Commodities & Energy Sector
Dear Client, Early next week, we will be sending you our BCA Outlook 2019 - our annual dialogue with the bearishly inclined Mr. X and his family. In this report, BCA editors will highlight the most impactful themes for the global economy next year, and the opportunities and risks they create for international asset markets. Next Friday, we will also send you our take on the implications of this discussion for the FX market. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A bearish consensus is forming around the dollar for 2019 as U.S. growth is falling prey to global economic deterioration. However, slowing global growth and inflation create the best environment for the dollar, suggesting the greenback could perform very well in early 2019. While EUR/USD should trade below 1.10 before mid-2019, the dollar should be strongest against the AUD, the NZD and the SEK. The yen faces a trickier picture. With a low degree of conviction, we anticipate USD/JPY to depreciate; but with a high level of confidence, we foresee additional strength in the JPY against the AUD, the NZD and the SEK; EUR/JPY should move below 120. Close short CAD/NOK. Feature The end of the year is approaching, which means that like BCA, banks and research houses around the world are rolling out their major forecasts for the upcoming year. The near-uniform bearishness toward the greenback of the current vintage of forecasts has struck us. Our contrarian streak inclines us to re-assert our bullish dollar stance, but being contrarian for the sake of it is often the perfect recipe to lose money. Welcome To The Jungle A bearish tone on the dollar appears justified right now. Speculators hold near-record long bets on the dollar, yet U.S. economic data seem to finally be succumbing to the gravitational pull of slowing global economic activity. U.S. core inflation has disappointed, orders have been weak, capex intentions have softened, the Conference Board's leading economic indicator has rolled over, and financial conditions have tightened as junk bonds have sold off. This combination could easily generate the perfect recipe for the dollar to sell off. The dollar's strength has been rooted in the divergence of U.S. growth from a weak world economy (Chart I-1). As the narrative goes, without U.S. strength, the Federal Reserve will not be tightening policy anymore, and the dollar will sag. Interest rate markets are already on this page, as after the December meeting they only foresee one more rate hike over the coming two years. Chart I-1Will The Dollar Lose A Key Support? Despite this tantalizing narrative, the dollar rarely weakens because of poor U.S. growth alone. To the contrary, dives in our diffusion index of 16 key U.S. economic variables are most often associated with a strengthening greenback (Chart I-2). The recent sharp fall in this diffusion index would actually point to an appreciating USD. Chart I-2The Plot Thickens This relationship is obviously paradoxical. It exists because the dollar is not a normal currency: it is the premier reserve currency of the world. Resting at the center of the global financial system, the dollar is more sensitive to global growth and inflation conditions than to U.S. growth and policy alone. As Chart I-3 shows, the dollar's behavior is a function of where we stand in the global economic and inflation cycle. We looked at the performance of G-10 currencies versus the dollar since 1986, decomposing the period in four samples based on trends in global activity and global headline inflation. We observed the following patterns: When global growth is accelerating but inflation is decelerating, the dollar tends to weaken, especially against the very pro-cyclical AUD, NZD and SEK (Bottom right quadrant). This is often an environment observed in the early days of a business cycle recovery. When global growth and global inflation are both accelerating, the dollar also tends to weaken, but the pattern is much less clear than in the previous stage (Top right quadrant). This is generally a mid-cycle environment. When global growth is decelerating but global inflation is accelerating, the dollar weakens much more clearly than in the mid-cycle stage (Top left quadrant). In this stage, global growth has begun to decelerate but is still elevated. Risk assets are doing well, but some clouds are gathering on the horizon. European currencies perform best. The most distinct change in the dollar's behavior happens when both global growth and global inflation are decelerating (Bottom left quadrant). In this context, the dollar is strong across the board. This is an end-of-cycle environment where global growth is poor and inflation sags. Investors become very risk averse and they favor the dollar. Commodity currencies and Scandinavian currencies are the worst performers, while the yen is the best. We were surprised that the yen did not manage to appreciate during the periods described by the bottom-left quadrant. However, this is due to the long sample used (since 1986). Prior to the mid-1990s, the yen was a decidedly pro-cyclical currency. This taints the study's overall results. If we only use a shortened time span, the yen in fact appreciates in the last stage of the global business cycle. The yen is the only currency to experience such a sharp regime shift in its relationship to the global business cycle. Chart I-3The Dollar And The Global Business Cycle Bottom Line: Dividing the business cycle into four periods shows that only when global growth and inflation are very weak can the dollar unequivocally rally. This is exactly what we would anticipate of a reserve currency. Investors flock to it when they are looking for safety. Moreover, since being the global reserve currency also means that most of the world's foreign-currency borrowing is in dollars, periods of tumult force debtors to repay their debt, prompting them to buy the greenback in the process. Finally, the low beta of the U.S. economy to the global industrial cycle only adds fuel to the fire, as it means that U.S. growth outperforms global growth when global activity deteriorates meaningfully. Paradise City Under this lens, the dollar's strength this year was rather impressive. We have seen global growth slow, but global inflation accelerate. This could have been a disastrous year for the dollar, but it was not. Markets have been sniffing out slower growth and its potentially deflationary impact; hence, the dollar has responded well. Moreover, the dollar started the year trading at a 5% discount to its fair value, and investors were massively short. Finally, as we have previously showed, the dollar is the epitome of momentum currencies within the G-10 space, and this year, our momentum measure flagged a very bullish signal for the dollar (Chart I-4).1 Chart I-4Momentum Has And Continues To Support The Greenback While the dollar has already been strong, the next three to six months could generate considerably more dollar strength. The dollar may not be cheap anymore, but as we argued last week, it is not expensive either.2 Moreover, while investors are already very long the dollar - a source of concern for us - momentum still favors the greenback. Finally, the global economy might spend some time in the bottom-left quadrant described above where global growth and global inflation both decelerate - the quadrant where the dollar strengthens. Thus, both momentum and economics could line up to enhance the dollar's appeal. First, we have already highlighted that global growth is in the process of weakening. Under the weight of China's deleveraging efforts, of uncertainty surrounding global trade under the Trump administration, and of the tightening in EM financial conditions, global export growth has been flailing.3 Now, our global economic and financial advance/decline line shows that enough variables are pointing in a growth-negative direction that global industrial production - not just orders and surveys - is set to deteriorate sharply (Chart I-5). Chart I-5Global Growth Will Slow Materially In The First Half Of 2019 This message is confirmed by the OECD's leading economic indicator, which is falling faster than it was in late 2015. Most crucially, the very poor performance of EM carry trades financed in yen, which have been a reliable forecaster of global industrial activity, point to a sharp deterioration of our Global Nowcast (Chart I-6), an indicator that measures the evolution of global industrial activity while bypassing the long publishing lags inherent in global IP statistics. Chart I-6The Canaries Are Suffocating Second, while global inflation has been on an uptrend, we expect it to soon relapse, potentially for six months or so. To begin with, we are already seeing some key global inflation measures soften. Recent U.S. core inflation releases have disappointed, Japan's GDP deflator has grown more negative, Germany's producer prices have decelerated, and both producer and core consumer prices in China are slowing sharply. If we are to believe financial markets, this development has further to run. The change in 10-year and 5-year/5-year forward U.S. inflation break-evens has collapsed, and the performance of U.S. industrial stocks relative to utilities suggest that global core inflation will soon decelerate noticeably (Chart I-7). Additionally, the annual total returns of EM equities relative to EM bonds, adjusted for their mutual volatility, has fallen, which normally also foreshadows a decline in underlying global inflation (Chart I-8). Chart I-7U.S. Financial Market Point To Slower Global Inflation... Chart I-8...So Do EM Stocks And Bonds The trend in some of the most important globally traded good prices is also very worrisome for inflation hawks, at least for the first half of 2019. Oil has fallen 26% since its October peak, but also, after rising nearly 90% from April to August, the Baltic Dry index has tumbled by nearly 45%. Another risk could exacerbate these deflationary forces: the Chinese yuan. The Chinese authorities are afraid of the potentially deeply negative impact on their economy of a trade war with the U.S. As a result, they have slowly been injecting monetary stimulus into the economy and are also adjusting fiscal policy to support the Chinese consumer. However, until now, these measures have not been enough to lift Chinese growth and investment. Chinese interest rates are thus likely to continue to lag behind U.S. rates. Deeper cuts to the reserve requirement ratio for commercial banks are also forthcoming. Historically, these developments have been associated with a weaker renminbi (Chart I-9). Chart I-9A Falling CNY Will Further Curtail Inflation A softening CNY is deflationary for the world for three reasons: It decreases the purchasing power of China abroad; it cuts Chinese export prices; and it forces competitors to China to also lower their prices and let their currencies depreciate in order to maintain their own competitiveness in international markets. In other words, a falling yuan unleashes China's own deflationary forces onto the rest of the world. Bottom Line: While momentum has already been a tailwind for the dollar, now the global economy is likely to enter the quadrant where both growth and inflation decelerate. This means the greenback is likely to pick up an additional strong tailwind. Stay long the dollar. Nightrain Based on this analysis, the first half of 2019 could be very positive for the dollar. The Bottom left quadrant of Chart I-3 implies that EUR/USD is unlikely to suffer the greatest downside. Nonetheless, based on our preferred fair-value model for the euro - which is based on real short-rate differentials, yield curve slope differences, and the price of lumber relative to copper - the common currency needs to move below 1.1 before trading at a discount (Chart I-10). We expect the euro will settle between 1.10 and 1.05. Chart I-10EUR/USD Will Fall Below 1.1 If business cycle analysis is any guide, the dollar should shine most brightly against commodity currencies - the AUD and NZD in particular - and Scandinavian currencies. We closed our long NZD trades last week, and this week's analysis implies completely curtailing our positive bias toward the kiwi. Positive domestic economic results have lifted the AUD, but slowing global growth and inflation will hurt this very pro-cyclical economy. A key support for the expensive AUD will dissipate as quickly as it appeared. We had sold CAD/NOK, but this trade is not panning out. Global business cycle dynamics suggest that we should terminate this bet. Slowing global growth and inflation historically hurt the NOK more than the CAD. As Chart I-11 shows, under these circumstances, CAD/NOK does not depreciate, it appreciates. However, we remain committed to our long-term short AUD/CAD trade. This cross performs poorly in this quadrant of the global business cycle. This view is reinforced by the fact that Robert Ryan, BCA's head of commodities, continues to favor energy over base metals. Furthermore, the Canadian government unveiled C$14billion of corporate tax cuts this week, creating a marginal additional positive for the Canadian economy. We therefore do not expect AUD/CAD to break above the important technical resistance it currently faces. Instead, it is likely to embark on the last leg of a downtrend started in March 2017, which could culminate with AUD/CAD trading between 0.88 and 0.86 (Chart I-12). Chart I-11The Global Business Cycle Votes Nay To Short CAD/NOK, But Yea To Long AUD/CAD Chart I-12Attractive Spot To Sell AUD/CAD The yen is potentially the trickiest of all the currencies. At face value, the global business cycle analysis suggests the yen could depreciate against the dollar, but as we argued, this is an artefact of the long sample used in this analysis. A shorter sample would show the yen appreciating against the dollar. We are inclined to agree with this conclusion. Slowing global growth and inflation as well as a strong trade-weighted dollar could very well put a bid under the price of Treasury bonds over the next few months, especially as speculators are still large sellers of the whole U.S. government bond universe (Chart I-13). Since the yen remains broadly inversely correlated to Treasury yields, it may appreciate against the dollar over the coming three to six months. Chart I-13Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Our view has been and remains that the yen offers its most attractive reward-to-risk ratio on its crosses, not against the U.S. dollar. The business cycle analysis confirms that the yen has upside against all the other currencies when both global growth and inflation slows (Chart I-3, bottom left quadrant). The yen should, therefore, offer plentiful upside against the AUD, the NZD, the SEK and the NOK. Moreover, since the beginning of the year, a core view of this publication has been that EUR/JPY would depreciate4 - a trend that has materialized, albeit in a volatile fashion. Since the global business cycle is likely to put downward pressure on global yields for another three to six months, it should also push EUR/JPY lower (Chart I-14). Hence, a move in EUR/JPY below 120 is likely over the coming months. Chart I-14...Which Will Hurt EUR/JPY Bottom Line: While EUR/USD could fall slightly below 1.1, the greenback is likely to experience its sharpest upside against the AUD, NZD, SEK and NOK. While selling CAD/NOK does not work when global growth and inflation decelerate, selling AUD/CAD does. The JPY is likely to experience more upside against the dollar, but the JPY is most attractive against commodity currencies and the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Six Questions From The Road", dated November 16, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Clashing Forces: The Fed And EM Financial Conditions", dated October 19, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "The Unstoppable Euro?", dated January 19, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization came in above expectations, coming in at 78.4%. However, both initial jobless claims and continuing jobless claims surprised negatively, coming in at 224 thousand and 1.688 million. Finally, durable goods orders also disappointed expectations DXY has been roughly flat this week. Several indicators point to a slowdown on economic data. At face value this could imply that the dollar could fall. However, falling oil prices, point to a slowdown in global inflation. This factor, alongside slowing global growth has historically been very positive for the U.S. dollar. Thus, we maintain our long dollar position. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Both core and headline inflation came in line with expectations, coming in at 1.1% and 2.2%, respectively. Headline inflation in Italy also came in line with expectations, at 1.6%. EUR/USD has risen by roughly 0.5% this week. Overall, we continue to be bearish on the euro, given that we expect an environment of declining growth and inflation, which usually is negative for EUR/USD. Moreover, large exposure to vulnerable emerging markets by European banks will continue to be a drag on how much the ECB can tighten policy. Report Links: Six Questions From The Road - November 16, 2018 Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The All Industry Activity Index monthly change underperformed expectations, coming in at -0.9%. Meanwhile, national inflation ex-fresh food came in line with expectations at 1%. Finally, national inflation also came in line with expectations, coming in at 1.4%. USD/JPY has been flat this week. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 GBP/USD has risen by 0.9% this week. The market reacted positively to the draft of the Brexit agreement. Even if risks have begun to decline, the all clear for the pound has not been reached as political risks will continue to regularly inject doses of volatility into British assets. Moreover, the strength in the dollar should continue to weigh on cable. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has been flat this week. We are most negative on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that global inflation will start to roll over. This deceleration in prices, coupled with slowing growth will provide a dangerous cocktail for this cross. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. While we were positive the NZD and capitalized on this view, we are becoming more cautious. We cannot rule out any further short-term upside, but on a six month basis, the NZD will likely experience heavy downside, as slowing global growth and inflation are major hurdles for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has risen by 0.6% this week. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Nonetheless the CAD tends to outperform other commodity currencies when the global business cycle slows. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen by 0.7% this week. While global volatility can temporarily support the swiss france versus the euro, w continue to be bearish on the franc on a 12 to 18 months basis, given that Swiss growth and inflation remain too tepid for the SNB to hike policy rates. This point is confirmed by the recent rollover in industrial production. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.4% this week. Overall, we expect for the krone to have further downside as oil continues to fall while U.S. rates continue to rise. Moreover, if the fall in oil prices causes a large fall in inflation the krone could depreciate even more against the CAD, as this cross has historically fallen when this particular set of circumstances occur. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has been flat this week. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. The optimism on domestic factors is tempered by global risks. The krona tends to perform very poorly when global growth slows, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights When we flagged the increasing likelihood of higher volatility a few weeks ago, we did not expect the Trump Administration's granting of waivers on sanctions against Iranian oil exports, which ultimately led to the oil-price meltdown.1 Neither, it seems, did the market, as the surge in Brent and WTI implied volatilities attests (Chart of the Week). Chart of the WeekOil-Price Volatility Surges As Markets Process Conflicting News In one fell swoop, the Trump Administration's volte-face on Iran oil-export sanctions transformed the threat of an oil-price spike to $100/bbl in 1Q19 into a price rout. Whether that persists depends on how OPEC 2.0 responds to sharply higher short-term supply. Our updated supply - demand balances and price forecast are highly conditional on our expectation OPEC 2.0 will reduce output in response to the 1mm+ b/d or so of oil put back into the market early next year because of waivers. Inventories globally are at risk of swelling once again, if OPEC 2.0 does not cut output. OPEC 2.0's interests will conflict with the Trump Administration's agenda. Going into OPEC 2.0's December 6 meeting in Vienna, we lowered our 2019 Brent expectation $82/bbl, and continue to expect WTI to trade $6/bbl below that. We expect volatility to persist. Energy: Overweight. Natgas futures raced above $4.00/MMBtu on the NYMEX as the U.S. heating season kicked off with inventories of 3.2 TCF - 16% below their five-year average, and the lowest since 2005, according to EIA data. Base Metals: Neutral. China's benchmark copper treatment and refining charges are expected to remain on either side of $82.25/MT next year, as concentrate supply tightens slightly, Metal Bulletin's Fastmarkets reported. Precious Metals: Neutral. The Fed is on course to lift the fed funds range 25bp to 2.25% - 2.50% at its December meeting, which will keep gold under pressure. Ags/Softs: Underweight. The USDA's latest ending stocks estimates for the 2018/19 crop year came in below trade expectations for corn and wheat - at 1.74 billion and 949mm bushels, respectively, vs. expectations of 1.78 billion and 969mm, according to agriculture.com. Soybean estimates came in at 955mm vs. an expected 906mm bushels. Feature Brent and WTI crude oil prices air-dropped from a high of $86.10/bbl in early October to a Wednesday low of $65.01/bbl as we went to press. This was a 24% drop in a little more than a month, reflecting the difficulty markets experienced recalibrating supply - demand balances in the wake of the Trump Administration's volte-face on Iranian export sanctions, which took effect last week. Over the past weeks, markets appear to be pricing the return of more than 1mm b/d of Iranian exports in 1Q19, on the back of these waivers for importers of Iranian crude. The full extent of the additional volumes that will be allowed back on the market still is unknown. Lacking certain information, market participants have to assume the waivers will dramatically expand short-term supplies, which already had been boosted by OPEC 2.0 and U.S. producers, in the lead-up to sanctions (Table 1).2 The sell-off on the back of the waivers did, however, dissipate some of the risk premium we identified in prices in October, and brought price more in line with actual balances (Chart 2).3 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 2Oil Risk Premium Dissipates Prior to the granting of waivers, markets were girding for sanctions-induced losses of as much as 1.7mm b/d. Now markets could see a far lower supply loss of 500k b/d in Iranian exports. This lower loss of exports from Iran reduced expected prices by $10/bbl in 1H19, vs. our previous expectation of $85/bbl for 1H19 using our ensemble forecast (Chart 3). For market participants hedging or trading based on the expectation of higher losses of Iranian exports, the granting of waivers creates even more "new-found" and unanticipated supply. In a simulation with the waivers extended to end-2019, average 2019 Brent prices fall to $75/bbl vs. $82/bbl using our current assumptions. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 In our estimation, "finding" this much supply via waivers amounts to a supply shock. This was compounded by surging U.S. crude and liquids production, which is boosting oil and product exports from America. Uncertain Balances, Volatile Prices Waivers are not the only factor contributing to price volatility. Fears of weaker global demand come up repeatedly - particularly as regards Asia in general, and China in particular.4 Those fears are not showing up in actual demand. In our balances estimates, we expect demand growth of 1.46mm b/d next year, down slightly from our previous estimate, given realized oil consumption remains strong (Chart 4 and Table 1). Supporting data - e.g., EM import volumes - continue to indicate incomes are holding up. Chart 4Demand Expected To Hold; Supply Highly Conditional On OPEC 2.0 On the supply side, references to an apparent disagreement between the Kingdom of Saudi Arabia (KSA) and Russia - the leaders of OPEC 2.0 - over the need to cut 1mm b/d of production next year, to keep inventories from once again swelling as they did in 2014 - 2016, compounding risks.5 While it appears KSA has carried the day on the need to cut production, that could change at OPEC 2.0's December meeting in Vienna. Output from OPEC 2.0's weakest member states - i.e., Libya and Nigeria - remains strong. Even Venezuela's rate of decline slowed some. Therefore, even without the waivers, KSA and its Gulf Arab allies would have had to reduce output to make room for these states, which are desperately trying to rebuild war-torn infrastructure. In addition to the OPEC 2.0 output surge, U.S. production has been unexpectedly strong, as have U.S. crude and refined product exports (Chart 5). The EIA - in an adjustment that surprised its analysts - revised its U.S. production estimate for October by 400k b/d vs. September's estimate to 11.4mm b/d. Production in the Big 4 shale plays - Permian, Eagle Ford, Bakken, Niobrara - is proving to be even stronger as well (Chart 6). U.S. shale output will be just under 8mm b/d by December, months ahead of schedule. The infrastructure buildout in the Permian will no doubt absorb this production and the subsequent growth in shale output by ~1.35mm b/d next year easily. Chart 5U.S. Production, Exports Surge Chart 6U.S. Shale Production Will Surge U.S. producers do not have an interest in managing their production. OPEC 2.0 does, however. We expect KSA and its Gulf Arab allies to reduce production in December and keep it low until the recently formed overhang brought on by the waivers to Iranian sanctions clears. This means OECD inventory levels will once again be a key variable for OPEC 2.0 in its production management decisions (Chart 7). Chart 7Once Again, OECD Stocks Are OPEC 2.0's Policy Variable We assume KSA will mobilize 800k to 1mm b/d of cuts in the coalition's production at least through 1H19. KSA already has said it will reduce exports by 500k b/d in Dec18, and that could be extended to Jun19. We also expect the rest of the Gulf Arab producers to follow suit, and cut back on the production increases they brought on line at President Trump's urging. By 2H19, the waivers will have expired, but U.S. shale output will be surging and newly built pipelines will be filling. We have been carrying lower 2H19 OPEC 2.0, particularly KSA, production estimates in anticipation of this increased production and exports from the U.S. (Table 1). OPEC 2.0 + 1? President Trump apparently wants to continue to have a say in OPEC 2.0's policy deliberations, as he obviously did in the run-up to U.S. mid-term elections earlier this year. In response to persistent messaging from President Trump, KSA, Russia and their allies surged production ~ 750k b/d in July - November over their 1H18 output, in preparation for the U.S. sanctions against Iran. In addition to pushing for higher production, the U.S. has taken a more activist approach to boosting oil production among U.S. allies, possibly ahead of another attempt to impose sanctions on Iran when the current waivers expire next year in June, assuming the 180-day wind-down begins in January. For example, the U.S. has taken a more active role in re-starting exports of oil from Iraq's semi-autonomous Kurdish province - some 400k b/d, which would flow to Turkey and on to Western consumers. Without higher production from Iraq and others in OPEC 2.0, the Iran waivers almost surely will have to be extended when they expire. As we have shown in our research, Brent prices mostly likely would push toward $100/bbl without a substantial increase in spare capacity within OPEC 2.0.6 President Trump gives every impression he and his administration now share our assessment, as the FT noted: "US president Donald Trump said this week he was 'driving' oil prices down and that he had granted waivers to some of Iran's customers as he did not want to see '$100 a barrel or $150 a barrel' crude."7 BCA's Geopolitical Strategy notes the waivers also send two very important messages to KSA: "First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output."8 Forecasting supply-demand fundamentals and, therefore, prices in this environment is extremely difficult, as it involves reconciling conflicting goals between the Trump Administration and OPEC 2.0. If President Trump prevails and KSA increases output - against its own best interests, given it requires higher prices to fund its budget - then prices will be lower for longer, once again. We are inclined to believe President Trump's alarm bells start sounding when oil prices are approaching the $85/bbl level. This also is the price level KSA needs to fund its fiscal obligations. For this reason, we expect KSA and its Gulf allies to reduce output in the near term until the waivers-induced overhang clears. Depending on how quickly they act, this could be done in fairly short order. Bottom Line: Volatility likely will persist as global markets absorb an unexpected supply surge resulting from the Trump Administration's last-minute volte-face on Iranian export sanctions, which is compounded by the supply ramp undertaken by OPEC 2.0 ahead of sanctions being imposed, and surging U.S. production gains. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published on October 25, 2018. It is available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the OPEC - non-OPEC producer coalition formed at the end of the price collapse of 2014 - 16 to get control over global output and bring down swollen crude oil and refined product inventories. The coalition meets December 6 in Vienna to consider formalizing the union as a production-management cartel. 3 Our price-decomposition model's residual term is our proxy for the risk premium in oil prices. This is the red bar in Chart 2. Please see discussion in "Risk Premium In Oil Prices rising; KSA Lifts West Coast Export Capacity," which is cited above. 4 Please see "Asia's weakening economies, record supply threaten to create oil glut," published November 14, 2018, by uk.reuters.com. 5 Please see "OPEC and Russia Prepare for Clash Over Oil Output Cuts," published online by the Wall Street Journal November 9, 2018. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published on September 20, 2018, and "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," published September 27, 2018. Both are available at ces.bcaresearch.com. 7 Please see "Iraq close to deal to restart oil exports from Kirkuk," published by the Financial Times November 9, 2018. 8 Please see BCA Research's Geopolitical Strategy Weekly Report "Insights From The Road - Constraints And Investing," published on November 14, 2018. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
The benchmark Brent oil price fell 11% in October, but has fallen another 7% in November. This has been enough to nearly wipe out the entire 20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil…
Highlights Falling Oil Prices & Bond Yields: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. ECB Corporate Bond Purchases: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days in this cycle for European corporate credit are behind us, as the ECB will not treat its corporate bond purchases any differently than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade & high-yield. Feature Are Falling Oil Prices Telling Us Something About Global Growth? Thus far in November, global financial markets have reversed some of the steep losses incurred during the "Red October" correction. This has occurred for U.S. equities (the S&P 500 fell -8% last month but has risen +4% so far this month), U.S. corporate bonds (high-yield spreads widened +71bps last month and have tightened -19bps this month) and emerging market hard currency debt (USD-denominated sovereign spreads widened +27bps last month and have tightened -9bps this month). One market that has not rebounded, however, is oil. The benchmark Brent oil price fell -11% in October, but has fallen another -7% in November. This has been enough to nearly wipe out the entire +20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil markets in recent years. Such a large decline in the oil price as has been seen of late would typically result in sharp drop in government bond yields, driven by falling inflation expectations. That correlation has been holding up in the major economies outside the U.S., where nominal yields and inflation expectations are lower than the levels seen before the October peak in oil prices. Nominal U.S. Treasury yields, by contrast, remain resilient, despite the fall in TIPS breakevens (Chart of the Week). This is because real Treasury yields have been climbing higher as investors acquiesce to the steady hawkish message from the Fed by making upward revisions to the expected path of U.S. policy rates. Chart of the WeekShifting Correlations The biggest impediment holding back a full recovery of the October losses for global risk assets is uncertainty over the global growth outlook. While the U.S. economy continues to churn along at an above-trend pace, there are signs that tighter monetary policy is starting to have an impact. Both housing and capital spending have cooled, although not yet by enough to pose a terminal threat to the current long business cycle expansion. The outlook for growth outside the U.S. is far more muddled, adding to investor confusion. China has seen a clear growth deceleration throughout 2018, but the recent reads from imports and the Li Keqiang index suggest that growth may be stabilizing or even modestly re-accelerating (Chart 2). Our China strategists are not convinced that this is anything more than a ramping up of imports and production in advance of the full imposition of U.S. trade tariffs, especially with Chinese policymakers reluctant to deploy significant fiscal or monetary stimulus to boost growth. Chart 2Mixed Messages On Growth A similar mixed read is evident in overall global trade data. World import growth has also slowed throughout 2018, but has shown some stabilization of late (second panel). A similar pattern can be seen in capital goods imports within the major developed economies. Our global leading economic indicator (LEI) continues to contract, but the pace of the decline has been moderating and our global LEI diffusion index - which measures the number of countries with a rising LEI versus those with a falling LEI - may be bottoming out (third panel). There are also large, and growing, divergences within the major developed economies. The manufacturing purchasing managers' indices (PMIs) for the euro area and the U.K. have been falling steadily since the start of the year, but the PMIs have recently ticked up in the U.S. and Japan (Chart 3). A similar pattern can be seen in the OECD LEIs, which have retreated from the latest cyclical peaks by far more in the U.K. (-1.6%) and euro area (-1.2%) than in the U.S. (-0.3%) and Japan (-0.6%). Chart 3Diverging Growth, Diverging Bond Yields With such mixed messages from the macro data, investors understandably lack conviction. The backdrop does not look soft enough yet to threaten global profit growth and justify sharply lower equity prices and wider corporate bond spreads. Yet the growth divergences between the U.S. and the rest of the world are intensifying, creating a backdrop of rising U.S. real interest rates and a stronger U.S. dollar. That combination is typically toxic for emerging markets, but the impact of that would be muted this time if China were to indeed see a genuine growth reacceleration. This macro backdrop lines up with our current major fixed income investment recommendations. We suggest only a neutral allocation to global corporate bonds given the uncertainty over growth, but favoring the U.S. over Europe and emerging markets given the clearer evidence of a strong U.S. economy. At the same time, we continue to recommend below-benchmark overall portfolio duration exposure, but with regional allocations favoring countries where central banks will have difficulty raising interest rates (Japan, Australia, core Europe, the U.K.) versus nations where policymakers are likely to tighten monetary policy (U.S., Canada). However, the latest dip in oil should not be ignored. A more sustained breakdown of oil prices could force us to downgrade corporate bonds and raise duration exposure - if it were a sign that global growth was slowing and inflation expectations had peaked. The current pullback in oil has occurred alongside a decelerating trend in global economic data surprises, after speculators had ramped up long positions in oil and prices were stretched relative to the 200-day moving average (Chart 4). This suggests that the latest move has been corrective, and not a change in trend, although the burden of proof now falls on the evolution of global growth, both in absolute terms and relative to investor expectations. Chart 4Oil Correction Or Growth Scare? Bottom Line: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. European Corporates Are About To Lose A Major Buyer Last week, we published a Special Report discussing the ECB's options at next month's critical monetary policy meeting.1 One of our conclusions was that the central bank will deliver on its commitment to end the new purchases phase of its Asset Purchase Program (APP) at year-end. The bulk of the assets in the APP are government bonds, but the ECB has also been buying corporate debt in the APP since June 2016. The ECB is set to end those purchases at the end of December, to the likely detriment of euro area corporate bond returns. The Corporate Sector Purchase Program (CSPP), as it is formally known, has been a targeted tool used by the ECB to ease financial conditions for euro area companies. This has occurred through three main channels: tighter corporate bond spreads, greater access for companies to issue debt in the corporate primary market, and increased bank lending to non-financial corporations. The CSPP was intended to complement the ECB's other monetary stimulus measures, like negative interest rates and the buying of government debt. The first CSPP purchases were made on June 8, 2016. The euro area corporate bond market responded as expected, with investment grade spreads tightening from 128bps to 86bps by the end of 2017. There were spillovers into high-yield bonds, as well, with spreads falling -129bps over the same period (Chart 5). Since then, however, spreads have steadily widened and European corporates have underperformed their U.S. equivalents. This suggests that some of the relative performance of euro area credit may have simply reflected the relative strength of the euro area economy compared to the U.S. The greater acceleration of euro area growth in 2017 helped euro area corporates outperform U.S. equivalents, while the opposite has held true in 2018. Chart 5ECB Buying Does Not Control European Credit Spreads The CSPP has operated with a defined set of rules governing the purchases. Bank debt was excluded, as were bonds rated below investment grade. Only debt issued by corporations established in the euro area were eligible for the CSPP, although bonds from euro-based companies with parents who were not based in the euro area were also eligible. The latest update on the holdings data from the ECB shows that there are just under 1,200 bonds in the CSPP portfolio. Yet despite the ECB's best efforts to maintain some degree of portfolio diversification, the impact of the CSPP on euro area corporate bond markets was fairly consistent across countries and sectors (Chart 6). Italy is the notable diverging country this year, as the rising risk premiums on all Italian financial assets have pushed corporate bond yields and spreads well above the levels seen in core Europe, even with the ECB owning some Italian names in the CSPP. Chart 6Spread Convergence During CSPP There was also convergence of yields and spreads among credit tiers during the first eighteen months of the CSPP, with valuations on BBB-rated debt falling towards the levels on AA-rated and A-rated bonds (Chart 7). That convergence has gone into reverse in 2018, with BBB-rated spreads widening by +55bps year-to-date (this compares to a smaller +25bps increase in U.S. BBB-rated corporate spreads). A surge in the available supply of BBB-rated euro area bonds is a likely factor in that spread widening, as evidenced by the sharp rise in the market capitalization of the BBB segment of the Bloomberg Barclays euro area corporate bond index (top panel). Chart 7A Worsening Supply/Demand Balance For European BBBs? More broadly, the CSPP has helped the ECB's goal of boosting the ability of European companies to issue debt in primary bond markets. Traditionally, European firms have used bank loans as their main source of borrowed funds, with only the largest firms being able to issue debt in credit markets. That has changed during the CSPP era. According to data from the ECB, gross debt issuance by euro area non-financial companies (NFCs) has risen by €104bn since the start of the CSPP, taking issuance back to levels not seen since 2014 (Chart 8). The bulk of the issuance has been in shorter-maturity bonds, but there has been a notable increase in the issuance of longer-dated debt since the CSPP began. Chart 8Bank Funding Versus Bond Funding The ECB's role as a marginal buyer of bonds in the primary, or newly-issued, market has helped boost that gross issuance figure. The share of bonds that the ECB owns in the CSPP that was issued in the primary market has gone from 6% soon after the CSPP started to the current 18% (Chart 9). The growth in euro area non-financial corporate debt went from 6% to over 10% during the peak of the CSPP buying between mid-2016 and end-2017, but has since decelerated to 7%. At the same time, the annual growth in loans to NFCs, which was essentially zero during the first eighteen months of the CSPP, has accelerated to 2% over the course of 2018. Chart 9More Bank Loans, Less Debt Issuance In other words, euro area companies had been substituting bank financing for bond financing in the CSPP "era", but have since shifted back towards bank loans in 2018. That shift in financing was most notable among CSPP-eligible companies, particularly those smaller firms that had not be able to issue debt in the primary market pre-CSPP, according to an ECB analysis conducted earlier this year.2 From the point of view of the investible euro area corporate bond market, however, even larger companies that have done that shift in bank financing to bond financing have seen no noticeable increase in aggregate corporate leverage. In Chart 10, we show our bottom-up version of our Corporate Health Monitor (CHM) for the euro area. This indicator is designed to measure the aggregate financial health of euro area companies using financial ratios incorporating actual data from individual companies. We separated out the list of companies used in that CHM that are currently held in the CSPP portfolio and created a "CSPP-only" version of the CHM (the blue lines in all panels). All issuers that were eligible for inclusion in the CSPP, but whose bonds were not actually purchased by the ECB, are used to create a "non-CSPP" CHM (the black dotted lines). Chart 10No Fundamental Changes From CSPP As can be seen in the chart, there is no material difference in any of the ratios for bonds within or outside the CSPP. The one notable exception is short-term liquidity, where the ratios were much lower for names purchased by the ECB than for those that were not. This lends credence to the idea that the CSPP most helped firms that were more liquidity-constrained, likely smaller companies. The biggest change in any of the ratios has been in interest coverage, but that has been for both CSPP and non-CSPP issuers, suggesting a common factor outside of ECB buying - zero/negative ECB policy rates, ECB purchases of government bonds that helped reduce all European borrowing rates - has been the main driver of lowering interest costs. Looking ahead, the ECB is likely to stop the net new purchases of its CSPP program when it does the same for the full APP next month. All of which is occurring for the same reason - the euro area economy is deemed by the central bank to no longer need the support of large-scale asset purchases given a full employment labor market and gently rising inflation. As we discussed in our Special Report last week, the ECB has other options available to them if there is a reduction in euro area banks' capacity or willingness to lend, such as introducing a new Targeted Long-Term Refinancing Operation (TLTRO). Continuing with unconventional measures involving direct ECB involvement in financial markets, like buying corporate debt, is no longer necessary. Our euro area CHM suggests that there are no major problems with European corporate health that require a wider credit risk premium. We still have our reservations, however, about recommending significant euro area corporate bond exposure while the ECB is set to end its asset purchase program. New buyers will certainly come in to replace the lost demand from the elimination of CSPP purchases, but private investors will likely require higher yields and spreads than the central bank - especially if the current period of slowing euro area growth were to continue. Bottom Line: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days for European corporate debt for the current cycle are behind us, as the ECB will not treat its corporate bond purchases any different than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade and high-yield. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Evaluating The ECB's Options In December", dated November 6th 2018, available at gfis.bcareserach.com and fes.bcaresearch.com. 2 The ECB report on its CSPP program was published in the March 2018 edition of the ECB Economic Bulletin, which can be found here. https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201804.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) Chart 10Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps
On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and,…
Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Chart 6... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market. Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms\ Chart 9Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Chinese copper imports came in strong in September. While unwrought copper imports reached a 2.5-year high, ores and concentrates forged new record highs. Copper inventories at the three major global exchange warehouses have been declining steadily and…