Commodities & Energy Sector

As the summer holidays become a memory, central banks globally are mobilizing to fight mounting recession risks. More than 30 at last count are busily easing financial conditions to boost growth (Chart of the Week). Going into 4Q19, this monetary stimulus – coupled with fiscal stimulus globally – should allow growth ex-U.S. to revive, which will weaken the USD. This will be bullish for commodity demand in general, oil in particular. Fundamentally, the supply side of the oil market is in good shape. Production discipline by OPEC 2.0 will be maintained, while members of the coalition iterate on the level of output required to keep the rate of growth on the supply side below that of consumption.1 Capital discipline is being forced on U.S. shale-oil operators by markets. This will restrain their output growth rates to levels markets can absorb without inducing unintended inventory accumulation. A ceasefire in the Sino-U.S. trade war also could brighten short-term demand prospects and revive global trade volumes. This would indicate a recovery in manufacturing, given the heavy weight of manufactured goods in trade flows, and also in the the low-sulfur marine fuel markets. Going into 4Q19 and 1Q20, these supply-demand fundamentals will tighten markets, and force crude oil and refined product inventories lower. This will push Brent crude oil prices to our forecast levels of $66 and $75/bbl on average this year and next, with WTI trading $6.50 and $4/bbl under that. In addition, it would further backwardate crude oil forward curves. Chart of the WeekFinancial Conditions Continue Easing Among the risks to this view: Too-weak monetary/fiscal stimulus, leading to a failure to revive demand and stave off recession; a breakdown in OPEC 2.0’s production discipline; an expansion of the Sino-U.S. trade war; a disorderly Brexit; and, critically, a stubbornly strong USD, which raises the risk of direct intervention in FX markets by the U.S. central bank. Highlights Energy: Overweight. Saudi Aramco’s board of directors apparently has ruled out a listing of its IPO in New York, owing to legal risk in the U.S., according to Reuters news service.2 Riyadh and London reportedly are favored by board members. The Kingdom’s Crown Prince Mohammed bin Salman reportedly has the final say. Base Metals: Neutral. The nickel rally likely corrects over the short term, after a vertical shot that lifted the metal ~56.2% between early June and this week. This was partly fueled by speculation over commentary from an Indonesian official in July reinforcing the country’s stated goal of banning raw ore exports by 2022. Indonesia is the largest nickel ore producer in the world.3 Precious Metals: Neutral. Our tactical long platinum position is up 3.9% since it was recommended last week. We continue to expect platinum will draft in gold’s wake, benefiting from safe-haven demand for precious metals generally. Fundamentally, the risk of power outages in South Africa, which produces ~67% of the world’s platinum, remains high this month, putting platinum-group metal production at risk there. Technically, the metal held long-term support at $785/oz this year – a level that goes back to the Global Financial Crisis lows – and has since rallied ~ 18%. Ags/Softs: Underweight. Chinese tariffs on U.S. soybean imports went up 5% to a total of 30% September 1, coinciding with the imposition of additional tariffs on $300 billion of Chinese imports. Feature USD strength remains a headwind to stronger EM growth, which is keeping oil demand growth in check (Chart 2).4 Indeed, in local-currency terms, oil prices remain closer to their 2014 highs, when Brent and WTI were trading above $100/bbl (Chart 3). The persistently strong USD is one reason we lowered our oil-demand forecast four times this year, which puts it at 1.2mm b/d for 2019. Chart 2USD Strength Hinders Oil Demand Growth Chart 3USD Strength Keeps Local-Currency Costs High The slowdown in global oil demand began in 2H18 and picked up speed in 1H19. We believe this largely was the result of a global tightening in financial conditions – apparent in the Chart of the Week – led by the Fed, which, with near-singular determination, raised its policy rate four times last year. Fed policy kept USD-denominated assets well bid, but, equally importantly, it raised the costs of commodities and all goods and services invoiced in USD globally in local-currency terms. This reduced aggregate demand ex-U.S. as households’ and firms’ discretionary incomes fell.5 Commodity demand also was derailed by the extended de-leveraging campaign by Chinese policymakers, which ran from 2017-18 and succeeded in its goal of bringing down the country’s debt-to-GDP ratio and the growth rate of leverage. Central Banks Scramble To Revive Growth The Treasury may be forced to up the ante and directly intervene in FX markets to weaken the dollar. To reverse the tightening of monetary conditions worldwide, central banks this year started moving to more accommodative monetary-policy settings, which we expect will continue to support looser financial conditions around the globe. In addition, fiscal stimulus either is being deployed or readied in key EM economies like China and India, which, together, account for 36% of the 53.5mm b/d of EM oil consumption we estimate for 2019. These policy responses should revive GDP growth – particularly in EM economies – and, all else equal, oil demand in the process going into 4Q19. The performance of our leading indicators support this expectation (Chart 4). That said, with so many systematically important central banks weakening their currencies, the USD could remain strong in relative terms.6 If the dollar remains a safe-haven asset in uncertain markets, while serving as the world’s reserve/invoicing/funding currency, weakening the USD during a period of high financial stress could be difficult. In that case, the Treasury may be forced to up the ante and directly intervene in FX markets to weaken the dollar. Chart 4Global LEIs Bottomed And Are Moving Up   Managing Financial Conditions In A Trade War We do not expect the Sino-U.S. trade war to be resolved. National security, foreign policy and technology positions that have been advanced by both sides appear impossible to walk back (e.g., protecting 5G networks from spying, and safeguarding intellectual property). This suggests the Sino-U.S. relationship is in the early stages of a Cold War, which could go hot in the short run.7 Still, a short-term agreement or ceasefire this year or next is still possible. The basis for such a shift would be President Trump staging a retreat to try to clinch a deal and improve the economy prior to his re-election campaign. China might accept a temporary reprieve. This would allow both sides to retreat to re-group for the almost-certain renewed trade tension that will mark the Sino-U.S. relationship going forward. Over the short run, a ceasefire could brighten demand prospects and revive global trade volumes. This would be supportive of crude oil and refined-products markets, particularly the low-sulfur marine fuel market, which, on January 1, will be bound by IMO 2020 standards.8 In the medium to longer-run, however, neither the U.S. nor China will cede ground if it strengthens the hand of the other, particularly regarding national security and technology, which will continue to be the key concern for all national security issues. This complicates fiscal and monetary policy for both sides going forward, along with trade relationships for each. We do not believe either side has these issues sorted, and likely will need time and space to develop policies for the medium- and longer-term. It also means each side’s respective allies will have to make hard choices in deciding whose camp they will migrate toward. These considerations cloud the outlook for the medium- to long-term oil markets. We will be exploring them in greater depth in forthcoming Commodity & Energy Strategy reports. Investment Implications We remain broadly long in our exposure to oil markets, expecting the fundamentals outlined above to tighten supply, strengthen demand and draw down inventories. Given this view, we remain long WTI flat price, and long 4Q19 Brent futures vs. short 4Q20 Brent futures, expecting a steeper backwardation. We also remain long the S&P GSCI commodity index, given its relatively heavy exposure to energy markets. Bottom Line: Supply-demand fundamentals, coupled with a favorable fiscal and monetary backdrop, indicate oil prices will move higher from current levels toward our forecasts of $75/bbl and $71/bbl next year for Brent and WTI, respectively. This view is not without risk – chiefly around the Sino-U.S. trade war, and the risk that an expansion of tensions would stunt global demand for oil significantly. We continue to follow this closely.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1      OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was formed in 2016 to manage production and reduce oil inventory levels globally. For a complete summary of our supply-demand expectations for this year and next, please see the August 22, 2019 Commodity & Energy Strategy Weekly Report, "USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl". 2      Please see Exclusive: Saudi Aramco board sees too many risks for New York IPO - sources, published by reuters.com August 30, 2019. 3      Please see Nickel price forecast revised up as speculative rally boosts tight market — report, published by mining.com August 29, 2019. 4      We have shown in previous research EM income growth accounts for most of the growth in oil demand globally. This year, for example, we expect EM demand growth to account for 87% of 2019’s 1.2mm b/d growth in oil consumption. Next year, EM is expected to account for 79% of the 1.5mm b/d of growth we expect. For this reason, oil prices – and base metals prices – are a good barometer of the of EM income growth. 5      Maurice Obstfeld noted at the Fed’s June 2019 Conference on Monetary Policy Strategy, Tools, and Communication Practices (A Fed Listens Event) that the USD is not only the world’s reserve currency, it also is the dominant invoicing and funding currency. “… the dollar’s invoice-currency role affects the international price mechanism by influencing how U.S. monetary policy will move real exchange rates, inflation, and export competitiveness throughout the world. … (The) dollar’s funding currency role mediates the transmission of U.S. monetary policy to global financing conditions. “Through both mechanisms, U.S. monetary policy has an outsized impact on global economic activity – consistent with the evidence on unconventional policy spillovers. … The Federal Reserve, more than other central banks, should therefore consider spillbacks from the global economy as a relevant transmission mechanism for its policies.” Prof. Obstfeld’s paper can be downloaded at the Fed website, Global Dimensions of U.S. Monetary Policy. 6      In the August 26, 2019, issue of BCA Research’s U.S. Investment Strategy, our colleague Doug Peta, chief U.S. investment strategist, notes, “No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.” For further discussion, please see Market Messages, published August 26, 2019, by BCA Research’s U.S. Investment Strategy. It is available at usis.bcaresearch.com. 7      Our geopolitical strategists make the odds of a trade agreement 40%, perhaps a bit higher. Please see Big Trouble In Greater China, published August 23, 2019, by BCA Research’s Geopolitical Strategy, for an excellent discussion of the fraught Sino-U.S. relationship. It is available at gps.bcaresearch.com. 8      We expect global shipping-fuels market to tighten as UN-mandated fuel standards kick in next year. This will keep ship fuels, specifically Gasoil and ULSFO, and other distillate prices – e.g., diesel and jet fuel – elevated relative to other refined products like gasoline. This will boost demand for lighter, sweeter crudes – particularly Brent and similar grades – that allow refiners to raise distillate yields, as they scramble to meet higher demand for low-sulfur ship-fuel next year. For more information on IMO 2020, please see IMO 2020: The Greening Of The Ship-Fuel Market, published by BCA Research’s Commodity & Energy Strategy February 28, 2019. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Away from the Sino-U.S. trade-war headlines – and the remarkable commodity price volatility they produce – apparent steel consumption in China is up 9.5% y/y in the first seven months of this year. This is being spurred by fiscal stimulus directed at infrastructure and construction spending, which remains strong relative to year-ago levels (Chart of the Week).1 Demand for copper normally drafts in the wake of China’s steel demand, and picks up when steel-intensive capital projects are being wired for use. In less uncertain times, getting long copper would make sense.2 Chart of the WeekFiscal Stimulus Boosts China Steel Consumption We are holding off getting long for now, given the policy uncertainty – particularly in re trade policy – that dominates commodity markets, none moreso than steel and base metals. While the odds of a resolution to the trade war might be edging up from our 40% expectation, moving them closer to those of a coin toss does not justify taking the risk.3 Highlights Energy: Overweight. Retaliatory tariffs on $75 billion of U.S. imports, including crude oil, into China, provoked an additional 5% duty by President Trump on ~ $550 billion of goods shipped to the U.S. by China. This will lift the total tariff on $250 billion of U.S. imports from China to 30%, and on another $300 billion to 15%, starting Oct. 1 and Sept. 1. Following the imposition of Chinese tariffs, China Petroleum & Chemical Corp, or Sinopec, petitioned Beijing for waivers on U.S. crude imports. Base Metals: Neutral. Included in the latest Chinese tit-for-tat tariff retaliations is a 5% tariff increase on copper scrap imports from the U.S., which takes the duty to 30%; the re-imposition of 25% tariffs on U.S. auto imports, and a 5% tariff on auto parts. The latter tariffs go into effect December 15, according to Fastmarkets MB. Precious Metals: Neutral. We are getting long platinum at tonight’s close, but with a tight stop of -10%, given highly volatile – and uncertain – trading markets. In addition to following the wake of safe-haven demand for gold, a physical deficit for platinum is possible.4 Markets have been well supported technically – bouncing off long-term support of ~ $785/oz dating to the depths of the Global Financial Crisis in 2008 – 09. Ags/Softs: Underweight. The USDA reported 57% of the U.S. corn crop is in good or excellent condition this week, vs. 68% a year ago. The Department also reported 55% of the soybean crop was in good or excellent shape vs. 66% last year at this time. Feature Iron ore price surged more than 38.1% y/y, while steel prices rallied in 1Q19 off their year-end 2018 lows, helped by the Central Committee fiscal stimulus directed at infrastructure and construction, which hit the market after the collapse of Vale’s Brumadinho dam in January (Chart 2). The combination of the fatal dam disaster and fiscal stimulus in China lifted prices for iron ore and steel sharply.5 Chart 2Iron Ore and Steel Rally Leaves Copper Behind Chart 3China's Construction, Real Estate Investment Spur Higher Steel Demand While policymakers guide domestic markets to expect reduced stimulus for the real-estate sector, we continue to expect copper demand to pick up in the short term. Our modeling indicates strong steel consumption presages higher copper consumption, especially when construction’s contribution is high (Chart 3). This is because the projects accounting for that consumption typically are fitted out with electrical wiring six months or so after the structures built with all that steel are made ready for residential or commercial use (Chart 4).6 This should support copper prices as we go through 2H19, although a slowdown in steel’s apparent consumption in 1Q19 followed by a rebound in April could make for a bumpy ride. CPC Central Committee guidance is stressing the need to get stimulus to the “real economy, such as privately-owned manufacturers and high-tech firms, which are the engines of long-term growth.”7 Still, while policymakers guide domestic markets to expect reduced stimulus for the real-estate sector, we continue to expect copper demand to pick up in the short term, as completed construction and infrastructure and projects in the pipeline from past stimulus are made ready for use.8 Chart 4Higher Steel Demand Normally Presages Higher Copper Demand   Copper Puzzle: Why Was It Left Behind? Part of the explanation for copper’s lackluster relative performance likely is USD-related: A strong dollar will reduce demand. Prices for iron ore and steel have come back to earth, following their impressive rallies this year. However, as Chart 2 illustrates, copper prices languished, and retreated to $2.50/lb on the COMEX. This, despite a contraction of physical copper concentrates supply, which kept copper treatment and refining charges (TC/RC) close to record lows, and inventories tight globally (Chart 5).9 Part of the explanation for copper’s lackluster relative performance likely is USD-related: A strong dollar will reduce demand (Chart 6).10 Our House view continues to expect the U.S. Fed to deliver a 25bp rate cut at its mid-September meeting. This could be followed by additional easing if Sino-U.S. trade tensions persist or get worse. Our House view expects Fed easing and a recovery in EM GDP growth will weaken the USD later this year. As iron ore shipments pick up from Brazil and Australia, we would expect pressure on those prices as the additional supply arrives at Chinese docks, and residential construction wanes (Chart 7). This should, in relative terms, mean copper outperforms iron ore, all else equal, since copper supplies and inventories are contracting. And, as construction spending moderates and winter restrictions on steel mills go into effect, we would expect copper to outperform steel. Chart 5Global Copper Inventories Remain Tight   Chart 6Strong USD Restrains Base Metal Demand Chart 7China's Iron Ore Imports Remain Strong Lastly, we would note from a technical perspective that copper has been – and remains – oversold (Chart 8). This could reflect the fact that, among base metals, it has the deepest liquidity, so that when hedgers or speculators are looking for a way to hedge trade-war risk vis-à-vis China – or to simply take a view on EM GDP prospects – copper is the preferred vehicle. It still is too early to wade into buying based on technicals, and, historically, copper has dipped further into oversold territory than where it now sits. But continued excursions into oversold territory will get our attention, and incline us to revisit our bullish bias. Chart 8Technically, Copper's Oversold   Trade War Deadweight The foregoing analysis suggests copper is due to rally. That is our expectation, at any rate. But uncertainty re the Sino-U.S. trade war and other exogenous policy issues – chiefly increasing recession risks arising from higher tariffs on Chinese imports to the U.S., a possible oil-price spike driven by military action in the Persian Gulf, and a disorderly Brexit – forces us to stand aside. Back in May, the N.Y. Fed conducted an analysis of U.S. President Donald Trump’s increase in tariff rates on $200 billion of Chinese imports from 10% to 25%.11 The N.Y. Fed estimated this increase in the tariff rates on that $200 billion would cost the average American household $831/yr, owing to a sharp increase in the deadweight loss arising from the increase. The deadweight loss estimated by the bank arising from tariff increase on the $200 billion of goods subject to the duty went from $132/household/year to $620/household/year. This means the total cost of the tariffs on the $200 billion of goods went from $414/household/year to $831/household/year. The N.Y. Fed notes: Economic theory tells us that deadweight losses tend to rise more than proportionally as tariffs rise because importers are induced to shift to ever more expensive sources of supply as the tariffs rise. Very high tariff rates can thereby cause tariff revenue to fall as buyers of imports stop purchasing imports from a targeted country and seek out imports from (less efficient) producers in other countries. The deadweight loss that comes from importers being forced to buy tariffed goods from higher-cost suppliers is, in other words, highly non-linear. This latest round of tariff increases is being levied on $550 billion of imports come September 1 and October 1. According to the Urban-Brookings Tax Policy Center, a Washington-based research joint-venture between the Urban Institute and the Brookings Institute, U.S. middle-class households earning $50k to $85k, received an average income tax cut of about $800 last year following passage of the 2017 Tax Cuts and Jobs Act (TCJA), which was signed in to law by President Trump December 22, 2017.12 Further increasing tariffs, as proposed, means the after-tax income of average U.S. households will contract, as the total cost of tariffs overwhelms the value of TCJA tax cuts for middle-income households, if they are imposed as scheduled. China's economy is struggling under the strain of the trade war, as it overlaps with President Xi’s reform and deleveraging campaign of 2017-18.  While these campaigns have been postponed, the lingering effects are weighing on growth.  In addition, banks and corporations appear to be backing away from taking on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability.12 Bottom Line: Fundamentals and technicals align to support copper prices. However, given the uncertainty surrounding the evolution of the Sino-U.S. trade war we are staying on the sidelines, and avoiding putting on a long position at present. Rising tariffs by the U.S. and China increases the risk of recession in both countries.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      In Copper Will Benefit Most From Chinese Stimulus, published April 25, 2019, we noted China would deploy $300 billion (~ 2 trillion RMB) to support policymakers’ GDP growth targets this year. See also the June 2019 issue of Resources and Energy Quarterly, published by the Australian Government’s Department of Industry, Innovation and Science, particularly Section 3 beginning on p. 22. 2      We are referring to Knightian uncertainty here, a distinction developed by economist Frank Knight in his 1921 book "Risk, Uncertainty and Profit". Uncertainty in Knight’s sense refers to a risk that is “not susceptible to measurement,” per the MIT.edu reference above. This differs from the “risk” we routinely consider in this publication, which can be measured via implied volatilities in options markets. A pdf of the book can be downloaded at the St. Louis Fed’s FRASER website. 3      These odds were calculated by BCA Research’s Geopolitical Strategy group. For a discussion, please see our article entitled Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published May 9, 2019. It is available at ces.bcaresearch.com. 4      This is not a certainty. In its PGM Market Report for May 2019, Johnson Matthey, the platinum-group metals refiner, forecast a slight physical platinum deficit this year of ~ 4MT, while Metals Focus expects a 20MT surplus. 5      The Australian Government DIIS report footnoted above (fn 1) states, “Production growth in China was driven by stimulatory government spending, which focused on higher infrastructure investment and boosting construction activity.” This is consistent with our framework for analyzing Chinese bulks (iron ore and steel) and base metals markets: Steel production and consumption are directed by the Communist Party of China (CPC) Central Committee, which motivates us to treat China’s steel market as a unified vertically integrated industry. Chinese steel production, accounts for ~ 50% of the global total. Its strong showing this year pushed world steel production up ~ 5% y/y in the first five months of this year, according to the DIIS. 6      In our modeling of copper prices, we lag steel apparent consumption by six months. 7      Please see Property sector cooling to help real economy funding, published by China Daily on August 1, 2019. 8      BCA Research’s China Investment Strategy noted, “The July Politburo statement signaled a greater willingness to stimulate the economy; as a result, we are penciling in a slightly more optimistic scenario on forthcoming credit growth through the remainder of the year, by adding 300 billion yuan of debt-to-bond swaps and 800 billion yuan of extra infrastructure spending to our baseline estimate for the rest of 2019. However, this would only add a credit impulse equivalent of 1 percentage point of nominal GDP and would only marginally reduce the probability of an earnings recession to 40%.” Please see Don’t Bottom-Fish Chinese Assets (Yet), published August 14, 2019. It is available at cis.bcaresearch.com. 9      The International Copper Study Group reported world mine production fell ~ 1% in the January – May 2019 period to ~ 8.3mm MT. Global refined copper production also was down ~ 1% to 9.8mm MT, while refined copper usage was down less than 1% over the same period. China’s refined usage – ~ 50% of world demand – was up 3.5%. 10   Our modeling indicates a 1% y/y increase in the broad trade-weighted USD translates into a 0.7% y/y decrease in the price of copper. Iron ore also is affected by USD levels, but price formation in this market is dominated by the overwhelming influence of Chinese demand on the seaborne iron-ore market, which accounts for close to 70% of global demand. For steel, China accounts for slightly more than half of global supply and demand, which somewhat insulates it from USD effects. 11   Please see New China Tariffs Increase Costs to U.S. Households, published by the N.Y. Fed May 23, 2019. 12   Please see Big Trouble In Greater China, a Special Report published by BCA Research's Geopolitical and China Investment strategies August 23, 2019.  It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Hard-to-predict policy risks and trade-war uncertainty will continue to hinder oil-demand growth, as will USD strength. The cost of oil in local-currency terms remains close to highs not seen since Brent and WTI traded above $100/bbl in 2014 in key EM economies, which partly explains the fall-off in demand begun in 2H18 that carried into 1H19 (Chart of the Week). We continue to expect oil demand to revive on the back of global fiscal and monetary stimulus, which, along with continued production discipline by OPEC 2.0 and capital discipline by U.S. shale producers, keeps our 2020 Brent forecast at $75/bbl. For 2019, however, our Brent forecast falls to $66/bbl from $70/bbl, following a re-basing of estimated demand in 2017-18 to bring it in line with lower historical data, and the lingering impact of a stronger USD.1 We also are revising our WTI expectation, as markets price in the last bits of ~ 2mm b/d of new pipeline takeaway capacity coming online in the Permian Basin. For 2019, we expect WTI to trade $6.50/bbl under Brent, and $4/bbl under next year, vs. $7/bbl and $5/bbl we expected last month. Chart of the WeekUSD Strength Hinders Oil-Demand Rebound Highlights Energy: Overweight. Distillate fuel accounted for 29.6% of the product derived from refining crude oil in the U.S. during July, a record for the month, according to the Energy Information Administration (EIA). Refiners are gearing up for the global change-over to low-sulfur marine fuels ahead of the January 1, 2020, implementation of IMO 2020. Base Metals: Neutral. Increased infrastructure spending will add ~ $2 billion (14 billion RMB) to China’s total infrastructure spending of 524 billion RMB, according to a Fastmarkets MB analyst survey. Copper usage is expected to increase as 2H19 grid spending picks up. Precious Metals: Neutral. Gold and silver continue to mark time close to recent highs. USD strength could slow the metals’ rally. We remain long both metals as portfolio hedges. Ags/Softs: Underweight. This week’s USDA’s Crop Progress report showed 56% of the corn crop was in good or excellent condition, vs. 68% in 2018. For beans, 53% of the crop is in good or excellent condition, vs. 65% last year. Feature We expect global fiscal and monetary stimulus to lift demand in EM economies, which will be visible over the balance of this year and next. In this month’s assessment of supply-demand balances, we are lowering our 2019 Brent forecast to $66/bbl from $70/bbl, after re-basing our demand estimates so that they are more in line with EIA’s historical data (Chart 2). We lowered our historical demand estimates up to and including 2017, in line with the EIA data. This reduces the base level for 2018-20 demand. As a result, the level of our 2018 demand is down by 200k b/d to 100.1mm b/d, vs. last month’s estimate, and the level of our 2019 and 2020 demand estimates is down by 250k b/d to 101.3mm b/d and to 102.8mm b/d. The adjustments are mainly due to the revision of historical level of demand in 2017-2018. In addition, we lowered our growth estimate for 2019 slightly to 1.2mm b/d from 1.25mm b/d last month, but kept our 2020 growth rate expectation at 1.5mm b/d. Chart 2Lower 2019 Demand Estimate, Price; Keeping 2020 Unchanged As noted above, we expect global fiscal and monetary stimulus to lift demand in EM economies, which will be visible over the balance of this year and next. Continued production discipline by OPEC 2.0 and capital discipline by U.S. shale producers leaves our 2020 Brent forecast unchanged at $75/bbl. In addition, this combination of stronger demand and tighter supply will create a physical supply deficit (Chart 3). This deficit will force inventories lower, which remains OPEC 2.0’s paramount goal, and backwardate the Brent and WTI forward curves (Chart 4). Chart 3Stronger Demand, Tighter Supply Produces Physical Deficit Chart 4Inventory Draws Will Resume For WTI, we now expect it to trade $6.50/bbl under Brent in 2019 and $4/bbl under in 2020, vs. the $7/bbl and $5/bbl differentials we expected last month. This narrowing of the differential comes on the back of the build-out of takeaway pipeline capacity in the Permian Basin, which amounts to ~ 2mm b/d by the end of this year. The expansion of deep-water harbor capacity in the U.S. Gulf is being delayed by regulatory action, which means the Brent vs. WTI differential will not significantly contract further until later in 2020 or 2021 when we expect crude-oil export volumes to pick up sharply. Over the course of the coming year, we do expect exports to pick up before 2021, as they have done in 2018-2019. This trend likely continues. We calculated there is ~ 4.5 mm b/d of current export capacity in the Gulf, therefore exports still can increase before being fully constrained. In addition, small capacity expansion projects already are under construction, which will lift capacity next year. That said, any delays could pressure differentials (LLS-Brent, WTI-Brent). But, as long as shale-oil production keeps increasing and foreign demand remains strong, exports can increase – likely at a slower pace – while differentials hold around the $4/bbl level next year. Digging Into The Oil Demand Slow-Down This was a stealthy USD rally, overshadowed by the Sino-U.S. trade war, and exogenous foreign-policy shocks re U.S. Venezuela and Iran policy. For 2019, a grouping of negative demand-side effects have proven to be quite strong – uncertainty spawned by the Sino-U.S. trade-war, tightening financial conditions globally, and the strong USD. Over the past year, these effects have combined to lower actual demand, and forced us to lower our growth expectation for this year for a fourth time to 1.2mm b/d. In hindsight, it is apparent the strong USD has affected EM demand by raising the local-currency cost of oil in particular over the past year to levels not seen since crude was trading above $100/bbl in 2014 (Charts 5A and 5B). Chart 5AAs USD Strengthened Local-Currency Costs Skyrocketed Chart 5BAs USD Strengthened Local-Currency Costs Skyrocketed   This was a stealthy USD rally, overshadowed by the Sino-U.S. trade war, and exogenous foreign-policy shocks re U.S. Venezuela and Iran policy. In addition to raising the cost of commodities priced in USD, in local-currency terms, the stronger dollar lowered the cost of producing commodities for countries like Russia, whose currencies are not pegged to the USD. So, in one fell swoop, USD strength lowered demand via higher prices, and increased supply via lower costs of production. In addition, weaker local currencies catalyze capital outflow, which reduces the supply of savings available to EM economies for investment. At the margin, this also stunts income growth.2 The effects of USD strength could persist, and continue to have a deleterious influence on oil demand into next year, given the way in which monetary policy – and its effects on FX rates – can act with “long and variable lags.” Our BCA Commodity-Demand Nowcasting model continues to point toward a revival of demand as EM economic growth picks up (Chart 6).3 Given the dollar is a counter-cyclical currency vis-à-vis the rest of the world, we expect this will weaken the USD and be supportive of commodity prices. Chart 6BCA Commodity-Demand Nowcast Remains Upbeat Chart 7Expect Further Backwardation In Crude Oil Forward Curves Higher oil demand and lower supply likely will further backwardate Brent and WTI forward curves, which will diminish the impact of the USD’s strength (Chart 7), and lead to higher volatility, as fundamentals once again dominate price formation (Chart 8). Still, the effects of USD strength could persist, and continue to have a deleterious influence on oil demand into next year, given the way in which monetary policy – and its effects on FX rates – can act with “long and variable lags," to borrow Milton Friedman's well-turned phrase.4 We will monitor this risk closely, and will be offering further research into it.   Supply Concerns Persist E&P companies are using their accumulated inventory of excess Drilled-but-Uncompleted (DUC) wells to reach their production targets, while controlling capital expenditures (i.e. flat/lower rig count). We continue to expect OPEC 2.0 to manage production, and to keep a laser focus on reducing inventories. The producer coalition continues to get a huge assist in this effort from the U.S. sanctions against Iran, which, according to the American Secretary of State Mike Pompeo have taken almost all of that country’s oil exports – some 2.7mm b/d – out of the market (Chart 9).5 In our balances estimates, we show OPEC producing 29.8mm b/d of crude oil on average this year, and 29.7mm b/d next year. This is down sharply from the 32mm b/d we estimate the Cartel produced last year, which included a surge in 2H18 undertaken in response to pressure from the U.S. to build inventories ahead of oil-export sanctions being re-imposed against Iran (Table 1). Given the lower demand estimate OPEC is forecasting for this year and next – 99.9mm b/d, and 101.1mm b/d this year and next – we expect OPEC’s leader, KSA, to keep production closer to 10mm b/d vs. its 10.33mm b/d quota. We expect the other putative leader of OPEC 2.0, Russia, to produce 11.43mm b/d and 11.41mm b/d this year and next, versus 11.4mm b/d last year. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Once again, U.S. shale-oil output provides the largest increase in supply globally. That said, shale-oil producers are being forced to temper production growth, as investors’ demand higher profits or greater return of capital. We revised down our U.S. shale production growth to 8.2mm b/d in 2019 and 9.1mm b/d in 2020 (Chart 10). In 2018, we estimated U.S. shale production at 7.2mm b/d. Chart 10Shale Output Reduced Slightly Lower-than-expected WTI prices and capital discipline will limit U.S. shale production growth this year, and temper it next year. E&P companies are using their accumulated inventory of excess Drilled-but-Uncompleted (DUC) wells to reach their production targets, while controlling capital expenditures (i.e. flat/lower rig count).6 Year to date, DUC completions increased in the Big Five tight-oil basins, overtaking new wells drilled (Chart 11).7 However, the Permian’s excess DUC inventory increased in July despite the ongoing pipeline capacity expansion and falling rig count. The Permian’s completion rate will be important to monitor. At current oil prices, producers need to tap into their excess DUC inventories to reach both their free-cash-flow and production goals. Bottom Line: We are reducing our Brent price forecast for 2019 to $66/bbl, on the back of weaker demand. Our forecast for 2020 remains unchanged at $75/bbl. Our expectations are driven by our expectation fiscal and monetary stimulus to lift commodity demand – oil in particular – and that production discipline by OPEC 2.0 and capital discipline from U.S. shale-oil producers will tighten markets and lift prices from here.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      OPEC 2.0 is the name we coined for the producer coalition formed in late 2016 by the Kingdom of Saudi Arabia (KSA) and Russia. The producer coalition’s mission was – and remains – managing global supply so as to reduce inventories. We expect OPEC 2.0 production to be at or below quota levels agreed December 7, 2018, when KSA and Russia and their respective allies set about once again to drain global inventories of the 62-million-barrel overhang that resulted from the production ramp-up undertaken in response to demands from U.S. President Donald Trump. 2      The International Energy Agency (IEA) noted that, on the back of higher prices last year, oil once again was “the most heavily subsidized” energy source, expanding its share of the $400 billion provided consumers by their governments to 40%. Please see Commentary: Fossil fuel consumption subsidies bounced back strongly in 2018, published by the IEA June 13, 2019. 3      For a description of our nowcast model, please see Just In Time For Christmas! U.S. Tariff Delay Rocks Oil published last week by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. We noted last week that our expectation of stronger EM growth and a weaker USD is contrary to the view of BCA Research’s Emerging Markets Strategy, which expects continued weakness in EM GDP growth. Moreover, as mentioned in last week's report, our nowcast’s last data point was observed in July, which is before the latest escalation in trade tensions. We could see a move down in some of the indicators used as input in our nowcast model in the coming month. 4      Friedman, the 1976 Nobel Laureate in Economics, noted monetary policy operates with long and varying lags, which makes it difficult to be precise as to when its effects will be noticed in the macroeconomy. Please see Milton Friedman’s article, “The Lag in Effect of Monetary Policy,” Journal of Political Economy Vol. 69, No. 5 (Oct., 1961), pp. 447-466. 5      To date, OPEC and non-OPEC producers have had no apparent trouble replacing lost Iranian and Venezuelan barrels taken off the market as a result of U.S. sanctions. This indicates spare capacity remains sufficient to meet short-term supply disruptions and unplanned outages. Please see U.S. removed almost 2.7 million barrels of Iranian oil from market - Pompeo, published by uk.reuters.com August 20, 2019. 6      The process of drilling and completing wells produces a normal inventory of uncompleted wells, because of the time lag between the moment wells are drilled and the time they are completed. The development of multi-well pad drilling in U.S. shales structurally increased the time lag between drilling and completion to ~ 5 months. This implies a normal level of DUC inventory that corresponds to ~ 5 - 6 months’ worth of drilling activity. We define any DUC above our estimate of normal as an excess DUC well. On average, completion accounts for ~ 65% of the total well costs. 7      The Big Five shale basins are the Permian; the Eagle Ford; Niobrara; the Bakken, and the Anadarko. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Chart II-1Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.1 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Chart II-3No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view.