War/Conflict
Supply - demand fundamentals point to higher oil prices going forward. Our expectation regarding OPEC production remains unchanged: The original cartel led by the Kingdom of Saudi Arabia (KSA) will maintain production discipline this year – likely continuing to over-comply with quotas agreed at the start of the year – to support its long-standing goal to reduce oil inventories globally. Non-OPEC member states in OPEC 2.0 led by Russia also will maintain lower output this year. The OPEC 2.0 coalition will meet July 1 - 2 in Vienna to determine whether it will extend production cuts. On the demand side, we lowered our expectation for this year and next, following the World Bank’s recent downgraded assessment of global GDP growth. Our expectation remains slightly above the EIA’s and the IEA’s. Globally, central bank easing will support demand. Following these adjustments, we are keeping our Brent forecast at $73/bbl this year and lowering our forecast for next year to $75/bbl from $77/bbl. We continue to expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The balance of risk is to the upside. The risk of hybrid warfare (see below) in the Persian Gulf -- and the wider region -- will increase, as Iranian and U.S. positions harden. Highlights Highlights Energy: Overweight. The U.S. Central Command released photos supporting an analysis claiming Iran was responsible for two attacks on commercial shipping in the Persian Gulf last week. The Pentagon deployed an additional 1,000 troops to the region, following this assessment. President Trump, meanwhile, downplayed the attacks, calling them a “very minor event.”1 Base Metals: Neutral. Copper speculators lifted their short position 6k lots to 51.7k lots on CME last week. This is a record short. But the cash market is getting tighter. Treatment and refining charges (TC/RCs) moved lower last week, as Fastmarkets MB’s TC/RC Asia – Pacific index hit $54.10/MT, $05.41/lb. This is the lowest level on record for the index, which was launched in June 2013. A low index reading means copper concentrate is in short supply, forcing refiners to lower the price of their services. We remain long the September 2019 $3.00/lb Calls vs. short the September 2019 $3.30/lb calls. Precious Metals: Neutral. Safe-haven demand continues to support gold prices, although news of a Trump – Xi meeting at the G20 in Japan to re-start trade talks reduced the urgency of buying earlier this week. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Rain continued to soak the U.S. Midwest this past week, putting a bid under grains – particularly corn – and beans. This week’s USDA Crop Progress report showed corn planting still behind schedule (at 92% vs. 100% on average in the 2014 – 18 period in the 18 states that accounted for 92% of total acres planted last year). Feature The information flows to oil markets are becoming internally contradictory. On the one hand, recent attacks on commercial oil-product tankers near the Strait of Hormuz – where close to 20% of the world’s oil supply transits daily – raised the ante in the U.S.-GCC-Iran stand-off. The attacks follow earlier aggression against shipping and pipelines in the region, and prompted KSA’s Energy Minister Khalid al-Falih to call for a collective response to keep Gulf sea lanes open to allow oil to flow freely worldwide.2 In the post-WWII era, the U.S. has willingly taken on the responsibility of keeping the world’s sea lanes open for the free flow of commodities and finished products. However, based on remarks U.S. President Donald Trump made to Time magazine this week, it would appear the U.S. no longer is willing to shoulder the burden of defending freedom of navigation in the Persian Gulf.3 The presidential sangfroid in the wake of last week’s attacks in the Gulf – which Pentagon analysts insist were launched by Iran – might be explained by the Trump administration’s belief the global oil market is “very well-supplied,” as U.S. Deputy Energy Secretary Dan Brouillette contended in an S&P Global Platts interview this past weekend.4 Indeed, this has become part of the narrative whenever the administration discusses oil markets. Brouillette said abundant crude availability prevented oil prices from spiking to $140/bbl in the wake of the attacks on the two commercial tankers. Will The U.S. Defend Gulf Sea Lanes? The global oil market is “well supplied” as long as the Strait of Hormuz – the most critical chokepoint in the world – stays open. Freedom of navigation on the open seas is the sine qua non of a well-functioning oil market – everything from getting supplies to refiners to getting products to consumers depends on it. Oil is a globally traded, waterborne commodity: ~ 60% of all crude exports are loaded on a ship and sent to refiners, directly or via trading companies.5 A liquid crude market requires an unimpeded shipping market, so that refiners can run their operations in a routine manner. In addition, a smoothly functioning shipping market allows refiners to pick and choose among various grades that can be arbitraged against each other, so they can optimize charging stocks. The market cannot absorb the loss of close to 20mm b/d of crude and refined products, which is what would happen if the Strait shut down. It is the most important choke point in the world (Map 1). We’re sure the White House knows this. President Trump’s professed desire to leave the U.S. commitment to maintaining the free flow of oil out of the Gulf is a “question mark” that might be taken as a taunt to up the ante with Iran. Already, in response to the U.S. re-imposing sanctions on Iranian oil exports after unilaterally abrogating the Joint Comprehensive Plan of Action (JCPOA) agreement, Iran announced it will resume production of enriched uranium for its nuclear program on June 27.6 As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated. The growing tension in this standoff increases the risk of hybrid warfare in the Persian Gulf, which, should it continue to escalate, increases the risk to global oil flows, as Anthony H. Cordesman at the Center For Strategic & International Studies in Washington recently noted: First, the military confrontation between Iran, the U.S., and the Arab Gulf states over everything from the JCPOA to Yemen can easily escalate to hybrid warfare that has far more serious forms of attack. And second, such attacks can impact critical aspects of the flow of energy to key industrial states and exporters that shape the success of the global economy as well as the economy of the U.S.7 There is a risk this hybrid warfare metastasizes into a full-on war in the Gulf, which would threaten the free flow of oil through the Strait of Hormuz. Should the Strait be closed, a global oil-price shock almost surely would occur, which most likely would send oil prices through $150/bbl. At that point either the warfare is contained and resolved quickly, or the world has to line up 20mm b/d of crude oil and refined products to replace the lost supply from the Gulf. As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated (Chart of the Week). Chart of the WeekVolatility Will Remain High OPEC 2.0 Will Maintain Production Discipline Even as tensions in the Persian Gulf escalate, we continue to expect OPEC 2.0 to maintain its production discipline. While the producer coalition agreed to remove 1.2mm b/d of production from the market last December, we estimate year-on-year (y/y) year-to-date (ytd) production of OPEC is down ~ 1.4mm b/d in the January-to-May period. For Russia, production over that period y/y is up 310k b/d ytd. For all of OPEC 2.0, we have the group increasing production in 2H19, but we have it ending 2019 with production 480k b/d lower than last month’s forecast. The increase is mainly from Saudi Arabia, which averages ~ 10.2mm b/d of production in 2H19, roughly 130k b/d below quota. We have Russian production averaging ~ 11.5mm b/d, which is close to quota, in 2H19 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) For the year as a whole, we are forecasting OPEC production will fall 1.6mm b/d this year versus 2018 levels, while Russia’s production grows slightly (~ 80k b/d). For next year, OPEC’s production will stay relatively flat (falling ~ 70k b/d), while we expect Russia’s production to increase 230k b/d (Table 1). Outside OPEC 2.0, the U.S. continues to dominate the production-growth story, led by increasing shale-oil output (Chart 2). We expect shale output to grow ~ 1.2mm b/d this year and just over 1mm b/d in 2020. Chart 2U.S. Shales Dominate Non-OPEC Production Growth Global Demand Is Holding Up While we do expect somewhat lower demand this year and next versus where we were earlier this year, we still expect consumption to remain fairly robust. We expect demand to grow ~ 1.35mm b/d this year and 1.55mm b/d next year, down from 1.50mm and 1.60mm b/d, respectively, in our base case. As always this is led by non-OECD demand growth, which we expect will clock in with an increase of just over 1mm b/d this year versus last year, and 1.3mm b/d next year on average. EM commodity importers will dominate growth, as usual (Chart 3). Trade-war concerns will continue to dominate headlines, but even so, demand remains reasonably stout. While it always is possible the U.S. and China will be able to resolve their trade war – perhaps in dramatic fashion following the G20 meeting in Japan – our colleagues in BCA Research’s doubt it.8 Continuing Sino – U.S. and Iranian – U.S. tension could keep the USD relatively well bid, which will present a headwind to oil demand. That said, we believe central banks generally will feel compelled to remain accommodative so long as trade wars persist. This accommodation, coupled with fiscal stimulus in many of the systemically important economies, will be supportive of demand overall, EM demand in particular. Chart 3EM Oil Demand Growth Once Again Leads The World Bottom Line: Supply – demand balances indicate crude oil prices still have room to run in 2H19 and next year. We are maintaining our forecast of $73/bbl for Brent this year. We are lowering our forecast for 2020 to $75/bbl (Chart 4). We expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The combination of stout demand growth, production discipline by OPEC 2.0 and capital discipline by U.S. shale producers will allow inventories to resume drawing this year (Chart 5). Chart 4Supply - Demand Balances Point To Higher Prices Chart 5Stout Demand, Supply Discipline Will Allow Inventories To Draw Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Please see Analyst: New Photos Are ‘Smoking Gun’ Proving Iranian Involvement in Tanker Attack published by USNI News, and Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. 2 Please see Saudi Energy Minister calls for collective effort to secure shipping lanes published by reuters.com June 17, 2019. 3 Please see Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. Tessa Berenson reported: “Facing twin challenges in the Persian Gulf, President Donald Trump said in an interview with TIME Monday that he might take military action to prevent Iran from getting a nuclear weapon, but cast doubt on going to war to protect international oil supplies.“I would certainly go over nuclear weapons,” the president said when asked what moves would lead him to consider going to war with Iran, “and I would keep the other a question mark.” 4 Please see Interview: Abundant oil supply prevented spike to $140/b after ship attacks - US DOE deputy published by S&P Global Platts June 16, 2019. 5 Please see World Oil Transit Chokepoints published by the U.S. EIA. 6 Please see Iran nuclear deal: Enriched uranium limit will be breached on 27 June published by bbc.co.uk June 17, 2019. JCPOA agreement between Iran and the so-called P5+1 nations – China, France, Germany, Russia, the U.K. and the U.S. – allowed Iran to return to global markets in exchange for limiting its nuclear development. Please see The Joint Comprehensive Plan of Action (JCPOA) at a Glance published by Arms Control Association in May 2018. 7 Please see The Strategic Threat from Iranian Hybrid Warfare in the Gulf published by CSIS June 13, 2019. 8 Please see Policy Risk Restrains Oil Prices published by BCA Research’s Commodity & Energy Strategy May 30, 2019, where we reprise the different policy risks oil markets are contending with at present, particularly the trade war. It is available at ces.bcaresearch.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 Closed
Highlights So What? U.S.-China relations are still in free fall as we go to press. Why? The trade war will elicit Chinese stimulus but downside risks to markets are front-loaded. The oil risk premium will remain elevated as Iran tensions will not abate any time soon. The odds of a no-deal Brexit are rising. Our GeoRisk Indicators show that Turkish and Brazilian risks have subsided, albeit only temporarily. Maintain safe-haven trades. Short the CNY-USD and go long non-Chinese rare earth providers. Feature The single-greatest reason for the increase in geopolitical risk remains the United States. The Democratic Primary race will heat up in June and President Trump, while favored in 2020 barring a recession, is currently lagging both Joe Biden and Bernie Sanders in the head-to-head polling. Trump’s legislative initiatives are bogged down in gridlock and scandal. The remaining avenue for him to achieve policy victories is foreign policy – hence his increasing aggressiveness on both China and Iran. The result is negative for global risk assets on a tactical horizon and possibly also on a cyclical horizon. A positive catalyst is badly needed in the form of greater Chinese stimulus, which we expect, and progress toward a trade agreement. Brexit, Italy, and European risks pale by comparison to what we have called “Cold War 2.0” since 2012. Nevertheless, the odds of Brexit actually happening are increasing. The uncertainty will weigh on sentiment in Europe through October even if it does not ultimately conclude in a no-deal shock that prevents the European economy from bouncing back. Yet the risk of a no-deal shock is higher than it was just weeks ago. We discuss these three headline geopolitical risks below: China, Iran, and the U.K. No End In Sight For U.S.-China Trade Tensions U.S.-China negotiations are in free fall, with no date set for another round of talks. On March 6 we argued that a deal had a 50% chance of getting settled by the June 28-29 G20 summit in Japan, with a 30% chance talks would totally collapse. Since then, we have reduced the odds of a deal to 40%, with a collapse at 50%, and a further downgrade on the horizon if a positive intervention is not forthcoming producing trade talks in early or mid-June (Table 1). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 We illustrate the difficulties of agreeing to a deal through the concept of a “two-level game.” In a theoretical two-level game, each country strives to find overlap between its international interests and its rival’s interests and must also seek overlap in such a way that the agreement can be sold to a domestic audience at home. The reason why the “win-win scenario” is so remote in the U.S.-China trade conflict is because although China has a relatively large win set – it can easily sell a deal at home due to its authoritarian control – the U.S. win set is small (Diagram 1). Diagram 1Tiny Win-Win Scenario In U.S.-China Trade Conflict The Democrats will attack any deal that Trump negotiates, making him look weak on his own pet issue of trade with China. This is especially the case if a stock market selloff forces Trump to accept small concessions. His international interest might overlap with China’s interest in minimizing concessions on foreign trade and investment access while maximizing technological acquisition from foreign companies. He would not be able to sell such a deal – focused on large-scale commodity purchases as a sop to farm states – on the campaign trail. Democrats will attack any deal that Trump negotiates. While it is still possible for both sides to reach an agreement, this Diagram highlights the limitations faced by both players. Meanwhile China is threatening to restrict exports of rare earths – minerals which are critical to the economy and national defense. China dominates global production and export markets (Chart 1), so this would be a serious disruption in the near term. Global sentiment would worsen, weighing on all risk assets, and tech companies and manufacturers that rely on rare earth inputs from China would face a hit to their bottom lines. Chart 1China Dominates Rare Earths Supply Over the long haul, this form of retaliation is self-defeating. First, China would presumably have to embargo all exports of rare earths to the world to prevent countries and companies from re-exporting to the United States. Second, rare earths are not actually rare in terms of quantity: they simply occur in low concentrations. As the world learned when China cut off rare earths to Japan for two months in 2010 over their conflict in the East China Sea, a rare earths ban will push up prices and incentivize production and processing in other regions. It will also create rapid substitution effects, recycling, and the use of stockpiles. Ultimately demand for Chinese rare earths exports would fall. Over the nine years since the Japan conflict, China’s share of global production has fallen by 19%, mostly at the expense of rising output from Australia. A survey of American companies suggests that they have diversified their sources more than import statistics suggest (Chart 2). Chart 2Import Stats May Be Overstating China’s Dominance The risk of a rare earths embargo is high – it fits with our 30% scenario of a major escalation in the conflict. It would clearly be a negative catalyst for companies and share prices. But as with China’s implicit threat of selling U.S. Treasuries, it is not a threat that will cause Trump to halt the trade war. The costs of conflict are not prohibitive and there are some political gains. Bottome Line: The S&P 500 is down 3.4% since our Global Investment Strategists initiated their tactical short on May 10. This is nearly equal to the weighted average impact on the S&P 500 that they have estimated using our probabilities. Obviously the selloff can overshoot this target. As it does, the chances of the two sides attempting to contain the tensions will rise. If we do not witness a positive intervention in the coming weeks, it will be too late to salvage the G20 and the risk of a major escalation will go way up. We recommend going short CNY-USD as a strategic play despite China’s recent assurances that the currency can be adequately defended. Our negative structural view of China’s economy now coincides with our tactical view that escalation is more likely than de-escalation. We also recommend going long a basket of companies in the MVIS global rare earth and strategic metals index – specifically those companies not based in China that have seen share prices appreciate this year but have a P/E ratio under 35. U.S.-Iran: An Unintentional War With Unintentional Consequences? “I really believe that Iran would like to make a deal, and I think that’s very smart of them, and I think that’s a possibility to happen.” -President Donald Trump, May 27, 2019 … We currently see no prospect of negotiations with America ... Iran pays no attention to words; what matters to us is a change of approach and behavior.” -Iranian Foreign Ministry spokesman Abbas Mousavi, May 28, 2019 The U.S. decision not to extend sanction waivers on Iran multiplied geopolitical risks at a time of already heightened uncertainty. Elevated tensions surrounding major producers in the Middle East could impact oil production and flows. In energy markets, this is reflected in the elevated risk premium – represented by the residuals in the price decompositions that include both supply and demand factors (Chart 3). Chart 3The Risk Premium Is Rising In Brent Crude Oil Prices Tensions surrounding major oil producers ... are reflected in the elevated risk premium – represented by the residuals in the Brent price decomposition. Already Iranian exports are down 500k b/d in April relative to March – the U.S. is acting on its threat to bring Iran’s exports to zero and corporations are complying (Chart 4). Chart 4Iran Oil Exports Collapsing What is more, the U.S. is taking a more hawkish military stance towards Iran – recently deploying a carrier strike group and bombers, partially evacuating American personnel from Iraq, and announcing plans to send 1,500 troops to the Middle East. The result of all these actions is not only to reduce Iranian oil exports, but also to imperil supplies of neighboring oil producers such as Iraq and Saudi Arabia which may become the victims of retaliation by an incandescent Iran. Our expectation of Iranian retaliation is already taking shape. The missile strike on Saudi facilities and the drone attack on four tankers near the UAE are just a preview of what is to come. Although Iran has not claimed responsibility for the acts, its location and extensive network of militant proxies affords it the ability to threaten oil supplies coming out of the region. Iran has also revived its doomsday threat of closing down the Strait of Hormuz through which 20% of global oil supplies transit – which becomes a much fatter tail-risk if Iran comes to believe that the U.S. is genuinely pursuing immediate regime change, since the first-mover advantage in the strait is critical. This will keep markets jittery. Current OPEC spare capacity would allow the coalition to raise production to offset losses from Venezuela and Iran. Yet any additional losses – potentially from already unstable regions such as Libya, Algeria, or Nigeria – will raise the probability that global supplies are unable to cover demand. Going into the OPEC meeting in Vienna in late June, our Commodity & Energy Strategy expects OPEC 2.0 to relax supply cuts implemented since the beginning of the year. They expect production to be raised by 0.9mm b/d in 2H2019 vs. 1H2019.1 Nevertheless, oil producers will likely adopt a cautious approach when bringing supplies back online, wary of letting prices fall too far. This was expressed at the May Joint Ministerial Monitoring Committee meeting in Jeddah, which also highlighted the growing divergence of interests within the group. Russia is in support of raising production at a faster pace than Saudi Arabia, which favors a gradual increase (conditional on U.S. sanctions enforcement). Both the Iranians and Americans claim that they do not want the current standoff to escalate to war. On the American side, Trump is encouraging Prime Minister Shinzo Abe to try his hand as a mediator in a possible visit to Tehran in June. We would not dismiss this possibility since it could produce a badly needed “off ramp” for tensions to de-escalate when all other trends point toward a summer and fall of “fire and fury” between the U.S. and Iran. If forced to make a call, we think President Trump’s foreign policy priority will center on China, not Iran. But this does not mean that downside risks to oil prices will prevail. China will stimulate more aggressively in June and subsequent months. And regardless of Washington’s and Tehran’s intentions, a wrong move in an already heated part of the world can turn ugly very quickly. Bottom Line: President Trump’s foreign policy priority is China, not Iran. Nevertheless, a wrong move can trigger a nasty escalation in the current standoff, jeopardizing oil supplies coming out of the Gulf region. In response to this risk, OPEC 2.0 will likely move to cautiously raise production at the next meeting in late June. Meanwhile China’s stimulus overshoot in the midst of trade war will most likely shore up demand over the course of the year. Can A New Prime Minister Break The Deadlock In Westminster? “There is a limited appetite for change in the EU, and negotiating it won’t be easy.” - Outgoing U.K. Prime Minister Theresa May Prime Minister Theresa May’s resignation has hurled the Conservative Party into a scramble to select her successor. While the timeline for this process is straightforward,2 the impact on the Brexit process is not. The odds of a “no-deal Brexit” have increased but so has the prospect of parliament passing a soft Brexit prior to any new election or second referendum. The odds of a “no-deal Brexit” have increased. Eleven candidates have declared their entry to the race and the vast majority are “hard Brexiters” willing to sacrifice market access on the continent (Table 2). Prominent contenders such as Boris Johnson and Dominic Raab have stated that they are willing to exit the EU without a deal. Table 2“Hard Brexiters” Dominate The Tory Race Given that the average Tory MP is more Euroskeptic than the average non-conservative voter or Brit, the final two contenders left standing at the end of June are likely to shift to a more aggressive Brexit stance. They will say they are willing to deliver Brexit at all costs and will avoid repeating Theresa May’s mistakes. This means at the very least the rhetoric will be negative for the pound in the coming months. A clear constraint on the U.K. in trying to negotiate a new withdrawal agreement is that the EU has the upper hand. It is the larger economy and less exposed to the ramifications of a no-deal exit (though still exposed). This puts it in a position of relative strength – exemplified by the European Commission’s insistence on keeping the current Withdrawal Agreement. Whoever the new prime minister is, it is unlikely that he or she will be able to negotiate a more palatable deal with the EU. Rather, the new leader will lead a fractured Conservative Party that still lacks a strong majority in parliament. The no-deal option is the default scenario if an agreement is not finalized by the Halloween deadline and no further extension is granted. However, Speaker of the House of Commons John Bercow recently stated that the prime minister will be unable to deliver a no-deal Brexit without parliamentary support. This will likely manifest in the form of a bill to block a no-deal Brexit. Alternatively, an attempt to force a no-deal exit could prompt a vote of no confidence in the government, most likely resulting in a general election.3 Chart 5British Euroskeptics Made Gains In EP Election While the Brexit Party amassed the largest number of seats in the European Parliament elections at the expense of the Labour, Conservative, and UKIP parties (Chart 5), the results do not suggest that British voters have generally shifted back toward Brexit. In fact, if we group parties according to their stance, the Bremain camp has a slight lead over the Brexit camp (Chart 6). Thus, it is not remotely apparent that a hard Brexiter can succeed in parliament; that a new election can be forestalled if a no-deal exit is attempted; or that a second referendum will repeat the earlier referendum’s outcome. Chart 6Bremain Camp Still Dominates Bottom Line: While the new Tory leader is likely to be more on the hard Brexit end of the spectrum than Theresa May, this does not change the position of either the European Commission or the British MPs and voters on Brexit. The median voter both within parliament and the British electorate remains tilted towards a softer exit or remaining in the EU. This imposes constraints on the likes of Boris Johnson and Dominic Raab if they take the helm of the Tory Party. These leaders may ultimately be forced to try to push through something a lot like Theresa May’s plan, or risk a total collapse of their party and control of government. Still, the odds of a no-deal exit – the default option if no agreement is reached by the October 31 deadline – have gone up. In the meantime, the GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. GeoRisk Indicators Update – May 31, 2019 Last month BCA’s Geopolitical Strategy introduced ten indicators to measure geopolitical risk implied by the market. These indicators attempt to capture risk premiums priced into various currencies – except for Euro Area countries, where the risk is embedded in equity prices. A currency or bourse that falls faster than it should fall, as implied by key explanatory variables, indicates increasing geopolitical risk. All ten indicators can be found in the Appendix, with full annotation. We will continue to highlight key developments on a monthly basis. This month, our GeoRisk indicators are picking up the following developments: Trade war: Our Korean and Taiwanese risk indicators are currently the best proxies to measure geopolitical risk implications of the U.S.-China trade war, as they are both based on trade data. Both measures, as expected, have increased more than our other indicators over the past month on the back of a sharp spike in tensions between the U.S. and China. Currently, the moves are largely due to depreciation in currencies, as trade is only beginning to feel the impact. We believe that we will see trade decline in the upcoming months. Brexit: While it is still too early to see the full effect of Prime Minister May’s resignation captured in our U.K. indicator, it has increased in recent days. We expect risk to continue to increase as a leadership race is beginning among the Conservatives that will raise the odds of a “no-deal exit” relative to “no exit.” EU elections: The EU elections did not register as a risk on our indicators. In fact, risk decreased slightly in France and Germany during the past few weeks, while it has steadily fallen in Spain and Italy. Moreover, the results of the election were largely in line with expectations – there was not a surprising wave of Euroskepticism. The real risks will emerge as the election results feed back into political risks in certain European countries, namely the U.K., where the hardline Conservatives will be emboldened, and Italy, where the anti-establishment League will also be emboldened. In both countries a new election could drastically increase uncertainty, but even without new elections the respective clashes with Brussels over Brexit and Italian fiscal policy will increase geopolitical risk. Emerging Markets: The largest positive moves in geopolitical risk were in Brazil and Turkey, where our indicators plunged to their lowest levels since late 2017 and early 2018. Brazilian risk has been steadily declining since pension reform – the most important element of Bolsonaro’s reform agenda – cleared an initial hurdle in Congress. While we would expect Bolsonaro to face many more ups and downs in the process of getting his reform bill passed, we have a high conviction view that the decrease in our Turkish risk indicator is unwarranted. This decrease can be attributed to the fact that the lira’s depreciation in recent weeks is slowing, which our model picks up as a decrease in risk. Nonetheless, uncertainty will prevail as a result of deepening political divisions (e.g. the ruling party’s attempt to overturn the Istanbul election), poor governance, ongoing clashes with the West, and an inability to defend the lira while also pursuing populist monetary policy. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Footnotes 1 Please see BCA Research Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 2 The long list of candidates will be whittled down to two by the end of June through a series of votes by Tory MPs. Conservative Party members will then cast their votes via a postal ballot with the final result announced by the end of July, before the Parliament’s summer recess. 3 A vote of no confidence would trigger a 14-day period for someone else to form a government, otherwise it will result in a general election. Geopolitical Calendar
Highlights In the political economy of oil, an awareness of the speed at which policy in systematically important states can change can restrain risk taking and investment. This can keep markets in an agitated state of anticipation, awaiting the next policy shift – or the fallout from earlier decisions – and can separate prices from fundamentals. Crude oil markets are in such an agitated state. Fundamentally, oil markets are tight and likely will get tighter, as backwardations in benchmark forward curves indicate (Chart 1). Oil demand continues to grow, with EM growth offsetting DM declines (Chart 2). Production is being restrained by OPEC 2.0, and could remain so in 2H19. U.S. shale-oil producers appear to be taking capital discipline seriously, and prioritizing shareholder interests, which likely will keep production growth within the limits dictated by free cash flow. Chart of the WeekBackwardations In Brent & WTI: Evidence Of Tight Oil Markets Chart 2EM Continues To Lead Global Oil Demand Growth The combination of these fundamentals will keep supply growth below demand growth this year, which means balances will remain tight (Table 1 below). This will drain inventories and keep forward curves backwardated (Chart 3). Globally, monetary policy will remain largely accommodative. However, policy risks – chiefly Sino – U.S. trade tensions and rising U.S. – Iran tensions – are taking their toll, increasing uncertainty re demand growth, and raising concerns over the security of oil supply from the Persian Gulf, which accounts for ~ 20% of global output. The combination of these policy-risk factors is putting a bid under the USD, which creates a demand headwind by raising the cost of oil ex-U.S.1 This is, in our view, keeping Brent prices below $70/bbl, vs. the $75/bbl we expect this year. Chart 3Commercial Oil Inventories Will Resume Drawing Highlights Energy: Overweight. U.S. National Security Adviser John Bolton declared Iran was responsible for naval mines attached to oil tankers off the coast of the UAE earlier this month, which damaged four ships, two of them belonging to Saudi Arabia. Bolton also said the Iranian naval operation was connected to a drone attack on the Saudi East – West pipeline two days later, and an unsuccessful attack on the Saudi Red Sea port of Yanbu.2 Base Metals: Neutral. Global copper markets continue to tighten: Fastmarkets MB’s Asian treatment and refining charges (TC/RC) weekly index dropped to its lowest level since it was launched June 2013 at the end of last week – to $58.30/MT, $0.0583/lb. Lower TC/RC charges reflect lower raw ore supplies available for refining. Global inventories remain low – down 22% y/y at the LME, COMEX, SHFE and Chinese bonded warehouses – and a threatened strike at on of Codelco's Chilean mines could tighten supplies further. We are re-establishing our tactical long July $3.00/lb Comex copper vs. short $3.30/lb Comex copper call spread at tonight’s close, expecting continued tightening in markets. Precious Metals: Neutral. Gold prices appear supported on either side of $1,280/oz, as trade, foreign and monetary policy risks remain elevated. Ags/Softs: Underweight. Heavier-than-expected rains are hampering plantings in the U.S. Midwest, which is driving grain prices higher. Corn, wheat, oats and beans surged Tuesday as markets re-opened from a long holiday weekend in the U.S. Feature Within the context of the political-economy framework we use to frame our analysis of oil markets, foreign policy and trade policy – particularly in the U.S. and China – are dominating fundamentals. Indeed, absent the threat of war in the Persian Gulf between Iran and the U.S., and their respective allies, and an uncertainty surrounding an expanded Sino – U.S. trade war, Brent crude oil would be trading above $75/bbl in 2H19, based on our modeling. As things stand now, we believe markets are under-pricing the risk of war in the Persian Gulf, and are over-estimating the short-term effects of the Sino – U.S. trade war. The longer-term consequences of a deeper and more protracted Sino – U.S. trade war, however, continue to be under-estimated. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) U.S. – Iran War Risk Is Under-priced We have noted in the past the risk of an escalation in the military confrontation in the Persian Gulf remains acute for global oil markets, most recently in our latest balances report.3 In particular, we believe the risk of this scenario is not fully priced, given market participants’ mark-down of the probability of the price of Brent for December 2019 delivery exceeding $75/bbl and $80/bbl from 39% to 26% and 25% to 16% over the past month in options markets. The probability of Brent for March 2020 delivery exceeding $75/bbl and $80/bbl has similarly been marked down from 38% to 28% and 26% to 19% (Chart 4). An escalation of attacks on soft targets – specifically Saudi and UAE oil shipping and pipeline networks, as occurred earlier this month – likely would provoke a U.S. response against Iran or its proxies, given U.S. National Security Adviser John Bolton’s declaration this week re Iran, which we noted above. A direct attack on the U.S. military presence in the Gulf would be met with extreme force, according to U.S. President Donald Trump.4 A shooting war in the Gulf would, once again, raise the odds of a closing of the Strait of Hormuz, which has been threatened in the past by Iran. Some 20% of the world’s oil supply transits the Strait daily.5 A credible attack against shipping in the Strait would send oil prices sharply higher. If Iran were to succeed in blocking transit through the Gulf, an even sharper move in prices – above $150/bbl – could be expected. Markets Too Sanguine Re Sino – U.S. Trade War Commodity markets are not fully pricing the recent escalation of Sino – U.S. trade war, which were dialled up recently when Chinese President Xi Jinping declared China is embarking on a “New Long March” at a domestic political visit.6 The size of the tariffs thus far imposed by the U.S. against China and the EU are trivial in the context of global trade flows of ~ $19.5 trillion this year (Chart 5).7 According to the WTO, the USD value of merchandise trade rose 10% last year to $19.5 trillion, partly on the back of higher energy prices, while the value of services increased to $5.8 trillion, an 8% gain. Against this, U.S. tariffs of 25% on $250 billion worth of goods imported from China remain trivial. U.S. tariffs so far on EU imports by the U.S. are de minimis. Trade concerns do matter, however, in the longer run. Our geopolitical strategists make the odds of a no-deal outcome 50%, vs. a 40% chance of a deal being reached, and a 10% chance trade talks extend beyond the G20 talks scheduled for June. If markets become convinced the current Sino – U.S. trade war will evolve into a larger standoff between the U.S. and China – military or economic – capex and global supply chains will undergo profound changes. Globally, states likely will find themselves in the orbit of one of these powers, which will fundamentally alter investment flows and, ultimately, the profitability of global businesses. A full-blown trade war could become a Cold War, in other words, which would re-order global supply chains.8 Should this occur, an increase in demand for oil, bulks like iron ore, and base metals could ensue, as China ramps its fiscal and monetary stimulus, and the U.S. and others in its sphere of influence bid up commodity prices as they are forced to pay for other higher-cost alternatives for once-cheaper goods and services.9 USD Will Remain A Short-Term Headwind Globally, central banks remain accommodative, which will support aggregate demand domestically. However, the combination of rising U.S. – Iran tensions and the prospect of a widening Sino – U.S. trade war have put a bid under the USD in the short term. Our FX strategists expect the USD will appreciate another 2 – 3% before cresting and heading lower later in the year. In the short term, USD strengthening is a headwind for oil prices. A stronger dollar translates into higher prices in local currencies ex U.S., which reduces demand, all else equal. On the supply side, a stronger dollar lowers local production costs, which stimulates supply ex U.S. at the margin. Together, these militate against higher oil prices. Assuming the USD does weaken later in the year, as our FX strategists expect, oil prices could pick up a slight tailwind. However, policy risk and supply-demand fundamentals will continue to drive oil prices for the balance of the year. Bottom Line: Oil prices are being restrained by policy risk – particularly U.S. and Chinese trade policy and U.S. foreign policy in the Persian Gulf. We believe markets are under-estimating the odds of Brent prices being above $75/bbl for barrels delivering in December 2019, and in March 2020. A resolution of Sino – U.S. trade tensions is less likely than a no-deal outcome (40% vs. 50%), with the odds of trade talks continuing beyond next month’s G20 meeting being very slim (10%). A deepening of the Sino – U.S. trade war will have longer-term consequences for commodity demand – possibly positive in the wake of Chinese fiscal and monetary stimulus. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see BCA’s Foreign Exchange Strategy Weekly Report titled“President Trump And The Dollar”, dated May 9, 2019, available at fes.bcaresearch.com. 2 Please see “Iranian naval mines likely used in UAE tankers attacks: Bolton,” published by reuters.com on May 29, 2019. See also BCA’s Commodity & Energy Strategy Weekly Report titled “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity”, dated October 25, 2018, and BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report “U.S.-Iran: This Means War?”, dated May 3, 2019, both available at ces.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled“Policy Risk Sustains Oil’s Unstable Equilibrium” , dated May 23, 2019, available at cesbcaresearch.com. 4 Please see Trump issues harsh warning to Iran, tweeting it would meet its "official end" if it fights U.S. posted by cbsnews.com on May 20, 2019. 5 Please see BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report titled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic”, dated July 19, 2018, available at ces.bcaresearch.com. 6 For an excellent discussion of these developments, please see BCA’s Geopolitical Strategy Weekly Report titled “Is Trump Ready For The New Long March?”, dated May 24, 2019, available at gps.bcaresearch.com. The “New Long March” is a reference to the 8,000-mile retreat of Chinese Communist Party fighters so they could regroup and ultimately prevail in their civil war in 1934-35. In recalling the Long March, “President Xi … told President Trump to ‘bring it on,’ as he apparently believes that a conflict with the U.S. will strengthen his rule,” according to Matt Gertken, BCA Research’s Chief Geopolitical Strategist. 7 Please see “Global trade growth loses momentum as trade tensions persist,” published by the WTO April 2, 2019. The World Trade Organization expects the growth in merchandise trade volume to drop from 3% last year to 2.6% in 2019, with a slight improvement next year back to 3% growth. Importantly, the WTO notes this is “dependent on an easing of trade tensions.” 8 The odds of a “hot war” between the U.S. and China also are rising, particularly in the South China Sea, according to Adm. James Stavridis (USN, Retired). Please see Collision course in the South China Sea published by the Nikkei Asian Review May 22, 2019. 9 Please see BCA’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. 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
Highlights The risk premium in crude oil prices is rising again, as policy risk – and the potential for large policy-driven errors – increases (Chart of the Week).1 This is not being fully reflected in options markets, where implied volatilities are trading close to their long-term average levels (Chart 2). In the past month, risks to oil flows – military and otherwise – and supply have risen, which is keeping a bid under prices. The Sino – U.S. trade war has worsened, and threatens to put global supply chains at risk, along with EM demand growth in the medium term. Meanwhile, amid global monetary easing, the USD has strengthened, producing a more immediate headwind for EM commodity demand. Against this backdrop of opposing forces, oil prices remain elevated and relatively stable in the low $70/bbl range for Brent. Our balances estimates and price forecasts have not changed materially this month. However, the balance of risks has widened in both tails of the price distribution. We expect implied volatilities in the crude oil options markets – particularly Brent – to move higher, as a result. As for prices, we continue to expect Brent to average $75/bbl this year and $80/bbl next year, with WTI trading $7/bbl and $5/bbl below those levels in 2019 and 2020, respectively. Energy: Overweight. The U.S. EIA moved closer to our fundamental assessment and Brent forecast in its most recent market update, lifting its Brent spot-price expectation for this year to an average of $70/bbl, ~ $5/bbl above its April forecast. The EIA’s revision reflects “tighter expected global oil market balances in mid-2019 and increasing supply disruption risks globally.” Base Metals: Neutral. In the wake of Vale’s January supply disaster at its Córrego do Feijão mine, iron ore shipments from Brazil were down 60% in April y/y. Cyclones disrupted supply in Western Australia, pushing 62% Fe iron ore prices to a 5-year high above $100/MT last week. Chinese steelmakers registered a 12.7% y/y gain in crude steel output last month, which, along with dockside iron ore inventory draws of ~ 20 MT ytd, is supporting prices generally. Precious Metals: Neutral. A stronger USD is weighing on gold. Global geopolitical tensions – chiefly in the Persian Gulf and in Sino – U.S. trade relations – are keeping prices above $1,270/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Severe weather conditions in the Midwest continues to delay corn planting, and is contributing to a rally this week in corn prices to $3.94/bushel on Tuesday, up $3.48/bushel from last week’s level. Feature The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz, where ~ 20% of global supply transits daily.2 Bellicose rhetoric from the U.S. – some of it directed at materially reducing Iran’s influence in Iraq – alternately is ramped up and walked back, while attacks on soft targets in the Kingdom of Saudi Arabia (KSA) – e.g., oil shipping and west-bound oil pipelines – draw attention to the exposure of this critical infrastructure, upon which global oil markets rely.3 Iran, meanwhile, uses the media to prepare its population for further economic deprivation, and to lob its own vituperative rhetoric at the U.S. Venezuela’s collapse as an oil producer and exporter continues unabated, keeping markets for the heavier sour crude favored by U.S. refiners tight. Civil war threatens to cut into Libyan production, which we are carrying at just over 1mm b/d, while whiffs of another Arab Spring can be detected in Algeria, where popular discontent with ruling elites grows.4 On the demand side, the summer driving season is about to kick off in the Northern Hemisphere, heralding increased gasoline demand. Countering that, the Sino – U.S. trade war shows signs of devolving into a Cold War, which could force a re-ordering of supply chains globally, lifting costs and consumer-level inflation in the process. Longer-term, this could work against central-bank easing globally, and retard growth in EM consumer demand. The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz. For the present, we continue to expect EM demand growth to hold up, expanding by 1.5mm b/d this year and 1.6mm b/d next year. This will be supported by continued monetary easing globally, and additional fiscal stimulus from China if its trade war with the U.S. worsens. There is a chance weakness in DM demand will persist, but we think the odds of a normal seasonal pick-up in 2H19 will continue to support demand overall (Chart 3). That said, given the threats to demand growth – an expanded Sino – U.S. trade war and stronger USD, in particular – we will continue to monitor the health of EM demand closely. Chart 2Brent Implied Volatility Will Move Higher Chart 3DM Oil Demand Growth Wobbles, EM Steady OPEC 2.0 Maintains Production Discipline Chart 4OPEC 2.0's Production Discipline, Strong Demand Drained Inventories The goal of OPEC 2.0 from its inception at the end of 2016 has been to drain OECD inventories, which swelled to 3.1 billion barrels in July 2016, on the back of a market-share war launched by the old OPEC under the leadership of KSA, and a surge in U.S. shale-oil production. KSA continues to stress the need to restrain crude oil production so as to draw down global oil inventories, and has done much of the heavy lifting this year to make that happen (Chart 4). The other putative leader of OPEC 2.0, Russia, continues to express misgivings with such a strategy, arguing instead the producer coalition should make more oil available to the market. We are more aligned with Russia’s view, and continue to believe OPEC 2.0 will need to increase production. In our balances (Table 1), our base case assumes those producers that can lift production – core OPEC and Russia – will do so to keep prices below $85/bbl (Chart 5). We expect OPEC 2.0 will be able to offset the loss of ~ 700kb/d from Iran exports by increasing production gradually from May to September in proportion to its quota agreement. In our base case, we have Iranian exports falling to 600k b/d. We continue to expect OPEC 2.0 to be able to offset the loss of Venezuela’s production throughout the year, which we expect to fall to 500k b/d by December (vs. ~ 735k b/d presently). Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. We also expect Russia to lift its production closer to 11.6mm b/d from ~ 11.4mm b/d at present. Even with OPEC 2.0 lifting production ~ 900k b/d in 2H19 vs. 1H19, the bulk of global production increases will be concentrated in the U.S., where we expect shale-oil output to grow 1.2mm b/d this year, and 840k b/d next year. This will account for 85% of the overall increase of 2.4mm b/d we expect in the U.S. this year and next. Our estimates of production growth in the U.S. shales is tempered by a growing conviction the large integrated oil majors and stand-alone E&P companies will continue to put the interests of shareholders above their desire to increase production just for the sake of increasing it, as was done in the past. This is driven by a desire to attract and retain capital, which will be critical to the majors and the big E&Ps in the years ahead.5 We continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories. Even with these production increases, we continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories (Chart 6). Chart 5Core OPEC 2.0 Will Lift Production Chart 6Balances Continue To Tighten Spare Capacity Will Be Stretched In addition to Iran and Venezuela, we are closely following what appears to be the early stages of another civil war in Libya, which threatens the ~ 1mm b/d of production flowing from there. In addition, we are seeing signs of growing civil discontent in Algeria not unlike that of 2011, which was sparked by popular dissatisfaction with ruling elites throughout the Middle East in the lead-up to the Arab Spring. We have maintained existing spare capacity can handle the loss of Iranian and Venezuelan production and exports we’ve built into our balances and price-forecast models. However, covering these losses will stretch the capacity of global supply to accommodate unplanned outages, which could leave markets extremely tight in the event of production losses in Libya or Nigeria, or in producing provinces prone to natural disasters (e.g., Canadian wildfires or U.S. Gulf hurricanes). At present, markets appear to be comfortable with OPEC 2.0’s ability to cover losses from Iran and Venezuela, given current spare capacity of ~ 3mm b/d, most of which remains in KSA, and continued growth in non-OPEC output (Chart 7). As inventories continue to draw globally, markets’ attention will turn more toward this spare capacity. Expect Higher Volatility We remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. Chart 8Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Our fundamental assessments of supply, demand and inventory levels remain fairly steady. Thus, our price forecasts – $75 and $80/bbl this year and next for Brent, with WTI trading $7 and $5/bbl under that – remain unchanged. With OPEC 2.0 maintaining production discipline and U.S. shale producers maintaining capital discipline, the rate of growth on the supply side will be restrained, and below the rate of growth in global demand. These forces combine to keep inventories drawing this year, which will lead to a steeper backwardation in forward curves, particularly Brent’s (Chart 8). Coupled with true uncertainty re how the U.S. – Iran confrontation in the Persian Gulf is resolved, and how the Sino – U.S. trade war plays out, this steepening backwardation will lead to higher implied volatility in crude oil options markets. Bottom Line: Our expectation of higher prices and steepening backwardation in forward curves is supported by our analysis of fundamentals and the current political economy of global oil markets, which emphasizes policy risk arising from the actions of geopolitically significant states. These factors also will push implied volatility in options markets higher. As a result, we remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. We also remain long 2H19 Brent vs. short 2H20 Brent futures in line with our view backwardation will increase; this position is up 155.4% since it was initiated in February, as a result of the steepening of backwardation in the forward curve. Steepening backwardation also will benefit our long S&P GSCI recommendation, which is heavily weighted to energy markets; this position is up 8% since inception. Lastly, we remain long spot WTI, which is up 34.6% since it was recommended in January. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 In the price decomposition shown in our Chart of the Week, we account for the contribution that changes in global supply, demand and inventory levels make to the evolution of Brent prices, using a proprietary econometric model. We treat the residual term of the model – what’s left of the price decomposition after these fundamental variables are accounted for – as a measure of the risk premium in prices. An expansion of the risk premium – in the positive or negative direction – is coincident with an expansion of the implied volatility of Brent crude oil options typically expands (sometimes with a lag or two), and vice versa. This is intuitively appealing, since risk premia and volatility expand as uncertainty in the market rises. 2 We considered this topic in depth in a Special Report written with BCA Research’s Geopolitical Strategy entitled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic,” published July 19, 2018, and in “Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf,” published July 5, 2018. Both reports are available at ces.bcaresearch.com. 3 Iran’s influence in Iraq is an internally divisive issue, and a focal point of the U.S., a view we share. Please see, “Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply,” a Special Report we published with BCA Research’s Geopolitical Strategy September 5, 2018. KSA and Western intelligence agencies allege Iran is behind the attacks on Saudi oil infrastructure. Please see “Saudi Arabia accuses Iran of ordering drone attack on oil pipeline,” published by reuters.com. The westbound pipelines in KSA are critical to maintaining the Kingdom’s export capacity, as we noted in “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity,” published by BCA Research’s Commodity & Energy Strategy October 25, 2018. This report is available at ces.bcaresearch.com. 4 Please see “Algeria Has a Legitimacy Problem,” posted on the LSE’s Middle East Centre Blog by Benjamin P. Nickels on May 20, 2019, and “Algeria’s Second Arab Spring?” by Ishac Diwan posted at project-syndicate.org March 28, 2019. 5 We will be exploring this topic in depth in a Special Report next month. 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 Trades Closed in
Highlights So what? EM elections bring opportunities as well as risks. Why? Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3. First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle – which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14. Chart 10Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Chart 20...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup. Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2 See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com. 3 The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4 See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com. Geopolitical Calendar