Copper

Highlights Our base case reflects our view that China’s strong fiscal and monetary stimulus, combined with a weaker US dollar, will provide a favorable backdrop for copper markets in 2H20. Supply factors are for the most part reflected in current copper prices. In 2H20, the speed of the demand recovery will be the determining factor for prices. Global policy uncertainty remains high.  Assessing the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted will keep uncertainty at relatively high levels.  A possible second wave of COVID-19 returning large economies to lockdown status looms large for copper markets, and for commodity markets generally. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines could keep the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin. Tactically, we remain on the sidelines until the fog clears around these known and unknown unknowns.  A $3/lb COMEX refined copper price is likely in 2H20, but the risks to this outlook remain high. Feature Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Assessing the synchronicity of EM recoveries and the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted is extremely difficult. Looming over all of these considerations: A possible second wave of COVID-19 returning large economies to lockdown status loom large. Tactically, we remain on the sidelines as the fog clears around some of these known and unknown unknowns. Importantly, our positive view rests on our expectation of a robust recovery in China’s economic activity and, to a lesser extent, in its main export destinations, which were hit later by the pandemic. A weak recovery in China would slow the rate at which the current copper supply surplus subsides. At ~ $2.50/lb, copper prices have recovered significantly since bottoming in March at $2.11/lb on the COMEX. Still, clearing the $3.30/lb double top reached in June 2018 will require either a significant increase in global demand or a sharp contraction in supply, which we do not expect. Copper markets were severely hit by the global pandemic: Prices fell 10% in January, as the case count grew in China – the largest copper-consuming market – followed by another 19% decline as the virus spread globally (Chart of the Week). The intensification of lockdowns globally pushed copper markets to a 60k MT surplus as of March – the latest data reported by the World Bureau of Metal Statistics (WBMS) – from a 20k MT deficit in 2019. Bearish sentiment moved our Tactical Composite Indicator – which captures sentiment, positioning, and momentum dynamics – to oversold territories on in March (Chart 2). Chart of the WeekCopper Prices Were Severely Hit By The Pandemic Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 2Bearish Sentiment Crushes Copper Prices Bearish Sentiment Crushes Copper Prices Bearish Sentiment Crushes Copper Prices After reaching a low of $2.11/lb on March 23, COMEX copper prices surged 18% with few interruptions as the Chinese economy reopened, and global monetary and fiscal authorities supplied unprecedented economic support (Chart 3). This prompted a wave of short-covering by money managers, releasing some of the downward pressure on prices (Chart 4). Chart 3Unprecedented Fiscal Response Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 4Money Managers Neutral For Now Money Managers Neutral For Now Money Managers Neutral For Now Still, hedge funds have not yet entered bullish positions on the metal. And, importantly, inventory levels are not drawing sharply. China’s Economy Bottomed, World ex-China Still Contracting Our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. Since the end of the Global Financial Crisis (GFC), copper prices have mostly shadowed China’s economic cycles (Chart 5). China’s importance for copper markets now dominates that of major DM countries (Chart 5, panel 3). The influence of global supply-demand fundamentals on copper prices has declined. Prices are increasingly policy-driven with supply adjusting to demand as dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in that economy. Thus, our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. According to the International Copper Study Group (ICSG), around 17% of Chinese copper demand comes from exports of products containing copper.1 In “normal” times, we rely heavily on our monthly indicators to gauge economic and commodity cycles. However, the speed with which the COVID-19 pandemic evolves – and the associated fiscal and monetary responses to it – makes short-term forecasting of cyclical commodities a perilous task. Chart 5DM Consumption Pales Vs. China DM Consumption Pales Vs. China DM Consumption Pales Vs. China High-frequency data suggest Chinese economic growth bottomed in March and is rapidly recovering (Chart 6). Chart 6Chinese Economy Returning To Normal Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Meanwhile in China’s major export destinations, the number of confirmed COVID-19 cases appear to be flattening, containment measures are gradually easing, and mobility is improving (Chart 7, panel 1 and 2). Globally, the copper- and oil-to-gold ratios have stabilized, and stock prices for nine of the largest copper producers have trended up since March 23 (Chart 7, panel 3 and 4). That said, we believe it is still too early to adopt a high-conviction view about a price recovery trajectory. For one, China recently reintroduced containment measures in certain regions, as clusters of coronavirus cases were detected, highlighting the fragility of the current recovery.2 Chart 7China's Major Export Partners Could Rebound Soon China's Major Export Partners Could Rebound Soon China's Major Export Partners Could Rebound Soon Chart 8Strong Domestic Demand, Weak Export Growth Strong Domestic Demand, Weak Export Growth Strong Domestic Demand, Weak Export Growth Moreover, the rebound in overall Chinese demand hasn’t fully offset the collapse in its exports. As a result, the reopening of the supply side of the economy outpaced demand growth (Chart 8). Extrapolating this to its copper market: Chinese refined copper production (40% share of world output) is facing robust domestic demand but weak export demand for copper (44% and 9% of world demand), leaving its market with a supply surplus. Nonetheless, absent a severe second wave of COVID-19 cases, the infrastructure-focused stimulus and market-friendly real estate policies in the country will allow internal demand to overtake production in 2H20, despite limited external demand (more on this below). China’s Credit Growth To Drive Copper Demand Higher The key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy.  Markets were unimpressed by the fiscal package announced during China’s National People’s Congress (NPC) last month, which, for the first time in decades, did not contain an annual economic growth target in the Government Work Report (Table 1). Even so, the key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy. Broad money and total social financing growth will accelerate relative to last year and notably exceed nominal GDP growth. Our Emerging Markets strategists expect China’s fiscal and credit impulse will reach 15.5% this year (Chart 9).3 Table 1No Economic Growth Target In The Government Work Report Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Additionally, China pledged to stabilize employment and targeted the creation of 9 million new jobs in urban areas. This is an ambitious target amidst the massive layoffs induced by the COVID-19 pandemic this year. Chart 9Chinese Credit Growth Will Surge Chinese Credit Growth Will Surge Chinese Credit Growth Will Surge Policymakers also reserved policy space to be used – without the approval of the NPC at the Politburo’s mid-year review – in the event the shock from the pandemic proves persistent.4 Past episodes of Chinese stimulus resulted in strong rallies in base metals prices. Given China now represents more than half of global copper consumption (vs. 43% in 2009 following the GFC, and 32% in 2012 following the euro area debt crisis), we expect this new round of stimulus will lead to a sharp increase in copper prices.5 By and large, refined copper prices are highly sensitive to growth in EM imports – particularly China’s – which are closely tied to income growth. The latest CPB World Trade Monitor data for March shows EM ex-China imports have been resilient suggesting the rebound in China’s economic activity might be spilling over to other EMs highly leveraged to China (Chart 10). Still, our main cyclical commodity demand indicators were declining as of April. We expect stimulus-driven EM income and investment growth will show up in our indicators in 2H20 (Chart 10). Chart 10Awaiting A Rebound In Our Cyclical Indicators Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Stalling Primary And Secondary Supply Growth In addition to the demand implications, lockdowns also resulted in restrictions – and few complete shutdowns – in mining activities in copper-producing countries. The ICSG revised down its global mine and refined copper output by 950k MT and 1.1mm MT, respectively, for this year on the back of the COVID-19 pandemic.6 The group now expects 2020 mine supply to decline by 3% this year and refined production to remain flat y/y, for a second consecutive year. While important, these adjustments were insufficient to completely offset the large negative demand shock in 1Q and 2Q20.7 In 2H20, the supply-side outlook rests on the evolution of COVID-19 cases and associated governments’ responses in major ore and refined copper-producing countries (i.e. Chile, Peru, US, DRC, China, Russia, and Japan). So far, mining activities were mostly treated as essential and allowed to operate at reduced capacity under additional sanitary and social distancing guidelines. Confirmed cases in these countries appears to be slowing, this could allow activity to slowly return to normal (Chart 11). Chart 11Further Supply Disruptions Are Unlikely Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices.  While mining and refining of copper concentrates were often classified as essential, scrap activities were not. According to the ICSG, copper scrap supplied decreased significantly as trade flows and generation, collection, and disassembling activities were disrupted by the pandemic. China’s import of scrap copper – a key input for Chinese refiners – declined 37% in 1Q20. This prompted the government to allow more scrap imports to fill the gap, but it might struggle to find suppliers. Globally, scrap makes up ~ 25% of total refined copper supply, thus, it usually plays a non-negligible role in the rebalancing of global markets. Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices. In addition, the crisis began at an abnormally low inventory level. Thus, despite the temporary build in 1Q20, inventories are still below their 2010 to 2019 average. The rebound in demand, combined with flat supply and limited scrap availability, will move Chinese inventory down in 2H20 and offset any builds at the LMEX and COMEX warehouses, supporting copper prices this year (Chart 12). Chart 12Inventories Still Low Despite Builds In 1Q20 Inventories Still Low Despite Builds In 1Q20 Inventories Still Low Despite Builds In 1Q20 USD Depreciation Leads To EM Economic Growth Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD. As the COVID-19 shock abates we expect a weaker US dollar to be more supportive to copper demand. Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD (Chart 13). The shortage of USD experienced by EM debtors servicing dollar-denominated debt continues to hamper their recovery. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines is keeping the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin (Chart 14, panel 1). Chart 13Global Financial Cycles Hurting EM Economies Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Chart 14Uncertainty Keeps USD Well Bid Uncertainty Keeps USD Well Bid Uncertainty Keeps USD Well Bid The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. EM economies – the bulk of base metals demand growth – are facing dual domestic demand and global financial shocks.8 These economies have become more dependent on foreign portfolio inflows, both in debt and equity markets (Chart 14, panel 2). Thus, global financial cycles now have a significant impact on their growth. The main factors influencing these flows are risk appetite, EM exchange rates, and DM interest rates.9 We expect all factors to support inflows to emerging markets as the COVID-19 shock abates. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. A lower USD will decrease the local-currency cost of consuming commodities ex-US. Metals producers' ex-US will face higher local-currency operating costs, reducing supply growth at the margin. A depreciating USD is a necessary factor for our bullish cyclical commodities view (Chart 15). The risk to this view is a severe second wave of COVID-19 infection which would cause safe assets to spike anew. Chart 15Metals Inversely Correlated With The US Dollar Metals Inversely Correlated With The US Dollar Metals Inversely Correlated With The US Dollar $3.00/lb Copper Price Likely; Geopolitical Risks Mounting Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets.  For April, our copper demand model suggested prices were at equilibrium relative to underlying demand trends (Chart 16). Chart 16Copper Prices Will Rise As The USD Depreciates Copper Prices Will Rise As The USD Depreciates Copper Prices Will Rise As The USD Depreciates When simulating a 10% decline in the USD and a rebound in EM import growth in 2H20, our model suggests COMEX copper prices could move 25% higher, holding everything else constant. In reality, the USD’s path and the extent of the EM import rebound are among the key known unknowns we confront in estimating a model for copper prices. We do not have a precise view on these variables, which is why we run simulations. Theory would suggest the stimulus we are seeing globally points to a lower USD and a pick-up in EM imports, however, and these factors will create a more supportive environment for metals prices. Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets. With the US election now only 5 months away, President Trump’s odds of being reelected on the back of a strong economy are fading amidst the COVID-19 pandemic. According to our Geopolitical strategists, Trump is the underdog and will need to double down on foreign and trade policies to prop-up his chances of winning. Meanwhile, China is seeking to solidify its sphere of influence.10 This is causing US-China tensions to intensify. Depending on the nature of the actions taken by the Trump administration (i.e. increasing tariffs on US imports of Chinese goods vs. cutting China’s access to foreign technology), metals prices could suffer, as was the case in 2018. With these geopolitical risks in mind, we maintain that China’s strong fiscal and monetary stimulus, combined with a falling US dollar will provide a favorable backdrop for copper markets in 2H20.   Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Doubts about OPEC 2.0’s commitment to extending their deepest-ever production cuts expiring this month to July, perhaps August, took some of the steam out of crude-oil rally earlier in the week. In our modeling, we do not see the need to extend the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies: KSA’s cuts of ~ 4.5mm b/d vs. its April output level of 12mm b/d starting this month will take the Kingdom’s output to ~ 7.5mm b/d. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. We continue to believe the current schedule of production cuts will result in a physical supply deficit in 3Q20, which will require OPEC 2.0 to begin raising production to keep prices from getting too high going into a US presidential election. We expect Brent prices to average $40/bbl this year and $68/bbl next year, with WTI trading $2 - $4/bbl below that (Chart 17).11 Base Metals: Neutral Iron ore prices breached $100/MT this week, as COVID-19-induced supply disruptions in Brazil – the largest exporter of high-grade ore – and South Africa leave the seaborne market open to Australian suppliers to meet higher Chinese demand as port inventories are rebuilt. FastMarkets MB, a sister company of BCA Research, reported May exports to China from Brazil were down 28% y/y to 21.5mm MT from just under 30mm MT the year prior. Iron ore exports from Australia are expected to exceed A$100 billion this year, according to government estimates reported by the Financial Times.12 Precious Metals: Neutral As we go to press, gold prices retreated to $1,700/oz from ~ $1,740/oz last week, exhibiting a positive correlation with the dollar. This is a result of rising risk appetite globally as economies exit lockdowns. In the US, interest rates are continuing to support gold. Going forward, the probability of negative rates is remains low, but the Fed will continue to buy more debt from the public and private sectors to push the shadow rate further down. This supports gold prices (Chart 18). Chart 17Crude Prices Will Rebound Crude Prices Will Rebound Crude Prices Will Rebound Chart 18Fed Buying Supports Gold Prices Fed Buying Supports Gold Prices Fed Buying Supports Gold Prices     Footnotes 1     Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 2     A resurgence of infection triggered renewed lockdowns over a region of 100 million people in May. Please see More than 100 million people in China's northeast back under lockdown to thwart potential second wave published by the National Post on May 19, 2020. 3    Please see BCA's Emerging Markets Strategy Weekly Report "EM Stocks Are At A Critical Resistance Level," published May 28, 2020. It is available at ems.bcaresearch.com. 4    Please see BCA's China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," published May 28, 2020. It is available at cis.bcaresearch.com. 5    There remains a risk global monetary stimulus fails to ignite strong consumer and business consumption. The unprecedented shock could raise precautionary savings and keep risk aversion elevated for an extended period. Based on the Quantity Theory of Money, money supply times velocity (the rate at which money changes hands) equals nominal GDP. Low confidence translates to a low velocity of money limiting the reach of monetary policy. This value is extremely difficult to forecast. 6    Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 7     According to BGRIMM Lilan Consulting, China’s real demand for refined copper declined by ~22% in 1Q20. This implies a ~11% decline in global copper consumption. Please see footnote 6 for more details. 8    Global financial cycles capture how global financial conditions affect individual economies. The analysis of these cycles stressed the importance of common factors in global risk asset prices which are driven by risk appetite and US monetary policy. These factors are mainly explained by developments in advanced economies but have a drastic effect on emerging markets. Please see Iñaki Aldasoro, Stefan Avdjiev, Claudio Borio and Piti Disyatat (2020). “Global and domestic financial cycles: variations on a theme,” BIS Working Papers, No 864. 9    Please see Chapter 3 of the Global Financial Stability Report titled “Managing Volatile Portfolio Flows,” published by IMF. 10   Please see BCA's Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," published May 29, 2020. It is available at gps.bcaresearch.com. 11    Please see our May 21, 2020 report entitled US Politics Will Drive 2H20 Oil Prices for our latest view on oil fundamentals and prices, available at ces.bcaresearch.com. 12    Please see Australia’s iron ore miners exploit supply gap as Covid-19 hobbles rivals published by the Financial Times June 3, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Speed Of Demand Recovery Remains Key To Copper Prices Speed Of Demand Recovery Remains Key To Copper Prices

Highlights The duration of this crisis and the details of the plan to reopen the economy will determine whether the initial uptick in median home prices will prove to be transitory. Phase I provides room for construction to resume at least partially, while demand for homes is likely to recover more gradually. This temporary supply/demand imbalance is unlikely to result in a meaningful price contraction as significant mitigating factors are at play. Government actions to support households and the availability of credit as well as low mortgage rates should prop up the homeownership rate. Housing’s wealth effect has decreased and is unlikely to drive consumption in a pandemic-related recession. Construction employment was highly affected though resuming work in this sector is more likely to boost steel demand than have a significant impact on the unemployment rate. Feature A recession typically occurs amidst imbalances in the economy and the 2008 sub-prime episode arguably embodied the epitome of housing excesses. Housing’s contribution to GDP has significantly decreased over the past seventy years, and today’s well-balanced housing market is unlikely to be the center of attention, but home prices are cyclical and large fluctuations can have repercussions in other areas of the economy. Social distancing is leading supply to contract first, altering the typical recessionary chain of events. We examine the COVID-induced shock to housing and its potential ramifications. Under the working assumption that a vaccine and/or effective treatment will allow economic activity to fully resume within the next twelve months, we conclude that home prices are unlikely to contract meaningfully. The homeownership rate should remain well supported and consumption is more likely to be impacted by unemployment than housing wealth effects. Meanwhile, a tightening in lending standards at the margin should not get in the way of credit availability. A Sellers’ Market Chart 1COVID-19 Is Destroying More Supply Than Demand COVID-19 Is Destroying More Supply Than Demand COVID-19 Is Destroying More Supply Than Demand The latest housing data releases strikingly contrast with the employment data and GDP growth estimates. The median home price actually increased by 8% on a year-on-year basis while new home sales contracted by 10%, suggesting that supply has been decreasing at a faster pace than demand (Chart 1). In the typical recession sequence of events, home prices slip as falling employment dents demand which in turn leads homebuilders to defer new starts and reduce prices on the existing supply of new homes. This is not a typical recession, however, and the supply shock preceded the demand shock. Confinement measures prevented construction professionals from going to work, thereby immediately halting the production of new homes. Meanwhile, the fact that most job losses have been temporary thus far has led to a relatively slower pace of demand destruction. Moreover, real estate transactions take a couple of months to close and the latest data may simply reflect purchase decisions that were made before the US became an epicenter of the pandemic. Median home prices may also be holding firm because sellers are not compromising on their asking price when social distancing prevents in-person visits (Chart 2), or because sellers are waiting things out before re-listing their property for sale. The housing market is effectively in a time-out where a reduced number of transactions is preventing prices from adjusting in a timely fashion. Chart 2Prospective Buyers Taking Social Distancing To Heart Prospective Buyers Taking Social Distancing To Heart Prospective Buyers Taking Social Distancing To Heart Prices Subject To Mitigating Forces Chart 3A Well-Balanced Housing Market A Well-Balanced Housing Market A Well-Balanced Housing Market The duration of the COVID-19 crisis and the details of the phases of economic reopening will ultimately determine whether this initial uptick in median home prices proves to be transitory. The housing market can remain a sellers’ market for as long as the mortgage forbearance allowed under CARES Act protects mortgage owners from defaults. It currently allows applicants to postpone their mortgage payments for up to a year amid COVID-related economic hardships. These payments are then tacked on to the end of the forbearance period and paid back over time in a mortgage modification. The winds will change if a vaccine is not mass-produced by then and Congress does not provide new aid. A wave of defaults would lead to mass property listings by desperate sellers, exerting significant downward pressure on home prices. Local homebuilders’ associations are making their case to Washington to be considered essential. The current plans to reopen the economy would provide room for residential construction to resume at least partly under Phase I, as mandated social distancing measures can be implemented on an open-air construction site. The US Census Bureau estimates that the average length of time from start to completion ranges between 7 and 15 months depending on the type of construction. Even if no new project begins until the end of the recession, currently pending constructions will resume and add another 730,0001 new homes on the market by fall - a conservative estimate that excludes any potential existing homes that might go up for sale. Existing homes account for the lion’s share of total inventory. Meanwhile, it would take much longer for demand to recover even in the unlikely event that the virus miraculously disappeared and life returned to normal in a fortnight. It generally takes time for the unemployment rate to recover to pre-recession levels, as matching available workers with employers is time-consuming and feedback loops are at play whereby unemployment leads to less spending which in turn reduces the incentive for firms to hire. The temporary nature of the layoffs and the government financial support to households will be mitigating factors, but precautionary savings tend to rise after a recession and unemployed workers might have drawn down their bank accounts. All these factors should contribute to a slower pace of housing demand recovery. Even though demand might take longer to recover, a generally well-balanced market will support prices. This temporary supply/demand imbalance scenario is bearish for home prices. However, it is worth remembering2 that unlike the previous downturn, the housing market was well balanced before this crisis began, another important factor that should mitigate the magnitude of any potential price decline (Chart 3). Bottom Line: Under the working assumption that a vaccine will be available and mass-produced within twelve months, this atypical recession is unlikely to result in a severe home price contraction. Support For Credit Chart 4Loan Deferrals Exert Pressure On Banks... Loan Deferrals Exert Pressure On Banks... Loan Deferrals Exert Pressure On Banks... An increasing share of banks have tightened residential mortgage lending standards at the margin (Chart 4), an unsurprising outcome given that a recession has arrived and payment deferrals reduce the net present value of any given mortgage. Securitization may also become more difficult or costly as mortgage servicers’ resources are strained by delayed reimbursement from Fannie Mae and Freddie Mac for the interest payments they have to advance to holders of agency mortgage-backed securities. Three-quarters of residential mortgages are backed by federal agencies, and banks presumably have little appetite to tie up limited capital with new loans at the onset of what might be a brutal recession. They will presumably be eager to get loans off their balance sheets by selling them into securitization pools, but if servicers are wary in an environment when 7.5% of all mortgages are already in forbearance, they would be well-advised to underwrite them as if they were going to have to hold them. However, banks have exerted significant restraint since their pre-Great Financial Crisis frenzy.3 Their loan books - across all core lending categories, but most prominently in the real estate segment - have grown at a markedly slower pace in the past decade than they did in any other postwar expansion4 (Chart 5). Banks are also better capitalized than they used to be, strengthening their ability to sustain losses (Chart 6). Chart 5...But Their Restrained Behavior In The Late Expansion... ...But Their Restrained Behavior In The Late Expansion... ...But Their Restrained Behavior In The Late Expansion...   Chart 6...And Increased Equity Capital Strengthen Their Ability To Sustain Losses ...And Increased Equity Capital Strengthen Their Ability To Sustain Losses ...And Increased Equity Capital Strengthen Their Ability To Sustain Losses Bottom Line: Financing should remain available to prospective home buyers. There are no excesses in the overall banking system and regulators will not allow the mortgage securitization machinery to break down. Resilient Homeownership Rate Just as the pandemic is unlikely to result in a drastic decline in home prices, the homeownership rate is unlikely to deteriorate meaningfully. Chart 7Better Situated Households Taking Advantage Of Competitive Rates Better Situated Households Taking Advantage Of Competitive Rates Better Situated Households Taking Advantage Of Competitive Rates COVID-19 may have claimed a staggering 33 million jobs and counting, but CARES Act forbearance will shield the most vulnerable households for the next twelve months, propping up their current rate of homeownership. Meanwhile, low mortgage rates create opportunities for better-situated households. Data from Corelogic suggest that millennials have driven the bulk of the uptick in mortgage applications (Chart 7). They are also the cohort most inclined to transition from renting to owning and their increasing access to homeownership these past few years suggests that their financial situation is not as dire as widely believed (Chart 8). Chart 8Millennials' Transition From Renting To Owning Millennials' Transition From Renting To Owning Millennials' Transition From Renting To Owning Low mortgage rates have also increased homeownership’s competitiveness relative to renting (Chart 9). This trend is unlikely to reverse in the near term. Eviction protection programs and rent forbearance under the CARES Act will only temporarily cap rent growth. Meanwhile, mortgage rates are set to remain competitive beyond the timeframe of this recession. Chart 9Owning Is More Attractive Than Renting... Owning Is More Attractive Than Renting... Owning Is More Attractive Than Renting... Low mortgage rates and relatively easy lending standards have prevailed since 2013 but home price appreciation has outpaced wage growth, denting housing affordability (Chart 10). While the tendency to build smaller housing units would contribute to decreasing median home prices at the margin (Chart 11), income growth will take a while to catch up. The labor market will have to tighten anew before income growth can revive. Chart 10...Even Though Homes Have Become Less Affordable ...Even Though Homes Have Become Less Affordable ...Even Though Homes Have Become Less Affordable Chart 11Is Smaller Becoming Better? Is Smaller Becoming Better? Is Smaller Becoming Better? Still, declining affordability has not prevented the homeownership rate from recovering to its long-run average. It may stand at a lower level today than it did in 2007 when it reached 69%, but it reflects sounder lending behaviors. Bottom Line: The COVID-19 crisis does not pose an immediate risk to the currently healthy level of homeownership. Better-situated households can take advantage of low mortgage rates but decreasing housing affordability will prevent homeownership from grinding meaningfully higher. Fading Wealth Effect Amid COVID-19 Consumers tend to spend more when the value or perceived value of their assets rises. Housing accounts for a sizable portion of homeowners’ equity, but the wealth effect of housing may have become less significant than most investors believe. The contribution to spending from housing wealth mirrors the decrease in housing as a share of households’ aggregate net worth (Chart 12). The latter now stands at 15%, way off its 1980s and 2006 peaks, while pension entitlements and equity and mutual fund holdings have filled the void, each accounting for a quarter of homeowners’ net worth. Chart 12The Wealth Effect Of Housing Is Decreasing... The Wealth Effect Of Housing Is Decreasing... The Wealth Effect Of Housing Is Decreasing... The wealth effect of housing remains positive. However, fluctuations in home prices are not evident to consumers in real time (Chart 13) and COVID-19 has precipitated the swiftest recession on record. The immediate or perceived future loss of employment and income are much more likely to drive consumption than home prices. Chart 13...And Is Unlikely To Influence Spending In A Pandemic ...And Is Unlikely To Influence Spending In A Pandemic ...And Is Unlikely To Influence Spending In A Pandemic Bottom Line: In a pandemic-induced downturn, home prices alone are unlikely to have a meaningful effect on consumption patterns. A Marginal Impact On Employment Overall housing-related sectors of the economy account for a marginal share of total employment. Construction activity makes up a mere 5% while related sectors including the sale and manufacturing of furniture, appliances and wood products, amongst others, chip in another 4.5% (Chart 14). On a rate of change basis, however, housing has been at the forefront. While the airline and leisure and hospitality sectors have been the center of attention in the past couple of months, construction has also suffered markedly. Total construction employment contracted by a third in April alone, behind only leisure and hospitality (Chart 15). Chart 14Housing's Marginal Impact On Overall Employment Housing's Marginal Impact On Overall Employment Housing's Marginal Impact On Overall Employment Chart 15Construction Was Highly Affected By COVID-19 Housing In The Time Of COVID-19 Housing In The Time Of COVID-19 A Phase I economic reopening will make room for activity in housing and many other sectors to resume and restore at least a portion of the jobs temporarily destroyed. The leisure and hospitality sector, however, is most likely to be the real game changer. 40% of the job losses so far have been in this single sector. While restaurants will be able to resume partial activity under Phase I, traveling is unlikely to return to normal for some time, even after a vaccine is mass-produced. It took several years after 9/11 for individuals to feel safe traveling again and for air traffic to reach its pre-crisis levels. Bottom Line: Although housing employment has been highly affected by COVID-19, it accounts for a small share of nonfarm payrolls and a pickup in this sector is unlikely to have a meaningful impact on the overall unemployment rate. A Significant Source Of Global Steel Demand A revival in housing activity is more likely to significantly impact commodity prices than the overall unemployment rate. Homebuilders are a key driver of lumber demand and construction activity accounts for half of the demand for steel and copper (Chart 16). The US is the largest net importer, making it a heavy player in the steel market, but its influence on copper prices is dwarfed by the demand stemming from Asia. Chart 16A Revival In Construction Would Boost Demand For Commodities Housing In The Time Of COVID-19 Housing In The Time Of COVID-19 Putting It All Together Over the past seventy years, housing has accounted for a steadily decreasing share of the economy and homeowners’ net wealth. In the absence of excessive lending and overbuilding, its ramifications for employment, consumption and the rest of the economy should remain muted in this crisis. BCA researchers tend to leave the thorough bottom-up analysis to professional stock pickers and instead focus their attention on the fundamental 30,000-feet top-down macroeconomic perspective. Although we do not expect overall home prices to contract drastically, “location, location, location” has always been real estate’s modus operandi. We would note that home prices in cities like Las Vegas or Orlando with economic activity tied to tourism, arts and entertainment, restaurants and recreation might be disproportionally affected by COVID-related externalities. It is too early to assess whether the widespread social distancing measures will result in lasting structural changes on society, housing preferences and the way we conduct business. There is sound basis, however, to hypothesize that cooped-up city dwellers might find suburbs and satellite cities to be more attractive going forward, and that lasting work-from-home arrangements will enable them to make that life-style change.   Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com Footnotes 1 The housing start data is seasonally adjusted. Starts averaged 1,466 million in 1Q20 and 1,443 million in 4Q19 meaning that a quarter of these projects actually started in 1Q20 and 4Q19 (367K and 361K starts, respectively). 2 Please see US Investment Strategy Special Report titled "Housing: Past, Present And (Near) Future", published November 19, 2018. Available at usis.bcaresearch.com. 3 Please see US Investment Strategy Special Report titled "How Vulnerable Are US Banks? Part 2: It’s Complicated", published April 6, 2020. Available at usis.bcaresearch.com. 4 Until the NBER makes the official designation, our working assumption is that the current recession began in March.

Highlights OPEC 2.0 production discipline and the capital markets’ parsimony in re funding US shale-oil producers will restrain oil supply growth. Monetary and fiscal stimulus will revive EM demand. These fundamentals will push inventories lower, further backwardating forward curves. Base metals demand will pick up as EM income growth revives. Demand also will get a boost from the ceasefire in the Sino-US trade war. Gold will remain range-bound for most of next year: A weaker USD and rising inflation expectations are bullish, but rising bond yields and reduced trade tensions will be headwinds. Grain markets will drift, although dry conditions in Argentina and the trade-war ceasefire could provide short-term price support, along with a weaker USD. Risk to our view: Continued elevated global policy uncertainty would support a stronger USD and stymie central bank efforts to revive global growth in 2020. Feature Dear Client, We present our key views for 2020 in this issue of Commodity & Energy Strategy. This will be our last publication of 2019, and we would like to take the opportunity to thank you for your on-going interest in the commodity markets and in our publication. It has been our privilege to serve you. We wish you and your loved ones all the best of this beautiful Christmas season and a prosperous New Year in 2020! Robert Ryan Chief Commodity & Energy Strategist Going into 2020, policy uncertainty again will be a key driver of commodity demand, the Sino-US trade-war ceasefire and UK election results notwithstanding.1 As uncertainty has increased, demand for safe havens like the USD and gold have increased. The principal impact of this uncertainty shows up in FX markets. As uncertainty has increased, demand for safe havens like the USD and gold has increased. Indeed, the Fed’s Broad Trade-Weighted USD index for goods (TWIBG) has become highly correlated with the Global Economic Policy Uncertainty index (GEPU). The three-year rolling correlation between these indexes reached a record high in November 2019 (Chart of the Week).2 Individually, the record for the TWIBG was posted in September 2019, while the GEPU record was hit in August 2019. Chart of the WeekGlobal Economic Policy Uncertainty Highly Correlated With USD 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets A strong USD affects commodity demand directly, because it slows income growth in EM economies – the engine-house of commodity demand. A stronger USD raises the local-currency cost of consuming commodities – an important driver of EM demand – and reduces the local-currency cost of producing commodities. So, at the margin, demand is pressured lower and supply growth is incentivized – together, these effects combine to push prices lower. Economic policy uncertainty likely will diminish in early 2020, following the Sino-US trade-war ceasefire, the decisive UK election results and continued central-bank signaling – particularly from the Fed – that rates policy will remain accommodative for the foreseeable future. That said, the ceasefire does not mark the end of the Sino-US trade war, and many issues – ongoing US-China tensions, US election uncertainty, global populism and nationalism, rising geopolitical tensions in the Persian Gulf, ad hoc monetary policy globally – still are to be resolved. Terra Incognita The GEPU index does not measure uncertainty per se, as uncertainty per se cannot be measured.3 The index picks up word usage connected with the word “uncertainty.” So, it is more the perception of uncertainty that is being reported by Economic Policy Uncertainty in its data. Nonetheless, this is a good way to measure such sentiment, as research from the St. Louis Fed found: “Increases in the economic uncertainty index tend to be associated with declines (or slower growth) in real GDP and in real business fixed investment.” In past three years, increased policy uncertainty also has been fueling demand for safe havens, chiefly the USD and gold. This is a highly unusual coincidence – i.e., a rising USD accompanied by a rising gold price. Typically, a weaker USD puts a bid under gold prices. Indeed, this relationship is one of the primary drivers of our gold model, which suggests the effect of the heightened policy uncertainty dominates the USD impact on gold prices in the current environment (Chart 2). Chart 2Gold Typically Rallies When the USD Weakens Gold Typically Rallies When the USD Weakens Gold Typically Rallies When the USD Weakens The flip-side of the deleterious effects of higher economic policy uncertainty is its resolution: Growing cash balances and a higher capacity to lever balance sheets of households, firms and investor accounts means there is a lot of dry powder available to recharge growth in the real and financial economies globally.4 Chart 3BCA's Grwowth Gauges Indicate Global Economy Rebounding BCA's Grwowth Gauges Indicate Global Economy Rebounding BCA's Grwowth Gauges Indicate Global Economy Rebounding Our commodity-driven economic activity gauges are picking up growth impulses, most likely in response to the global monetary stimulus that has been deployed this year (Chart 3). In addition, systemically important central banks have given no indication they are going to be reversing this stimulus. A meaningful reduction in uncertainty could turbo-charge global growth prospects. Below, we provide our key views for each of the commodity complexes we cover. Oil Outlook Energy: Overweight. The oil market is poised to move higher on the back of OPEC 2.0’s deepening of production cuts to 1.7mm b/d, mostly because of actions by the Kingdom of Saudi Arabia (KSA) to cut output deeper, to a total of close to 900k b/d vs. its October 2018 production levels.5 Combined with the loss of ~ 1.9mm b/d of production in Iran and Venezuela due to US sanctions, the supply side can be expected to tighten next year (Chart 4). The Vienna meeting – which ended December 6, 2019 – demonstrated commitment to OPEC 2.0’s production-restraint strategy, and we expect member states will deliver. At least they will reduce the incidence of free riding at KSA’s expense – there were subtle hints from the Saudis they will not tolerate such behavior. KSA’s threats in this regard are credible, given its follow-through in 1986 when they surged production and briefly drove WTI prices below $10/bbl to send a message to free riders in the OPEC cartel. The Saudis acted similarly during the 2014 – 2016 market share war. US shale-oil production growth will slow next year to 800k b/d y/y, vs. the 1.35mm b/d we expect for this year. US lower 48 crude production will increase to 10.7mm b/d in 2020, taking total US production to 13.1mm b/d, a ~ 850k b/d increase y/y. On the demand side, we lowered our expectation for 2019 growth to 1.0mm b/d, given the continued downgrades of historical consumption estimates this year from the EIA, IEA and OPEC. Nonetheless, we continue to expect 2020 growth of 1.4mm b/d, on the back of continued easing of global financial conditions, led by central-bank accommodation. Given our view, we remain long oil exposures in several ways. First, we remain long WTI futures outright going into 2020; this position is up 30% from January 3, 2019 when it was initiated. Second, we recommended getting long 2H20 vs. short 2H21 Brent futures, expecting crude oil forward curves to backwardate further as tighter supply and stronger demand force refiners to draw inventories harder next year (Chart 5). Chart 4Markets Will Tighten In 2020 Markets Will Tighten In 2020 Markets Will Tighten In 2020 Chart 5Oil Inventories Will Draw Harder In 2020 Oil Inventories Will Draw Harder In 2020 Oil Inventories Will Draw Harder In 2020 We expect Brent crude oil to average $67/bbl next year, given the fundamentals outlined above. We also expect a weaker dollar to be supportive of demand ex-US. WTI will trade at a $4/bbl discount to Brent next year, based on our modeling (Chart 6). Chart 6Brent, WTI Will Trade Higher Brent, WTI Will Trade Higher Brent, WTI Will Trade Higher We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. Bottom Line: We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. This expectation will be challenged by continued economic policy uncertainty. On the flip side, however, a meaningful resolution to this uncertainty could turbo-charge growth as real economic activity picks up and the USD weakens. Base Metals Outlook Base Metals: Neutral. We remain strategically neutral base metals going into 2020, but tactically bullish, carrying a long LMEX and iron-ore spread position into the new year.6 The behavior of base metals prices – used by economists as proxies for EM growth – is indicating industrial demand is picking up (Chart 7). This aligns well with our proprietary indicators of commodity demand and global industrial activity (Chart 8). Base metals prices are more sensitive to changes in global growth than other commodities. For this reason, we use these prices to confirm the signals coming from the proprietary models we use to gauge EM growth. Chart 7Base Metals Prices Signaling EM Growth Revival Base Metals Prices Signaling EM Growth Revival Base Metals Prices Signaling EM Growth Revival The so-called phase-one agreement to reduce tariffs in the Sino-US trade war will support global demand at the margin for base metals. This is a ceasefire in the trade war not a resolution, so we are not expecting a surge in demand. Chart 8BCA Proprietary Indicators Also Signaling Growth Revival BCA Proprietary Indicators Also Signaling Growth Revival BCA Proprietary Indicators Also Signaling Growth Revival That said, base metals – aluminum and copper, in particular – have a tailwind in the form of global monetary accommodation by central banks. This was undertaken to reverse the negative effect on global financial conditions brought about by the Fed’s rates normalization policy last year and China’s 2017-18 deleveraging campaign. In addition, our China strategists expect modest fiscal and monetary stimulus from Beijing, which also will be supportive of demand.7 Aluminium and copper comprise 75% of the LMEX index. These are primary industrial markets, in which China accounts for ~ 50% of global demand, and EM ex-China demand remains stout. Even with a trade war raging for most of 2019, the supply and demand of aluminum and copper – the largest components of the LMEX index – was diverging: Consumption outpaced production – a multi-year trend – which forced inventories to draw hard (Charts 9A and 9B). Chart 9AGlobal Aluminum Markets Getting Tighter … Global Aluminum Markets Getting Tighter ... Global Aluminum Markets Getting Tighter ... Chart 9B… As Are Copper Markets ... As Are Copper Markets ... As Are Copper Markets Bottom Line: Inventories in industrial-metals markets have been drawing hard for years – particularly in aluminum – as metals' demand remained above supply. Given this, we are long the LMEX index: Even a marginal growth pick-up could rally prices. Precious Metals Outlook Precious Metals: Neutral. Going into 2020, gold’s outlook could be volatile – especially in 1H20 – as the metal’s key drivers will send conflicting signals (Table 1). Table 1Fundamental And Technical Gold-Price Drivers 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets Gold prices are holding up above $1,450/oz. Our latest fair-value estimate indicates gold will hover around $1,475/Oz over the short-term (Chart 10). We break next year’s gold forecast into two parts: Phase 1: Growth revival and uncertainty respite. These two factors are closely intertwined; the magnitude of global growth’s rebound is conditional on a reduction of global economic policy uncertainty. We expect this relief will come from a ceasefire in the US-China trade war. Combined, accelerating economic activity – mainly driven by EM economies – and falling uncertainty will push the US dollar lower.8 For gold prices, this phase will be characterized by two contrasting forces: A falling USD (bullish gold) vs. lower safe-haven demand and rising US interest rates (bearish gold). US rates will increase early next year as global uncertainty is reduced and bond markets price-out Fed rates cuts. The current unusually high correlation between gold and US rates implies gold will face selling pressures during this period (Chart 11). Nonetheless, we expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Chart 10High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 Chart 11US Rates Could Hurt Gold Prices In 1H20 US Rates Could Hurt Gold Prices In 1H20 US Rates Could Hurt Gold Prices In 1H20 Phase 2: EM wealth effect and inflation rebound. As income growth accelerates, EM households will slowly accumulate jewelry, coins, and bars – of which China and India are the largest consumers. Demand pressure from these consumers will manifest itself in 2H20, adding to buoyant central-banks purchases of gold. The upside in bond yields will be limited by major central banks’ dovish stance until inflation is well-established above target. Closely monitoring the evolution of inflation will become increasingly important in 2020, given inflation pressures are building in the US and globally (Chart 12). A lower USD – supporting stronger commodity demand – will magnify global inflation trends (Chart 13). There is a very real risk inflation shoots up in 4Q20, keeping real rates low. This differs from our BCA House view, which does not see inflation pressures building until 2021. Chart 12Inflationary Pressures Are Building Up In The US And Globally Inflationary Pressures Are Building Up In The US And Globally Inflationary Pressures Are Building Up In The US And Globally Political uncertainty likely will return ahead of the 2020 US election. A resurgence in popular support for one of the progressive Democratic candidates – Elizabeth Warren or Bernie Sanders – could disrupt US stock markets. Gold would advance in such an environment. Chart 13No Inflation Without A Weaker USD No Inflation Without A Weaker USD No Inflation Without A Weaker USD Progressive populists would lead to domestic policy uncertainty and larger budget deficits, yet would not remove the threat of trade protectionism. We expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Bottom Line: Gold prices will move sideways in 1H20 and will drift higher in 4Q20 supported by depressed real rates, a lower dollar, and US election uncertainty. Silver Market Chart 14Silver Prices Will Move Higher With Gold Prices Silver Prices Will Move Higher With Gold Prices Silver Prices Will Move Higher With Gold Prices Silver prices have traded closely with gold since the Global Financial Crisis (GFC), moreso than with industrial metals (Chart 14). Prior to the GFC, silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization. Post-GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. Thus, we expect it will continue to follow the evolution of gold prices outlined above. Nonetheless, industrial applications still represent ~ 50% of silver’s physical demand and its supply-demand balance is estimated to have been tight this year. Silver likely will outperform gold next year as global growth and industrial activity rebound. PGM Markets The palladium market will remain tight in 2020. According to Johnson Matthey, the 10-year-long supply deficit is expected to widen massively this year, when all’s said and done. Prices surpassed $1,900/oz in December, forcing inventory liquidation (Chart 15). We believe the platinum-to-palladium ratio is at a level that would incentivize substitution in the pollution-control technology in gasoline-powered engines, and supports higher platinum content in diesel catalyzers (Chart 16).9 Nonetheless, swapping palladium for platinum is complex and requires a redesign of the production process. A lot will depend on how much the added cost of the more expensive palladium affects new-car buyers’ demand.10 To date, there are no signs car makers have already – or are willing to – initiate this process on a significant scale. Chart 15Palladium Inventories Are Depleted Palladium Inventories Are Depleted Palladium Inventories Are Depleted A few factors need to align to incentivize substitution of palladium for platinum. The price ratio between the two metals should reach extreme levels; the price divergence should be expected to last for a prolonged period of time, and concerns over supply security of platinum should be low. Chart 16Relative Inventory levels Drive The Palladium To Platinum Price Ratio Relative Inventory levels Drive The Palladium To Platinum Price Ratio Relative Inventory levels Drive The Palladium To Platinum Price Ratio In today’s context, this last condition could slow substitution. South African platinum supply – which represents close to 73% of the world primary supply – is projected to fall by close to 3% next year. Automakers need stable platinum supplies as they increase their demand for the metal and with persistent power-supply issues in South Africa – exacerbated by recent flooding – this condition will be hard to meet. No market has been harder hit by the Sino-US trade war than grains and ags generally. Thus, palladium holds an advantage over platinum on that front. Its supply sources are more diversified, and with 15% comes from stable North American countries and 40% comes from Russia. We believe substitution will commence, but this is a gradual process and will only slowly affect the metals’ price ratio.11 For 2020, we expect palladium prices to continue increasing due to stricter pollution regulation in China, India, and Europe.12 Ag Outlook Chart 17Sino-US Trade War, USD Hammer Grain Prices Sino-US Trade War, USD Hammer Grain Prices Sino-US Trade War, USD Hammer Grain Prices Ags/Softs: Underweight. The final form of the ceasefire in the Sino-US trade war – i.e., the “phase one” deal between China and the US to roll back tariffs – has yet to show itself. Last Friday, US Trade Representative Robert Lighthizer stated China has agreed to buy $32 billion – over the next two years – of US ag products as part of a “phase one” deal. This news moved corn, wheat and beans prices up 6.3%, 3.2%, and 3.4% respectively as of Tuesday’s close. Another positive news for US farmers was an announcement from the USDA that the final $3.6 billion of the $14.5 billion budgeted for farm subsidies this year to offset the trade war impact on US farmers most likely would be made in the near future by the Trump administration.13 No market has been harder hit by the Sino-US trade war than grains and ags generally. Severe weather across much of the US Midwest should have produced a rally, as offshore demand competed for available supply, which likely would have been lower at the margin last year absent a trade war. Instead, corn, wheat and beans are going into 2020 pretty much at the same price levels they went into 2019. In addition to the deleterious effect of the US-China trade war, ag markets have been particularly hard hit by the strong USD, which makes exports from the US expensive relative to alternative suppliers – e.g., Argentina and Brazil, which are posing serious challenges to US farmers (Chart 17).   Global inventories are, nonetheless, being whittled away, which is good news for farmers generally (Chart 18). And, this likely will continue in 2020, given the physical deficits expected this year (Chart 19). Chart 18GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... Chart 19... Physical Deficits Will Whittle Stocks Further Next Year ... Physical Deficits Will Whittle Stocks Further Next Year ... Physical Deficits Will Whittle Stocks Further Next Year Markets are still awaiting final details of the ceasefire in the Sino-US trade war. The deal is expected to be signed in the first week of January. 2020 could be the year the global ag markets come more into balance, with stocks-to-use levels falling and normal trade resuming. We are not inclined to take a view on this possibility and are therefore remaining underweight the ag complex. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Our outlook last year was entitled 2019 Key Views: Policy-Induced Volatility Will Drive Markets. It was published December 13, 2018, and is available at ces.bcaresearch.com. This year’s outlook again reflects our House view, which was published in the Bank Credit Analyst on November 28, 2019, entitled OUTLOOK 2020: Heading Into The End Game. It was sent to all clients last month and is available at bca.bcaresearch.com. 2 Uncertainty is measured using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange rates-weighted basis) are scoured monthly to create the index. Please see Economic Policy Uncertainty for additional information. We use the Fed's USD broad trade-weighted index for goods (TWIBG) reported by the St. Louis Fed to track the USD. Please see the St. Louis Fed’s FRED website at Trade Weighted U.S. Dollar Index: Broad, Goods. 3In a June 2011 interview with the Minneapolis Fed, Ricardo Caballero, a professor of economics at MIT, provided a succinct description of risk and uncertainty, paraphrasing former US Defense Secretary under President George W. Bush Donald Rumsfeld: “(W)hen he talked about the difference between known unknowns and unknown unknowns. The former is risk; the latter is uncertainty. Risk has a more or less well-defined set of outcomes and probabilities associated with them. Uncertainty does not—things are much less clear.” Kevin L. Kliesen of the St. Louis Fed explores the link between rising uncertainty and slower economic growth in Uncertainty and the Economy (April 2013), observing, “If the business and financial community believes the near-term outlook is murkier than usual, then the pace of hiring and outlays for capital spending projects may be unnecessarily constrained, thereby slowing the overall pace of economic activity.” 4The Wall Street Journal reported investors have accumulated a $3.4 trillion cash position, a decade-high level; this is consistent with the risk aversion that can be expected when economic uncertainty is high. Please see Ready to Boost Stocks: Investors’ Multitrillion Cash Hoard, published by The Wall Street Journal November 5, 2019. 5 Accounting for Saudi Arabia's 400k b/d of additional voluntary cuts. 6 The LMEX no long trades on the LME, but we are using the index as a proxy for a position. In iron ore, we are long December 2020 65% Fe futures vs. short 62% Fe futures on the Singapore Exchange, expecting steelmakers will favor the high-grade material in the new mills they’ve brought on line. 7 Our China strategists expect “Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate.” Please see 2020 Key Views: Four Themes For China In The Coming Year, published by BCA Research’s China Investment Strategy December 11, 2019. It is available at cis.bcareserach.com. 8 The US dollar is a countercyclical – i.e. it is inversely correlated with the global business cycle – due to the fact that the US economy is driven more by services than manufacturing. 9 Palladium is used mostly in pollution-abatement catalysts in gasoline-powered cars, while Platinum is favored in diesel-engine cars (along with a small amount of palladium). Catalysts production represents close to 80% and 45% of palladium's and platinum's total demand. 10 Considering there’s ~ 3.5g of palladium in a new car and palladium trades at ~ $1,900/oz, close to $240 is added to the cost of a new gasoline-powered car by using this metal in pollution-abatement technology. 11 Please see South African Mines Grind To Halt As Floods Deepen Power Crisis, published by reuters.com on December 10, 2019. 12 Stricter emissions standards in the car industry – mainly in China where China 6 emissions legislation is taking effect – are increasing the PGMs loadings in each car, supporting demand growth. 13 Please see China May Agree to Buy U.S. Ag Exports, But a Final Tranche of Cash to Farmers is Still Likely, published by agriculture.com’s Successful Farming news service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets 2020 Key Views: Policy Uncertainty Continues To Drive Commodity Markets

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 Fiscal Stimulus Boosts China Steel Consumption Fiscal 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 Iron Ore and Steel Rally Leaves Copper Behind Iron Ore and Steel Rally Leaves Copper Behind Chart 3China's Construction, Real Estate Investment Spur Higher Steel Demand China's Construction, Real Estate Investment Spur Higher Steel Demand China'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 Higher Steel Demand Normally Presages Higher Copper Demand Higher 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 Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight   Chart 6Strong USD Restrains Base Metal Demand Strong USD Restrains Base Metal Demand Strong USD Restrains Base Metal Demand Chart 7China's Iron Ore Imports Remain Strong China's Iron Ore Imports Remain Strong China'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 Technically, Copper's Oversold Technically, 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 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image