these regions contributes a relatively small share to global wheat output. This analysis also finds that yields and supply generally recover in the crop year following an extreme climate event. This implies that while the extent of damage from these events can be severe, they are not persistent unless the increasing frequency of extreme events leads to a secular change. Aside from the price impact, the weather and temperature changes will manifest in the form of greater volatility in supply, translating to greater price volatility. Options-implied volatilities for corn, wheat and soybeans have been on a general downtrend since the two major global food scares in 2007/08 and 2010/11 (Chart 14). We expect the trend to reverse going forward as the frequency of weather events will create greater price uncertainty. We summarize the findings of this report in Table 3 (Appendix, on page 16). Chart 14Volatility Will Go Up Roukaya Ibrahim Editor/Strategist RoukayaI@bcaresearch.com Jeremie Peloso Research Analyst JeremieP@bcaresearch.com Amr Hanafy Research Associate AmrH@bcaresearch.com Hugo Bélanger Senior Analyst HugoB@bcaresearch.com Isabelle Dimyadi Research Associate Isabelled@bcaresearch.com Appendix Table 2Extreme Weather Events In The U.S. Table 3Summary Table Footnotes 1 Please see Vogel et al, The effects of climate extremes on global agricultural yields, Environ. Res. Lett 14 054010, 2019. 2 As a consequence of greenhouse gas emissions precipitation is expected to increase in high altitude regions such as much of the U.S. and decrease in subtropical regions such as the southwest U.S., Central America, southern Africa, and the Mediterranean basin. 3 Plants can be broken down into either C3 or C4 based on the way they assimilate atmospheric CO2 into different physiological components. While rising CO2 causes C3 plants to raise the rate of photosynthesis and reduce the respiration rate, C4 plants do not experience a rise in photosynthesis since  photosynthesis is already saturated. For example, studies show that soybean yields increased 12%-15% under 550 ppm vs. 370 ppm CO2 concentrations while corn experienced negligible yield increases. 4 Please see Lesk C., P. Rowhani, and N. Ramankutty, Influence of extreme weather disasters on global crop production, Nature, 529(7584), 84-87, 2016. 5 Please see The State Of Food And Agriculture: Climate Change, Agriculture, And Food Security, Food and Agriculture Organization of the United Nations, 2016. 6 Please see Stevanovic et al., The impact of high-end climate change on agricultural welfare, Sci-Adv 2(8), 2016.

Special Report

The steady expansion of global population and rising per-capita calorie consumption has directly translated to growing demand for agricultural products of all types. However, these demand-side pressures increasingly will be met with disruptions to global supply of agricultural commodities, as the impact of climate change raises uncertainty. In any given year, the aggregate decisions of farmers all over the world – i.e., the choice of which crops to plant and how much acreage to dedicate to each crop – determine the supply and market prices of ags. In this competitive market, each farmer attempts to maximize his or her welfare by planting the crops that are expected to yield the greatest profit. The collective action of these producers in reaction to perceived demand generally leads to stable prices, especially for staple commodities such as grains and oilseeds, which differ from industrial commodities in that they are not highly correlated with global business cycles. Demand trends are long-term and slow moving, and typically do not result in abrupt price pressures, as farmers have time to adjust and adapt to changing consumer preferences. Unforeseen, weather-induced supply-side shocks, therefore, are the main source of sudden price changes in ag markets. Such a shock was dramatically on display during the drought-induced crop failures in major grain and cereal producing regions in the most recent global food crisis of 2010/11. While this massive supply shock was not the first of its kind (Chart 1), it highlighted the vulnerability of ag markets to weather risks and specifically the evolving environment under climate change. A 2019 study quantifies the impact of shifting weather patterns on the agricultural market, finding that year-to-year changes in climate factors during the growing season explain 20%-49% of change in corn, rice, soybean, and wheat yields, with climate extremes accounting for 18%-43% of this variation.1 In theory, the impact can manifest in several ways, sometimes contradictory: Chart 12010/11 Shock Highlights Ag Vulnerability To Weather Extreme weather events: An increase in the frequency and intensity of droughts or floods which threaten to wipe out crops or reduce yields, creating unpredictable supply shocks. The gradual rise in temperature: Each crop has cardinal temperatures – defined by the minimum, maximum and optimum – that determine its boundaries for growth. Increases in temperatures induced by global warming may push the boundary, reducing yields in some regions. Changes in precipitation patterns: In many areas precipitation is projected to increase – both in short bursts and over longer periods. This will lead to greater soil erosion resulting in deterioration in the quality of soil. In other regions, precipitation will decrease, and drought is expected to become more frequent.2 Moreover, the interaction of these factors – along with other region-specific variables – will amplify the impact on crops: Rising temperatures and greater precipitation will result in greater amounts of water in the atmosphere, producing increased water vapor and greater cloud cover. This will reduce solar radiation, and will harm crop productivity. Elevated atmospheric carbon dioxide and CO2 fertilization: Greater CO2 concentrations brought on by continued growth in air pollution are positive for crops as they stimulate photosynthesis and plant growth. However, the impact differs across crops with plants such as soybeans, rice and wheat set to benefit relatively more than plants such as corn.3 Moreover, elevated atmospheric CO2 levels can help crops respond to environmental stresses and reduce yield losses due to ozone and crop water loss through partial stomatal closure and a reduction in ozone penetration into leaves. Temperature changes and the magnitude and intensity of precipitation impact soil moisture and surface runoff. Indirect effects of climate change – weeds, pests and pathogens – also present challenges as they require changes to management practices and may raise farming costs required. The confluence of these factors, and the region- and crop-specific nature of these variables, makes it impossible to estimate the impact of evolving climate conditions on ag products with great accuracy. Nevertheless, our research suggests that the impact of climate change on ag markets will create opportunities in this evolving and highly uncertain market. Abrupt Shocks Amid Gradual Warming: The Long And Short View The impact of climate change on agriculture markets is already evident in increasing intensity and frequency of extreme-weather events. The impact of climate change on agriculture markets is already evident in the increasing intensity and frequency of extreme-weather events such as heatwaves, floods, and droughts. Charts 2A, 2B, and 2C, illustrate the impact of major weather events in crop-producing regions of the U.S. on yields, production and acreage for the crop year in which the events took place. While the individual losses are a function of the magnitude of the event, the events highlighted translate to a 16%, 10%, and 7% decline in corn, soybean, and wheat yields, respectively. These supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. Chart 2AExtreme Weather Events Reduce U.S. Corn Supplies Chart 2BExtreme Weather Events Reduce U.S. Soybean Supplies Chart 2CExtreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Chart 3Climate-Induced U.S. Supply Shocks Associated With Price Spikes Given that the U.S. is a major global supplier of these crops, extreme weather events and the subsequent supply reductions lead to non-negligible price pressures (Chart 3). While crop conditions thus far have failed to deteriorate in trend (Chart 4), greater frequency and intensity of weather events raise the probability of a decline in overall crop and could lower supply. Chart 4Crop Conditions Have Generally Held Up Expanding the analysis to other major crop-producing regions of the world, we find that once again, extreme-weather events are associated with a decline in yields and production in the corresponding crop year (Chart 5). This exercise also indicates that the impact of droughts is significantly more pronounced than the impact of floods.4 The net impact of rising temperatures over the coming decade is not a clear negative. While the weather-induced supply shocks described above are unpredictable, abrupt, and have an immediate impact on output and prices, the gradual warming of temperatures is a slow-moving process. Consequently, the impact will manifest in the form of gradual changes that are difficult to capture and quantify, especially given the mitigating effect of CO2 fertilization – i.e., higher yields resulting from higher CO2 in the atmosphere. Nonetheless, rising temperatures will become a serious risk in crop-planting regions both in the U.S. and globally (Chart 6). While rising temperatures are expected to bring about increasingly more wide-ranging supply disruptions (Chart 7), the net impact over the coming decade is not a clear negative. Chart 5Weather Events, Especially Droughts, Hurt Global Supplies Chart 6Rising Global Temperatures Will Pose A Serious Risk …   One study expects the positive impact of CO2 fertilization on yields to overwhelm the negative effect of rising temperatures over the coming decade (Table 1). Elsewhere, studies forecast different responses, with some predicting incremental yield gains over the coming decade before temperatures rise to levels that overwhelm the benefits of greater CO2. Similarly, according to the FAO’s assessment, the net negative impact of climate change on global crop yields will only become apparent with a high degree of certainty post-2030.5 Chart 7… Especially Above The 2 ℃ Mark Table 1Estimates For The Response Of Global Average Crop Yields To Warming And CO2 Changes Over The Next Decades Bottom Line: Given that rising crop yields have been the main vehicle through which global ag supply grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. The impact will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The Winners … And Losers Rising temperatures are expected to result in a negligible impact on ag markets over the coming decade; yet this finding is not uniform across all regions. The FAO study cited above finds that by 2030, the projected impact on crop yields will be slightly net negative in developing countries. However, in developed countries, the effect will be net positive. In terms of global supply, the impact of climate change over the coming decade is expected to remain relatively contained, affecting certain regions at various times without causing major global disruptions. That said, as global warming and extreme weather persist, the ramifications will begin to extend beyond individual regions, and will cause supply shocks on a global scale. In part, this can be explained by a greater potential for net reductions in crop yields in warmer, low-latitude areas and semi-arid regions of the world.6 This non-uniform impact will create relative winners and losers. Producers located in temperate regions – where climate change does not yet pose as serious a threat – are set to profit from their increased role in global supply. Conversely, tropical regions are much more vulnerable to climate change. This is especially true for those whose economies are highly dependent on agriculture (Chart 8). Chart 8Agricultural Economies In Tropical Regions Are Most Vulnerable On net, the overall economies of DM countries – which generally are not economically dependent on agriculture and are located in northern regions – will be relatively more insulated from the impact of climate change on the agriculture sector. Aside from the impact on producers, the implications on consumers are also region-dependent. Clearly the direct impact of climate change on global agriculture will be higher food prices, which directly impacts the food component of inflation generally. As a result, consumers who spend a large share of their income to food – generally consumers in lower income countries – will be hardest hit (Chart 9). Chart 9Higher Food Prices Disproportionately Hurt Consumers In Lower Income Countries In theory, a food supply shock is transitory, and given that food is usually excluded from core inflation gauges targeted by central banks, monetary policy should not react to these price spikes. All the same, aside from this direct impact on inflation, food inflation can also pass-through into other components of the CPI basket, for example through wage pressures or inflation expectations. This would lead to a more persistent impact on core inflation, forcing policy makers to react to these transitory forces, complicating the monetary policy response function for these countries. Given that inflation expectations are less well-anchored in lower income economies and that food makes up a larger share of consumption expenditures in these economies, they are most vulnerable to weather-induced food shocks. Individuals who spend a large share of their income on food are set to suffer most. In countries where food prices are highly subsidized, the impact of higher global food prices will not immediately translate to higher domestic prices. This explains why there is no one-to-one relationship between global food prices and domestic food prices (Chart 10). Instead, the higher prices are absorbed by the governments, resulting in an expansion in government expenditures. This distorts the local food market, as it prevents demand from adjusting to the higher prices, and could potentially result in an undershoot in inventories that makes global markets even more vulnerable to further supply shocks Chart 10Subsidies Partially Insulate Against International Shocks Bottom Line: The implications of climate change on ag producers are non-uniform. While higher-latitude regions are set to benefit, at least in the short-run, low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. On the consumer side, individuals who spend a large share of their income on food are set to suffer most. While consumers in countries that subsidize the crops will be protected from the immediate inflation risk, they may feel a delayed impact due to an increase in budget expenditures needed to cover the larger import bill. Mitigation Efforts While the potential impact of climate change on the agriculture sector can be large, it will be at least partially managed through adoption of mitigation policies (Diagram 1). Diagram 1Adaptation Reduces Vulnerability A key question in determining the extent of this behavior is whether warming temperatures and the increased occurrence and intensity of extreme events will be sufficient to justify a major acceleration of investment in agriculture. These efforts would range from simple management changes on the part of farmers to technological advances that raise the productivity of farming or reduce the vulnerability of farmers to climate change. For example, farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates (Chart 11). The earlier planting has also been accompanied by a longer growing season with the average number of days in the season increasing. Farmers are also adapting by altering their decisions on which crops to plant. For example, since soybean and corn are planted in many of the same regions of the U.S., farmers often plant more soybeans than corn when experiencing weather shocks. Chart 11Farmers Are Planting Earlier In The Season The agriculture sector is also using more efficient machinery that can plant and harvest crops much faster as well as developing heartier seeds and more potent fertilizers. In turn, farmers will alter their decision making by selecting crop varieties or species that are more resistant to heat and drought. Or they will change fertilizer rates, amounts and timing of irrigation, along with other water-management techniques. Farmers also are making wider use of integrated pest and pathogen management techniques, in order to raise the effectiveness of pest, disease, and weed control. Given that the number of firms in the agriculture sector are fewer in developed markets than in the rest of the world, management decisions can be more easily implemented in the former. On the other hand, emerging market countries where ag output is driven by numerous individual farmers will have a more difficult time implementing policies. Individual farms may not have the means to support themselves, which raises the potential impact of climate change. What is more, climate-change mitigation efforts may require projects, programs, or funds set aside by the government to support these efforts. This is more likely to occur in wealthier developed countries. Bottom Line: Adaptation and mitigation measures on the part of farmers have the potential to reduce the impact of climate change. That said, farmers in richer countries with the funds and institutions in place to support the ag sector likely will fare better. Investment Implications Over the coming decade, the ramifications of climate change are likely to be contained to a regional level. Although global supply will be vulnerable to regional disruptions, the impact will, in part, be mitigated by inventories, which have been rising for years. These stocks will create a buffer against unpredictable supply shocks (Chart 12). Chart 12Higher Inventories Needed To Buffer Against Unpredictable Shocks However, given that the global soybean market resembles an oligopoly with Brazil, the U.S., and Argentina accounting for 81% of global supply, global soybean prices will be more vulnerable to supply events in these regions than other crops (Chart 13). At the other end of the spectrum, global wheat markets will be relatively more insulated from isolated weather events impacting any one major producer as each of these regions contributes a relatively small share to global wheat output. This analysis also finds that yields and supply generally recover in the crop year following an extreme climate event. This implies that while the extent of damage from these events can be severe, they are not persistent unless the increasing frequency of extreme events leads to a secular change. Aside from the price impact, the weather and temperature changes will manifest in the form of greater volatility in supply, translating to greater price volatility. Options-implied volatilities for corn, wheat and soybeans have been on a general downtrend since the two major global food scares in 2007/08 and 2010/11 (Chart 14). We expect the trend to reverse going forward as the frequency of weather events will create greater price uncertainty. Chart 13Soybeans Most Vulnerable To Shocks Affecting Major Producers   Chart 14Volatility Will Go Up   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Jeremie Peloso, Research Analyst U.S. Bond Strategy JeremieP@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Amr Hanafy, Research Associate Global Asset Allocation AmrH@bcaresearch.com Isabelle Dimyadi, Research Associate Isabelled@bcaresearch.com     Appendix Table 2Extreme Weather Events In The U.S.   Footnotes 1      Please see Vogel et al, The effects of climate extremes on global agricultural yields, Environ. Res. Lett 14 054010, 2019. 2      As a consequence of greenhouse gas emissions precipitation is expected to increase in high altitude regions such as much of the U.S. and decrease in subtropical regions such as the southwest U.S., Central America, southern Africa, and the Mediterranean basin. 3           Plants can be broken down into either C3 or C4 based on the way they assimilate atmospheric CO2 into different physiological components. While rising CO2 causes C3 plants to raise the rate of photosynthesis and reduce the respiration rate, C4 plants do not experience a rise in photosynthesis since photosynthesis is already saturated. For example, studies show that soybean yields increased 12%-15% under 550 ppm vs. 370 ppm CO2 concentrations while corn experienced negligible yield increases. 4      Please see Lesk C., P. Rowhani, and N. Ramankutty, Influence of extreme weather disasters on global crop production, Nature, 529(7584), 84-87, 2016. 5      Please see The State Of Food And Agriculture: Climate Change, Agriculture, And Food Security, Food and Agriculture Organization of the United Nations, 2016. 6      Please see Stevanovic et al., The impact of high-end climate change on agricultural welfare, Sci-Adv 2(8), 2016.

Underweight High-Conviction The latest GDP release as it pertains to housing made for grim reading: residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel). Residential investment is also on the verge of contracting in absolute terms (second panel) and will likely weigh on home improvement retailers (HIR). The direct link to HIR comes via existing home sales: when a home changes ownership usually some renovation activity takes place. Finally, lumber prices continue to crumble and given that HIR make a set margin on lumber sales, HIR profits will likely underwhelm (bottom panel). Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Home Improvement Retailers: Timber Alert    

President Trump’s announcement this week of a new deployment of aid to U.S. farmers, to offset China’s retaliation to steeper tariffs, highlights that agriculture has been the sacrificial lamb in the U.S.’s hawkish trade policy. The $15 billion announcement follows last year’s $12 billion disbursement, and suggests that the path to a trade agreement with China remains fraught. Although China and the U.S. continue to negotiate, and President Trump has indicated that “maybe something will happen” within a “three or four week” timeframe, last week’s events indicate that a resolution is far from guaranteed. Both positive and negative trade war news will dominate the near term evolution of ag prices – stay on the sidelines as negotiations will sway markets. Highlights Energy: Overweight. Crude oil prices are up ~2% since the beginning of the week on escalating tensions in the Middle East, as expected. Two Saudi oil-pumping stations were targeted in a drone attack on Tuesday. This follows attacks on four oil tankers – including two Saudi ships – off the coast of the United Arab Emirates. These events highlight the increased risk of supply outages since the U.S. decision not to extend waivers on Iran sanctions.1 Base Metals: Neutral. The recent escalation in Sino-U.S. trade tensions pushed LMEX prices down 2% since the beginning of last week. Nevertheless, we believe that in the medium term Chinese authorities will manage to offset the negative economic impact on metals by ramping up fiscal-and-credit stimulus.2 Precious Metals: Gold’s geopolitical risk premium is rising amid escalating trade tensions. Gold rallied ~2% since May 3, amid declining global equities. Our gold trade is up 5.3% since inception. Ags/Softs: Underweight. Sino-U.S. trade tensions are weighing heavily on agriculture commodities. The grains and oilseed index is down 9% since the beginning of the year. Continued trade war uncertainty will keep risks elevated in the ags space (see below). Feature Several factors – including dollar strength and bearish fundamentals – have come together to drive down ag prices so far this year. However, the latest plunge highlights that trade risks remain a real threat to ag markets. This is in line with the sharp cutback in Chinese imports of U.S. ags, which make up a large share of Chinese imports from the U.S. and have been hit hard by tariffs (Chart of the Week). Soybeans in particular have become the poster child of the dispute. Uncertainty has taken their prices down to 10 year lows. In 2017, they accounted for $12.4 worth, or 9.3%, of U.S. exports to China. However, since the onset of the dispute, American soybean farmers have been struggling to market their crops. U.S. exports to China are down more than 80% y/y since 2H18 (Chart 2), and while there have been efforts to find other markets, they have yet to offset the impact of lower trade with China (Chart 3). Chart 2Soybeans Are The Poster Child Of The Conflict A long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. In fact, the Chinese tariffs add to ongoing trade disputes between the U.S. and some of its other major ag markets (Charts 4A & 4B). Canada, Mexico, and the EU have placed tariffs on a range of U.S. agricultural goods in response to the Section 232 tariffs on steel and aluminum. As such, American farmers are suffering the brunt of the trade war’s burden. Chinese retaliation comes at a time when U.S. ag stockpiles are already elevated (Chart 5). Inflation-adjusted farm income had been deteriorating prior to the trade dispute, falling to about half its 2013 level (Chart 6). The trade dispute has only reinforced this trend. In its most recent Ag Credit Survey, the Kansas City Fed found the pace of decline in farm loan repayment rates increased, while carry-over debt increased for many borrowers, ultimately causing a deterioration in ag credit conditions. Given that exports account for 20% of U.S. farm income, according to USDA estimates, a long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. Otherwise, tariffs will simply be another constraint on U.S. ag exports, which have been losing global market share since the mid-1990s (Chart 7). Chart 5U.S. Stocks Are Relatively Elevated Chart 6Farmers Suffering The Brunt Of The Burden Chart 7U.S. Agriculture Losing Global Market Share Even though China briefly resumed some purchases of U.S. ags this year as a goodwill gesture during negotiations, these purchases stand significantly below those of previous years. They resulted from one-time purchases by Chinese state-owned enterprises, and barriers to trade remain in place. Such ad hoc attempts at reconciliation will not be sufficient to support a distrustful market going forward. The trade war is just one facet of a broader strategic U.S.-China conflict. This means a reso­lution would be only a cyclical improvement in an ongoing structural deterioration in relations. A number of potential outcomes can result from the ongoing negotiations: Most bearish: China raises the tariff rate on U.S. ag exports even further. A situation in which a fallout in the negotiations leads to strategic tensions – a scenario to which BCA’s geopolitical strategists attribute a 50% chance – could result in further ratcheting up of tariffs by China. Given that Chinese imports of U.S. ags are approaching zero, there is limited significant further downside even in this most pessimistic scenario. However, unless the U.S. is able to smoothly market its crops in other regions, upside will also be limited for some time. Since trade tariffs have already been initiated with many of the U.S.’s major ag consumers, securing reliable alternative markets may prove a challenge. Especially since Trump’s hawkish foreign policy raises risks and uncertainties for America’s trade partners. Bearish: Tariffs remain at current levels. Similar to the most bearish scenario, given that the U.S. is already having a difficult time marketing its crops abroad, significant further downside from current levels is also limited. However, any premium priced on the expectation of a resolution of the trade conflict will be eliminated. Again, as in the most bearish scenario, the loss of the Chinese market may be mitigated by an expansion of alternative markets, but challenges will remain. Bullish: Tariffs are cut back to pre-trade war levels. In this scenario, the tariffs imposed since the onset of the trade war will be unwound. This would once again raise the competitiveness of American crops in Chinese markets, and would entail higher ag prices as demand channels are re-established. Most Bullish: Tariffs fall to equalized levels. One of Trump’s key complaints is that U.S. and Chinese tariffs are not “reciprocal in nature and value” (Chart 8). Given that Chinese tariffs are above those of the U.S., this would entail a reduction in Chinese tariffs to below trade war levels (Table 1). Table 1... And They Have Gone Up A lasting trade deal will likely include measures to close the bilateral trade deficit, which in 2018 stood at $379 billion. Last year Trump called on Beijing to reduce this deficit by $200 billion over two years. If we make the overly simplistic assumption that the share of imports remains unchanged, such a reduction would lead to an additional $19 billion in soybeans, $0.54 billion in wheat, and $0.23 billion in corn imports. This back of the envelope calculation implies a doubling of these U.S. exports to China, relative to 2017 levels. As we highlighted in our March ags update, investors had become overly optimistic with their expectation of a swift resolution of the trade war.3 In fact, according to BCA’s geopolitical strategists, the trade war is just one facet of a broader strategic U.S.-China conflict. This means a resolution would be only a cyclical improvement in an ongoing structural deterioration in relations. They assign only 40% odds that a deal will be finalized by year-end, with 30% odds that the frictions will escalate into strategic tensions. In the meantime, Trump’s palliatives – which include a “trade relief” program, an EU promise to purchase more U.S. soybeans, and last week’s suggestion of government purchases for humanitarian aid – are unlikely to lift ag prices. Bottom Line: The U.S.-China trade war has weighed on American ag exports. The impact on farmers – in terms of lower incomes, and higher stockpiles – has been significant. Granting that odds of a resolution this year are no greater than 40%, we recommend a cautious stance on ag markets. However, a trade deal that entails Chinese promises to import U.S. ags – either through more favorable tariff rates or commitments to purchase large volumes – would provide a buying opportunity. In any case, we suspect that prices are near the bottom, but will require a significant catalyst – in the form of a trade deal – to begin to climb materially. No Relief From Fundamentals, Either With spring planting underway, the recent escalation in trade tensions comes at a busy time of year for U.S. farmers. According to the USDA’s annual Prospective Planting Report, released at the end of March, the planted area of corn will likely increase by 4% in 2019, while soybean and wheat will fall 5% y/y and 4% y/y, respectively. If realized, the planting area that farmers intend to dedicate to wheat will be the lowest on record – that is, since 1919 (Chart 9). However, farms in the Midwest were hit by a “bomb cyclone” in March, which has damaged crops and delayed planting. Inundated fields mean farmers are forced to push back their schedule. The latest Weekly Crop Progress Report from the USDA, indicates that farmers have fallen behind relative to typical progress at this time of year (Table 2). Although farmers’ current lack of headway is cause for concern, they may still be able to catch up and attain their targeted acreage. Chart 9Record Low Wheat Acreage Table 2Flooding Has Delayed Spring Planting Given that stockpiles are full, due to years of surplus, the impact of the flooding is unlikely to move international ag prices. Nevertheless, planting delays raise the possibility that corn farmers will switch to soybeans, which can be planted later in the season. In the May update of the World Supply And Demand Estimates – which includes the first estimates for the 2019/20 crop year — the USDA projected a decline in U.S. soybean ending stocks on the back of lower production and a pickup in exports. The switch in planting intentions towards soybeans at the expense of corn may at least partially reverse this expectation, raising global soybean inventories which are expected to remain unchanged (Chart 10). In addition to trade war, the African swine fever has hit pig herds in China – the main consumers of soybeans. According to China’s official statistics, more than a million pigs have been culled, and Chinese pork production is expected to be slashed by between a quarter and a half this year. This will depress demand for soybeans, further weighing on prices. So far this year the greenback has been a source of bearishness toward ags. Since the epidemic has spread to other Asian neighbors including Hong Kong and Vietnam, soybean demand from Asia will be reduced, regardless of the outcome of the trade war. This will also weigh on other major producers such as Brazil and Argentina, which have so far benefited from China’s shunning of the American crop. South American producers are also at risk if a positive outcome emerges from the negotiations. Chart 10No Change In Soybean Inventories Expected In The Coming Crop Year Chart 11Preliminary Projections Of Uptick In 2019/20 Wheat Inventories On the other hand, according to the latest USDA estimates, both global and U.S. year-end wheat inventories are expected to pick up in the 2019/2020 crop year (Chart 11). Greater European production will add to already elevated supplies. While global corn inventories are projected to come down, U.S. inventories will likely rise amid greater production and weaker exports. However, these acres are at risk given the flood delays (Chart 12). In addition to these supply-demand fundamentals, U.S. financial conditions – especially the U.S. dollar – will remain a key driver of ag prices. So far this year the greenback has been a source of bearishness toward ags. Ag prices have an inverse relationship with the U.S. trade-weighted dollar (Chart 13). While in our earlier report we had expected the dollar to peak by mid-year, the May 5 escalation in the trade war poses a risk to this view by threatening the global trade and growth outlook and spurring risk-off sentiment. Chart 12Another Deficit Expected ##br##For Corn Bottom Line: Farmers in the U.S. Midwest facing inundated fields are behind schedule in their spring planting. This poses a risk that a greater number of soybeans will be planted at the expense of corn – weighing down on an already depressed soybean market and potentially requiring the USDA to revise down its U.S. bean ending stocks in its next WASDE report. Chart 13U.S. Financial Conditions Continue To Weigh On Ags What is more, the African swine fever, which is spreading across East Asia, is reducing demand for animal feed there. Unless the trade conflict is resolved, we expect corn and wheat to outperform the soybean market.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Special Report titled “U.S.-Iran: This Means War?” dated May 3, 2019, available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Expanded Sino-U.S. Trade War Could Be Bullish For Base Metals,” dated May 9, 2019, available at ces.bcaresearch.com. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Financial Conditions, Trade War Continue To Dominate Ag Market,” dated March 28, 2019, available at ces.bcaresearh.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Closed Trades

Lumber is a hyper-sensitive variable that has historically moved in lockstep with the SPX, its momentum (bottom panel) and of course EPS. Lumber’s leading properties are tied to the housing market link and the recent plunge in lumber futures is disconcerting. The top panel of the chart shows that lumber peaked in mid-May and then the SPX followed suit in late-September. Similarly, lumber troughed in late-October again leading the SPX trough. Currently this economically sensitive indicator is not confirming the bullish SPX run as it peaked in early February. We reiterate our view held since early-March that at least some short-term equity market caution is warranted, especially given the negative EPS backdrop on the eve of earnings season.      

Highlights Just when it looked like the agricultural complex was starting to perk up, it was slapped down again. After crawling its way back from a mid-2018 crash – retracing more than half of its decline – the CCI Grains and Oilseeds index plummeted in February, declining by nearly 9% (Chart Of The Week). The decline was broad-based, but was led by wheat, which was dragged down by muted demand and accounted for most of the index’s decline. Looking forward, we expect U.S. financial conditions and developments on the trade-war front to remain the main forces driving ag prices. Ample inventories will provide the cushion necessary to moderate the impact of potential supply-side shocks. Highlights Energy: Overweight. Venezuela suffered another power outage earlier this week, indicating the deterioration of its infrastructure is accelerating. While officials claim to have restored power, we expect more such outages going forward, which will severely reduce the country’s production and export capacity. Separately, Aramco announced it will buy 70% of Sabic, a Saudi state-owned petchem producer, for $69 billion, according to the Wall Street Journal. Base Metals: Neutral. China’s MMG Ltd was set to declare force majeure following protests at its Las Bambas mine in Peru earlier this week. The mine produces ~ 385k MT p.a., most of which goes to China. Precious Metals: Neutral. The inversion of the U.S. yield curve put a bid into the gold market this week, as investors sought a safe-haven refuge. Continued weakness in bond yields, and accommodative central banks responding to low inflation expectations globally will continue to support gold. Agriculture: Underweight. A more patient Fed will be supportive of ag prices in 2H19, as we discuss below. Feature Chart of the WeekWheat Had A Rough Start To 2019 A Patient Fed Will Support Ags In 2H19 While differences across ag markets will arise due to idiosyncratic supply shocks and targeted trade policies, a common determinant of ag price movements more generally is U.S. financial conditions. Since our last assessment of global ag markets, Fed policymakers have adopted a much more patient approach to monetary policy.1 In line with the pause in the Fed’s rates-normalization policy, financial conditions have eased considerably (Chart 2). We believe this will, ceteris paribus, bring relief to commodity markets in general, ags in particular, in the second half of this year. Chart 2Easier Financial Conditions Bode Well For Ags The bulk of this relief will be transmitted through the impact of a weaker dollar. Since the dollar is a countercyclical currency, its weakness implies an improvement in global growth. This more solid economic backdrop is associated with greater aggregate demand, particularly in EM economies, as well as demand for agricultural products. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. Furthermore, when the USD weakens against the currencies of ag exporting countries, farmers there are incentivized to hoard or cut exports – thus reducing supply – awaiting periods when a stronger greenback will raise their profits. At the same time, ags priced in USD become relatively more affordable for importing nations, incentivizing them to raise consumption. The net impact of this contraction in supply amid greater demand will pull up prices – illustrated by the relatively tight inverse relationship between ag prices and the dollar (Chart 3). Chart 3A Weaker USD Will Be A Tailwind In 2H19 Going into mid-2019, we expect global economic indicators to continue to be uninspiring. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. However, as these factors fade and give way to an improvement in global economic conditions and easier financial conditions, we expect the dollar to peak around mid-year. As such, a resurgence in global growth in the second half of the year will be reflected in an improvement in the value of the currencies of major ag exporters ex-U.S. (Chart 4). Ceteris paribus, this also benefits ag prices. Chart 4Weak Local Currencies Supporting Farm Profits, Incentivizing Production China’s Economy Remains Central Our outlook hinges on developments in the Chinese economy. Peter Berezin – our Chief Global Investment Strategist – expects Chinese authorities to not only stabilize credit growth, but also increase it, creating room for improvement in the world’s second largest economy.2 This combination of supportive global growth and a softer dollar bodes well for ag prices in 2H19. The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. Apart from the currency impact, easy financial conditions are supportive of global growth. A rise in income levels of emerging economies will support demand for goods and services generally, and agricultural commodities specifically.3 The market now expects 36 and 51 basis points of rate cuts over the coming 12 and 24 months, respectively. Similarly, following last week’s FOMC meeting, the median Fed dot indicates no rate hikes this year from the U.S. central bank, and only one in 2020. While our Global Investment Strategists would not be surprised to see a hike this year, the noticeably less hawkish tone in the Fed’s forward guidance and dot plots are positive for ag markets.4 Looking beyond that into late-2020 or early 2021, a potential pick-up in inflation will force the Fed to take a more hawkish stance, and once again support the U.S. dollar. This will weigh down on ag prices over the strategic time horizon. Bottom Line: The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. However, this is unlikely to occur before mid-year. In the meantime, a stronger dollar on the back of the lagged effects of growth dampening events in 2018, will remain a headwind. Ample Inventories Will Cushion Against Supply Shocks Putting aside the more or less uniform impact of U.S. financial conditions, individual supply-demand fundamentals will manifest as idiosyncratic risks and opportunities. The USDA has been revising its projections for ending stocks higher in its monthly World Agricultural Supply and Demand Estimates (WASDE) across the board since it released the first projections for the 2018/2019 crop year last May. However, we find that solely on the back of fundamentals, soybeans are more likely to resist upward pressure from easier U.S. financial conditions in 2H19 vs. wheat and corn. The USDA’s latest projections for the current crop year indicate that global bean markets are well supplied. Expectations of a global surplus this crop year – for the seventh consecutive year – will add to the growing cushion (Chart 5). Chart 5Beans Surplus Will Add To the Glut Since May, global ending bean stocks have been revised higher by a total of 20.47mm MT. The change in projections comes on the back of upward revisions to production and beginning stocks, compounded by downward revisions to consumption. The latter will likely contract further if the U.S. and China do not reach an agreement on the trade front (see below). Consequently, unless a weather disruption weakens supply, we expect soybean inventories to stand at record highs relative to consumption at the end of the current crop year. In the case of wheat, the impact on prices will likely be marginal. The global balance is expected to shift to a deficit in the current marketing year, following five years of surplus (Chart 6). While this is a positive for wheat prices, given that global inventory levels are relatively elevated – capable of supporting 37% of consumption – and the current deficit is relatively small, we do not expect the deficit to pressure prices in the near term. Chart 6Elevated Wheat Inventories Will Cushion Against Minor Deficit Despite continued downward revisions to the USDA’s wheat production projections, expectations of ending stocks have actually risen on the back of downward revisions to consumption. Similarly, corn fundamentals are also unlikely to sway prices much. The grain is expected to remain in deficit for the second consecutive year, which will pull inventories down off their 2016/17 peak to be capable of covering ~27% of global consumption (Chart 7). Despite this contraction in availability, global supplies remain relatively elevated, especially compared to the 2003 to 2012 period. Thus unless there is a significant supply shock, we don’t expect much support from fundamentals. Chart 7A Global Corn Deficit ... Unlike wheat demand, which has been downgraded, the USDA has revised corn consumption up relative to the first projections for the crop year released last May. Nevertheless, stronger expectations of consumption have been overwhelmed by upward revisions to production and beginning inventory levels. Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Since the mid-1990s, U.S. farmers had been planting more corn and wheat at the expense of soybean acreage (Chart 8). On a global level, while wheat remains more popular in terms of acreage, it is generally trending downwards, while corn and soybean plantings are trending up. However, over the longer term, U.S. farmers are expected to dedicate more land to corn relative to soybeans. Chart 8... Will Be Met By Rising U.S. Acreage Bottom Line: Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Similarly, a global glut in soybean supplies will only add to swelling inventories. The Trade War And Soybeans: It Ain’t Over Till It’s Over Aside from U.S. financial conditions and supply-demand balances, U.S. trade policy has also been roiling ag markets since China slapped U.S. soybeans with 25% tariffs in mid-2018. In fact, since the escalation of the trade dispute, soybean prices have been moving largely in response to developments on the trade front (Chart 9). As developments since the G20 Summit in Buenos Aires last December have been more favorable, soybean markets are on the path to recovery. Chart 9Markets Optimistic Of A Trade War Resolution So far, even though U.S. soybean exports to China picked up over the past two months, total U.S. exports still lag levels typical for this time of year (Chart 10). This comes despite U.S. efforts to raise shipments to other trading partners. Furthermore, U.S. exports will now be in direct competition with the Brazilian crop, which usually dominates trade flows at this time of year (Chart 11). While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. The Trump-Xi meeting that was expected to occur in late-March was postponed; the next most likely date for a meeting is at the G20 summit in end-June. This leaves another 3 months of trade uncertainty. Nevertheless, our models indicate that soybeans are now priced at fair value, based on U.S. financial variables – absent a trade war (Chart 12). Furthermore, the premium priced into Brazilian beans above those traded on the CBOT has returned to its historical average (Chart 13). Thus, we do not expect a further reduction in the premium in the event Sino-U.S. trade negotiations are successful. Chart 13Premium For Brazilian Beans Has Normalized Rather, markets will be disappointed if the U.S. and China are unable to conclude a deal. This would put CBOT prices at risk and support the premium on those traded in Brazil. Given that our geopolitical strategists assign a non-negligible 30% probability that the trade war escalates further, we believe markets are overly optimistic that a deal will be concluded.5 If the trade war drags on and turns into a multi-year conflict, soybean markets will likely take a more meaningful hit. According to the USDA’s latest long-term projections released earlier this month, China’s soybean imports were projected to rise 32.1mm MT during the 2018-28 period – a massive downward revision from the 46mm MT expected for the 2017-2027 period contained in the previous long-run projections. Furthermore, outbreaks of African swine fever in China may put demand there at risk. Over 100 cases have so far been reported in China, with several cases already reported in Vietnam as well. This threatens to depress China’s need for soybean as animal feed, regardless of what happens on the trade front. Bottom Line: A positive outcome from the U.S.-China trade negotiations is not a given. Nevertheless, soybean markets are treating it as such. Our geopolitical strategists assign 30% odds that a final deal falls through. This non-negligible probability threatens to cause soybean prices to relapse anew, should Sino-U.S. trade negotiations break down.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published by BCA Research’s Commodity & Energy Strategy December 13, 2018.  It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Global Investment Strategy Weekly Report titled “What’s Next For The Dollar,” dated March 15, 2019, available at gis.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Global Financial Conditions Will Drive Grain Prices In 2018,” dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see BCA Research’s Global Investment Strategy Weekly Report titled “Questions From The Road,” dated March 22, 2019, available at gis.bcaresearch.com. 5 Please see BCA Research’s Geopolitical Strategy Special Report titled “China-U.S. Trade: A Structural Deal?,” dated March 6, 2019, available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades  

As the world’s second most populous country with an economy projected to grow over 7% annually, India’s potential as a commodity consumer is massive. However, years of distortionary and unfriendly policies have held back the Indian manufacturing sector – the prime consumer of commodities. This has translated into weak “consumption intensity” of industrial commodities. The past four years have witnessed a shift to more business-friendly policies. These policies and an eventual expansion of the manufacturing base will support steeper demand for industrial commodities over the longer term. India’s economic model stands in stark contrast with China’s, which became a voracious consumer of commodities as it industrialized. It is not “the next China” when it comes to metals demand, but it will play an important and growing global role. In terms of agricultural commodities, favorable demographic trends will raise aggregate demand, regardless of the success of India’s industrialization. Highlights Energy: Overweight. Russia’s production was down 42k b/d in January, a trifle compared to the ~ 450k b/d reduction by the Kingdom of Saudi Arabia (KSA) in December. Officials indicate Russia will cut production by 228k b/d in 1Q19. Base Metals/Bulks: Neutral. Indian steelmakers are seeking relief from increasing imports in the form of higher duties, as slowing Asian demand leads to higher shipments from China, Korea, and Japan, according to Reuters.1 Precious Metals: Neutral. Gold markets appear more confident in the Fed’s capitulation on its rates-normalization policy, at least in 1H19, as prices rallied above USD 1,320/oz in end-January. Gold traded slightly lower this week. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA releases its WASDE report tomorrow. Feature The impact of China’s rapid industrialization since 2000 on commodity markets is well known. Its share of global consumption of copper and crude oil rose from a modest 10.9% and 6.0% in 2000 to 51.1% and 13.5%, respectively (Chart of the Week). As such, China fueled global demand growth over this period (Chart 2) and, in large part, is responsible for the commodity price boom that ensued. Chart of the WeekChina Now Dominates Industrial Commodity Demand With such a large chunk of demand originating in China, its economic health remains a dominant variable in accurately predicting the path of industrial commodity prices globally. However, with economic priorities shifting from the industrial sector to consumer-driven services, the era of insatiable Chinese commodity demand growth looks to be nearing its end. In search of a replacement to take up the slack, India has often been singled out as a potential leading source of commodity demand growth going forward, and for good reason: India is massive. In terms of population, it is roughly on par with China, boasting a population of 1.3 billion people. And while its share of global wealth is dwarfed by China’s, India’s economy is growing at a rapid pace. According to the most recent IMF projections, its GDP will expand at a 7.5%, and 7.7% clip this year and next – faster than China’s projected 6.2% for both years. Typically, as low income economies develop, their manufacturing sector outpaces economy-wide growth, raising the contribution of industry to overall GDP. Stronger activity in this sector correlates well with industrial commodity demand, which rises accordingly. Meanwhile ag demand is determined by both population and income growth. India, however, has missed the boat (Table 1). Its share of global demand is disproportionate to its current size and its future potential. Table 1India’s Consumption Of Industrial Metals Stands Out As Disproportionately Low In fact, the intensity of commodity usage per dollar of GDP is low even relative to countries at similar income levels (Chart 3). This is most clear in the case of metals. It can be put down to the relatively small role of manufacturing in India’s economy. India did not follow the traditional path of growing its manufacturing base first before re-orienting its economy towards services. Rather, the manufacturing sector has been held back by poor infrastructure and distortionary policies. In fact, services – such as financial services, business services, and telecom – already dominate India’s economy, accounting for 53.9% of GDP, compared to 16.7% in the case of manufacturing (Chart 4). This is in stark contrast with other economies such as China, Korea, and Thailand, in which manufacturing accounts for 29%, 28%, and 27%, respectively (Chart 5). Chart 5No Pickup In Manufacturing Yet Given that the services sector is relatively less metals- and energy-intensive, India’s contribution to global demand for industrial commodities has been disproportionately low. Bottom Line: India’s growth model to date is oriented toward the services sector. As a result, the intensity of industrial commodity demand there – measured as consumption per dollar of GDP – is significantly lower than its peers. This has prevented India from playing a larger role in global commodity markets. The Case For Greater Commodity Demand: Theories And Evidence Economist Walt Whitman Rostow postulated that economies develop through five distinct phases: Traditional society: subsistence agriculture, low level of technology, labor-intensive Preconditions to takeoff: regional trade, the development of manufacturing Take off: the beginning of industrialization Drive to maturity: rising living standards, economic diversification, strong use of technology High mass consumption: mass production and consumerism Along this path, economies in phases (2), (3), and (4) are the most notable in terms of rising appetite for industrial commodities. During these stages, the industrialization and urbanization processes require an expansion of electricity grids, infrastructure and housing. As such, these stages are characterized by high base metals demand. Yet as illustrated by the sigmoid, or S curve, the period of exponential growth in commodity demand eventually slows down and in many cases falls after the country reaches a certain level of GDP per capita (Chart 6). Evidence from metals and oil corroborate this theory. In fact, if we single out the commodity intensity path of DM economies as their incomes were rising, we find that commodity intensity there has already started to decline (Chart 7). This S-curve is also evident in the commodity intensity of emerging economies (Chart 8). China’s path to development stands out as an extreme case of high consumption usage. While not all economies follow China, the paths are similar. In the case of oil, it appears that the consumption intensity of countries that have developed more recently peaked at both a lower income level and a lower oil usage level than countries that developed earlier. This is clearly the case for Korea and Malaysia, and suggests that technology has raised the efficiency of oil. On this basis, we do not expect India’s commodity intensity to reach the same peaks as its more wealthy peers. However, India’s usage has remained stagnant and in some cases fallen. This highlights the relatively muted role of manufacturing in India’s economy. As India’s economy grows and evolves, this should change. We project India’s commodity intensity path as it grows its manufacturing base (Chart 9). Based on this exercise, we find that by the year 2040, India’s consumption of refined copper will account for 12% of global consumption -- up from 2% today.  The impact is more muted in the oil sector -- we expect it will account for almost 12% of global crude oil demand, from the current 5%. This trajectory reveals that the scope for rising demand is greater for metals than for the oil sector, implying that industrial commodities are set to benefit in the case of a boom in Indian manufacturing. Bottom Line: Both theory and evidence suggests that the intensity of India’s commodity usage is set to rise over time as its manufacturing sector expands. This is especially true in the case of metals. Even in our most conservative projection, India’s copper consumption is set to rise more than 10-fold by 2040. The Path Forward: “Make In India” While the Rostow model is instructive in framing our thinking on the path to development, it is a crude theory – not all countries will necessarily follow the same path to development. These are the lessons from economist Alexander Gerschenkron’s theory of economic backwardness, which highlights that countries’ growth paths may not be identical or replicable due to cross-country differences, and differences in the state of technology available at varying points of time. Applying these ideas to India means that while India is able to access current technology, which supports a more rapid industrialization process, its economic model is also very different. The China model rested on a powerful single-party state, with privileged access to the American market, that used its control of the financial system to funnel a swell of national savings into an aggressive industrialization effort. On the other hand, the India model required the government to move forward incrementally. Indian leaders had to pursue industrialization while grappling for democratic consensus in the context of extreme social diversity and a more restrictive trade environment. Thus, India is likely to mimic the circuitous path of emerging markets like Brazil or Mexico. Over the past four years, Indian policymakers have tried to unwind unfavorable business policies and spur growth in the manufacturing sector. The “Make in India” initiative of Prime Minister Narendra Modi seeks to encourage both foreign and domestic investment, and to raise the manufacturing sector’s contribution to GDP to 25% by the year 2025. In the process it aims to create 100 million jobs. This target is unrealistic. In fact, the manufacturing sector’s contribution to GDP has come down slightly, with economists blaming the demonetization drive and the chaotic, complicated and unclear roll out of the new Goods and Services Tax. Modi also faces tough elections this spring, which could put his initiative on ice. Nevertheless, there is a positive omen in the automobile industry. According to figures from the Society of Indian Automobile Manufacturers, roughly 4 million cars were manufactured last year – up from 3.2 million just five years ago (Chart 10). This is in line with India’s Automotive Mission Plan 2026, which aims for the auto industry to become one of the top three, accounting for 40% of the manufacturing sector and contributing 12% to India’s GDP by 2026. Chart 10An Encouraging Trend For Manufacturing Moreover, Modi’s impact has been a net positive in making India more welcoming for investment. While poor infrastructure, red tape, and restive labor laws are still constraining industry, measures of institutional performance are improving (Chart 11). This is a prerequisite for a brighter manufacturing future. As for the election, even if India’s opposition Congress Party should come to power, it will have learned from its five years in the political wilderness that Modi’s message of economic development resonates with the public. Their current stance on economic policy calls for import substitution, economic liberalization, and a faster pace of development – consistent with a growing manufacturing sector. Chart 11The Business Environment Is Improving The Business Environment Is Improving Bottom Line: While the “Make In India” campaign says as much about Modi’s flair for public relations as anything, India’s business environment is now more conducive to growth and investment. This bodes well for commodity demand going forward. Ags In The Age Of Manufacturing While a much-needed push in India’s manufacturing sector would clearly have a direct impact on its demand for industrial metals, the resulting improvement in the economy and employment would also raise incomes. In theory, this would support the consumption of agricultural commodities. Nonetheless, a couple of observations suggest that India is less of an opportunity for ags as it is for metals (Chart 12): In terms of the level of ag consumption per capita, rice usage is actually relatively high in India. While corn intensity levels are still quite low, wheat consumption per capita is near the level at which China plateaued. The differences across these grains likely reflects differences in preferred sources across countries and implies there is not as much room for catch up. Furthermore, ag consumption per capita generally plateaus at fairly low-income levels, in stark contrast to the industrial metals. A clear outlier is corn consumption in the United States, where high-usage patterns can be put down to the rising use of corn for ethanol production on the back of biodiesel mandates. We do not expect growth in ag consumption intensity on the back of rising incomes. Nevertheless, India’s population is projected to continue rising, in turn supporting aggregate food consumption there. That said, policies promoting India’s self-sufficiency in agriculture have generally prevented rising demand from spilling over into global markets. In fact, in terms of the trade balance, India is usually a net exporter of these grains, especially in the case of rice (Chart 13). This is a positive for India – in that it has so far avoided the risk of food shortage that occasionally rears its head – but it is a negative for global ag demand. Chart 13Self-Sufficiency Policies Insulate The Indian Ag Sector Bottom Line: Unlike industrial commodities, we do not anticipate a rise in per capita ag consumption in India. Nevertheless, a rapidly growing population will mean that aggregate demand for ags will grow briskly.    Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “Exclusive: Indian steel firms seek higher duties on steel imports as prices drop,” published by Reuters.com on February 5, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Commodity Prices and Plays Reference Table Summary of Trades Closed in 2018