Energy

Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 4AIG Energy Risk Profile IG Energy Risk Profile IG Energy Risk Profile Chart 4BIG Integrated Risk Profile IG Integrated Risk Profile IG Integrated Risk Profile Chart 4CIG Independent Risk Profile IG Independent Risk Profile IG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile IG Oil Field Services Risk Profile IG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile IG Midstream Risk Profile IG Midstream Risk Profile Chart 4FIG Refining Risk Profile IG Refining Risk Profile IG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth IG Energy Debt Growth IG Energy Debt Growth Chart 5BIG Integrated Debt Growth IG Integrated Debt Growth IG Integrated Debt Growth Chart 5CIG Independent Debt Growth IG Independent Debt Growth IG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth IG Oil Field Services Debt Growth IG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth IG Midstream Debt Growth IG Midstream Debt Growth Chart 5FIG Refining Debt Growth IG Refining Debt Growth IG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 7AHY Energy Risk Profile HY Energy Risk Profile HY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile HY Independent Risk Profile HY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile HY Oil Field Services Risk Profile HY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile HY Midstream Risk Profile HY Midstream Risk Profile Chart 7EHY Refining Risk Profile HY Refining Risk Profile HY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth HY Energy Debt Growth HY Energy Debt Growth Chart 8BHY Independent Debt Growth HY Independent Debt Growth HY Independent Debt Growth Chart 8CHY Oil Field Services Debt Growth HY Oil Field Services Debt Growth HY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth HY Midstream Debt Growth HY Midstream Debt Growth Chart 8EHY Refining Debt Growth HY Refining Debt Growth HY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Appendix B High-Yield Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy  

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories Watch For Falling Inventories Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com

Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart I-1Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Chart I-1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart I-2A and Chart I-2B). Chart I-2ACurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-2BCurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table I-1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table I-1Sector Weights Across G10 Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart I-3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. Chart I-3Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart I-4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. Chart I-4The Dollar And Funding Stresses The Dollar And Funding Stresses The Dollar And Funding Stresses A lower dollar also boosts resource prices through the numeraire effect (Chart I-5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart I-6), which has kept their cost of capital low, even as the dollar has risen. Chart I-5Tied To The Hip Tied To The Hip Tied To The Hip Chart I-6Lots Of Non-US Debt Lots Of Non-US Debt Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart I-7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart I-7Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies This demand has come in the form of Chinese stimulus. Chart I-8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years. Chart I-8China And Commodities China And Commodities China And Commodities A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart I-9A and Chart I-9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart I-9AMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Chart I-9BMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart I-10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart I-11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart I-10A Dearth Of Value Managers A Dearth Of Value Managers A Dearth Of Value Managers Chart I-11Lots Of Value Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart I-12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart I-13A, Chart I-13B, Chart I-13C, Chart I-13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart I-14). This suggests some measure of convergence is due. Chart I-13AProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13BProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13CProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13DProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Chart I-14Attractive Growth Stocks Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction Chart I-15CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table I-1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart I-15). While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart I-16). As such, the neutral rate of interest is bound to head lower. Chart I-16A Top For NZD/CAD? A Top For NZD/CAD? A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: The ISM non-manufacturing PMI jumped from 45.4 to 57.1 in June, with the new orders component surging from 41.9 to 61.6 and the employment component at 43.1 versus 31.8 earlier. JOLTS job openings increased from 5 million to 5.4 million in May. Initial jobless claims fell from 1413K to 1314K for the week ended July 3rd. The DXY index fell by 1% this week, alongside the outperformance of non-US equities, particularly emerging market stocks. Recent data have shown budding signs of a recovery as many countries gradually reopen their economies. As a counter-cyclical currency, this has pressured the dollar. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit services PMI increased from 47.3 to 48.3 in June. The Sentix investor confidence index rebounded from -24.8 to -18.2 in July. Retail sales fell by 5.1% year-on-year in May. However, this is a 17.8% increase on a month-on-month basis.  The euro increased by 0.6% against the US dollar this week. While recent data have been promising, the Summer 2020 Economic Forecast released by the European Union sounded quite pessimistic this week. The Summer Forecast projects that the euro area will contract by 8.7% in 2020 and grow by 6.1% in 2021, much worse than the spring forecast. That said, a mild second wave could trigger the European Union to revise these estimates higher. Meanwhile, the ECB remains committed to lowering the cost of capital for Eurozone countries. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: The current account balance surged from ¥262.7 billion to ¥1176.8 billion in May, as imports fell faster than exports. The preliminary coincident index fell from 80.1 to 74.6 in May, while the leading economic index increased from 77.7 to 79.3. Machinery orders fell by 16.3% year-on-year in May, following a 17.7% decrease the previous month. Moreover, preliminary machine tool orders in June continued to fall by 32% year-on-year. USD/JPY fell by 0.5% this week. The June Eco Watchers Survey released this Wednesday shows that the current conditions index increased sharply from 15.5 to 38.8. Moreover, the outlook index rose to 44 in June from 36.5 the previous month. The Survey sounded cautiously optimistic and indicated that while COVID-19 continues to be a downside risk, activities are starting to pick up in recent months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit services PMI ticked up marginally from 47 to 47.1 in June. The construction PMI surged from 28.9 to 55.3. Halifax house prices increased by 2.5% year-on-year in June. The British pound jumped by 1.3% against the US dollar this week. The Bank of England chief economist, Andy Haldane, has warned about second, third or even fourth wave of COVID-19 infections. However, he also acknowledged that the UK economy has received a boost since restaurants and bars have reopened. We remain bullish on the pound as an undervalued currency, but are monitoring Brexit developments closely as they continue to add more volatility to trading patterns. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services performance index was flat at 31.5 in June. Home loans fell by 7.6% month-on-month in May, following a 4.4% decline the previous month. The Australian dollar rose by 0.6% against the US dollar this week. On Tuesday, the RBA held its interest rate unchanged at 0.25%, as widely expected. The Bank sounded optimistic about the recovery and the government’s effective measures to contain the virus. That said, with Melbourne returning into lockdown, a dose of skepticism is warranted. We continue to favor the Australian dollar as a key barometer for procyclical trades, but domestic factors could be a risk to this view. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ preliminary business confidence index recovered from -34.4 to -29.8 in July. The New Zealand dollar rose by 0.9% against the US dollar this week. The Q2 NZIER Quarterly Survey of Business Opinion (QSBO) indicated that economic activities plunged sharply in Q2. According to the survey, a net 63% of businesses expect conditions to deteriorate, compared with 70% in the previous survey. While confidence has picked up slightly, business sentiment remains downbeat with less intensions to invest and hire, particularly in the subdued construction sector. As such, a tactical opportunity is opening for short NZD trades at the crosses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The Ivey PMI surged from 39.1 to 58.2 in June. The Markit manufacturing PMI also increased from 40.6 to 47.8 in June. Bloomberg Nanos confidence increased from 46 to 46.2 for the week ended July 3rd. Housing starts picked up from 195.5K in May to 211.7K in June. The Canadian dollar appreciated by 0.5% against the US dollar this week. The BoC Business Outlook Survey was released this week and survey results suggest that “business sentiment is strongly negative in all regions and sectors” due falling energy prices. Most firms believe that production could pick up quickly but sales might take longer to recover. That said, both interest rate differentials and recovering oil prices are bullish for the Canadian dollar for now.  Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: FX reserves increased from CHF 817 billion to CHF 850 billion in June. The unemployment rate declined from 3.4% to 3.2% in June. Total sight deposits increased from CHF 683 billion to CHF 687 billion for the week ended July 3rd. The Swiss franc appreciated by 0.7% against the US dollar this week. The Swiss franc has been quite resilient recently despite the rebound in risk sentiment since the March lows. The expensive franc remains a headache for the SNB and the Swiss economy. We are looking to go long EUR/CHF at 1.055. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Manufacturing output fell by 3% month-on-month in May. The Norwegian krone surged by 1.3% against the US dollar this week. We remain bullish on the krone due to its cheap valuation and signs of a recovery in energy prices. Our Nordic Basket is now around 10% in the money and we also went long a petrocurrency basket including the Norwegian krone last week. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Industrial production fell by 15.5% year-on-year in May. Manufacturing new orders plunged by 18.4% year-on-year in May. The Swedish krona surged by 1.3% against the US dollar this week. Like the Norwegian krone, the Swedish krona is tremendously undervalued and remains one of our favorite G10 currencies at the moment. As a small open economy, Sweden relies heavily on exports and imports. While global trade was hit hard during COVID-19, signs of stabilization bode well for the Swedish krona. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In this report, we initiate coverage of the EU Emission Trading System’s (ETS) CO2 allowances. We expect this policy-driven cap-and-trade market to become central to the market-driven pricing mechanism for CO2 fundamentals. Futures on EU CO2 emissions allowances will resume their rally – and surpass the €30 level seen in July 2019 – as ETS allowances supplies tighten in September. Global CO2 emissions are projected to fall 8% this year – 2.6 billion MT (2.6 gigatonnes, or Gt) – as a result of the COVID-19 pandemic, based on IEA modeling. If realized, this would be up to six times the decline in CO2 emissions following the Global Financial Crisis (GFC). The speed at which actual CO2 emissions return to pre-COVID-19 levels will be a function of how quickly global growth recovers, and the intensity of “green” investments. Post-COVID-19, the rebound in emissions could be sharply higher, as has been the case with previous global downturns. Following the GFC, CO2 emissions recovered all of the year-on-year (y/y) decline in 2009 by 2010 (Chart of the Week). As with any COVID-19-related projection, uncertainty – to the upside and downside – dominates our outlook. Chart of the WeekCOVID-19 Crushes Global CO2 Emissions COVID-19 Crushes Global CO2 Emissions COVID-19 Crushes Global CO2 Emissions Feature The EU’s CO2 emissions market is designed to achieve policy goals – i.e., reducing the carbon footprint of utilities and manufacturers in Europe. As tempting as it may be to view the surge in EU CO2 emission allowances futures as a harbinger of a powerful recovery in European economic growth, such hopes would be misplaced (Chart 2).1 The sharp rally in part reflects the expected decrease in the volume of CO2 emission allowances that will be available for trading over the September 2020 – August 2021 period. In line with its policy mandates, the ETS reduced this volume by 0.33 Gt following a May 2020 meeting, bringing the total volume available for trade in the year beginning in September to ~ 1.32 Gt.2 The EU’s CO2 emissions market is designed to achieve policy goals – i.e., reducing the carbon footprint of utilities and manufacturers in Europe – vs. pricing those emissions purely as a function of supply-demand fundamentals. Chart 2CO2 Allowances Rally Reflects Anticipated Supply Squeeze CO2 Allowances Rally Reflects Anticipated Supply Squeeze CO2 Allowances Rally Reflects Anticipated Supply Squeeze CO2 Emissions As is the case with industrial commodities – particularly oil, base metals, iron ore and steel – non-OECD markets dominate CO2 emissions. CO2 is the largest greenhouse gas (GHG) emitted into the atmosphere, and the largest share – almost two-thirds – of it is accounted for by fossil fuel use in industrial and transportation processes (Chart 3). CO2 emissions are closely tied to oil consumption. In non-OECD economies, this means they are closely tied to GDP, as the income elasticity of oil consumption for EM economies is ~ 0.65, meaning a 1% increase in income translates to a 0.65% increase in oil demand. In DM, transportation and electric generation drive hydrocarbon usage. In non-OECD and OECD markets, we model emissions as a function of oil consumption and financial variables (Chart 4). Chart 3Fossil-Fuel CO2 Dominates GHG Emissions EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Markets Rally On Lower Allowances Supply It comes as no surprise that commodity prices generally are highly correlated with CO2 emissions, given the markets in which they trade are continually responding to supply-demand shifts in industrial and consumer markets. This can be seen in our Global Commodity Factor, which extracts the common factor across 28 real commodity prices (Chart 5). Chart 4CO2 Emissions Trend With GDP, Oil Consumption CO2 Emissions Trend With GDP, Oil Consumption CO2 Emissions Trend With GDP, Oil Consumption As is the case with industrial commodities – particularly oil, base metals, iron ore and steel – non-OECD markets dominate CO2 emissions (Chart 6). Chart 5CO2, Commodity Prices Closely Aligned CO2, Commodity Prices Closely Aligned CO2, Commodity Prices Closely Aligned Chart 6Non-OECD Economies Dominate CO2 Emissions EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Markets Rally On Lower Allowances Supply Within this category, China accounts for ~ 45% of non-OECD CO2 emissions post-GFC, and close to 28% of global emissions, according to BP’s 2020 Statistical Review.3 China’s heavy reliance on coal-fired power generation and heating drive its CO2 emissions (Chart 7, top panel). Asia as a whole accounts for ~ 19 Gt of CO2 emissions, or 53% of the global total, while the US and Europe account for 18% and 17%, respectively.4 US CO2 emissions are driven by electric generation and transport, as the bottom panel of Chart 7 shows. Chart 7Electric Generation And Heating Drive China’s CO2 Emissions EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Emission Allowances The ETS also will force the overall number of emission allowances to contract at a 2.2% rate p.a. beginning next year. In the 21st century, ICE EUA futures prices have not followed actual EU CO2 emissions (Chart 8). This is not unexpected, given this market largely is a policy-driven market, not a fundamentally driven market. The ETS runs a cap-and-trade system covering ~ 45% of the EU’s GHG emissions, which limits emissions by more than 11,000 power stations, industrial plants and other heavy energy-use applications. Until 2019, the ETS adjusted supplies of emissions allowances by literally removing surpluses from the market resulting from overallocations of supplies via its free allocations and auctions. Thereafter, the ETS Market Stability Reserve (MSR), began absorbing unallocated emissions allowances to keep prices from falling to the point that investment in CO2 abatement would be disincentivized.5 Chart 8Two Ships In The Night: EU CO2 Emissions and EUA Futures Two Ships In The Night: EU CO2 Emissions and EUA Futures Two Ships In The Night: EU CO2 Emissions and EUA Futures As ETS system surplus allocations are reduced, we expect this market will more closely reflect the actual supply and demand for CO2 allowances. The ETS also will force the overall number of emission allowances to contract at a 2.2% rate p.a. beginning next year, versus the 1.74% p.a. contraction observed over the 2013-2020 period, in order, it says, to keep the GHG emissions falling to policy levels set for 2030. Even with its flaws vis-à-vis a true commodity market driven by supply-demand fundamentals, the ETS’s CO2 emissions allowances market is extremely important as a source of information regarding the state of the world. Last year, Reuters’s Refinitiv service estimated that of the $164 billion worth of CO2 emissions traded globally 90% was accounted for by the European market.6 As ETS system surplus allocations are reduced, we expect this market will more closely reflect the actual supply and demand for CO2 allowances. This will allow it to generate a market-clearing price for emissions allowances, which will be a valuable data point for global markets, especially when it comes to allocating capital to reducing GHG emissions. The ETS is retaining the right to issue free allocations, so that participants in the system are not disadvantaged by other jurisdictions not subject to the stringent requirements imposed by the ETS. Bottom Line: The ETS’s CO2 emission allowances will resume the rally launched in March 2020, as the supply of allowances contracts beginning in September. We are not ready to recommend any positions in this market, but will continue to follow and write about it going forward, expecting it will become not only a viable market but an important source of information of the market-clearing price of CO2 emissions.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI prices have been moving side-ways since June at ~ $41/bbl and $39/bbl, respectively. Fundamentals are tightening but fear of a second wave of COVID-19 infections weighs on prices. Bakken shale-oil producers could struggle to restart drilling and production activities after a court ordered the closure of the basin’s crucial Dakota Access pipeline – responsible for moving ~ 600k b/d – due to insufficient environmental checks. As previously shut-in production comes back on line, regional prices could remain under pressure to incentivize additional crude-by-rail volumes – at close to double the transportation costs – out of the basin, keeping prices below producers’ breakevens (Chart 9). Base Metals: Neutral Copper prices continue moving up as economic activity in China recovers (Chart 10). Prices are now 32% higher vs. March lows. Large metal-producing countries in Latin America have been hit hard by the COVID-19 pandemic. This puts supply at risk and could have lasting impacts as needed investment in new mines is delayed. In fact, Codelco announced it is suspending construction at its El Teniente mine in Chile due to rising COVID-19 cases in the region. Copper could enter a persistent supply-deficit period if demand remains in its upward trend. Precious Metals: Neutral Gold prices crossed $1,800/oz on Tuesday, reaching their highest level since 2011. The yellow metal’s rally continues to be fueled by record Western investment demand. ETFs inflows in June reached 104 tons, pushing gold-backed ETF volumes and AUM to new highs. Globally, ETF holdings’ tonnage increased by 25% ytd. This more than offsets the collapse in physical demand from China and India. Going forward, we expect a lower US dollar will support income growth in EM countries, providing additional demand for gold. Ags/Softs:  Underweight The latest USDA Acreage report surprised the market, with corn producers planting 5 million less acres than their intentions in March. This large decline caused corn futures to rally to 3-month highs. Since then, the market has focused on adverse weather, hoping dryness in major corn producing areas would reduce corn yields. However, that didn’t materialize. Forecasts are showing less intense heat in the Midwest crop belt and futures are losing some ground compared to recent highs. The market is now awaiting Friday’s USDA Supply and Demand report. With exports on pace to come in slightly below the USDA estimate for the year and a much-reduced planting area, we expect corn ending stocks to be well below the June estimate of 3.32 Bn bushels. Chart 9Bakken Crude Prices Are Falling Vs WTI Bakken Crude Prices Are Falling Vs WTI Bakken Crude Prices Are Falling Vs WTI Chart 10China's Economic Growth Supports Copper Prices China's Economic Growth Supports Copper Prices China's Economic Growth Supports Copper Prices     Footnotes 1    These futures are the EUA contracts for delivery of Carbon Emission Allowances at the Union Registry, which was set up to account “for all allowances issued under the EU emissions trading system (EU ETS).”  Contracts for delivery of these allowances are traded on ICE Futures Europe’s platform. 2    Please see ETS Market Stability Reserve to reduce auction volume by over 330 million allowances between September 2020 and August 2021 published by the European Commission May 8, 2020. 3    Please see bp Statistical Review of World Energy 2020: a pivotal moment published June 17, 2020. 4    Please see CO2 and Greenhouse Gas Emissions published by Our World in Data, a collaboration between researchers at the University of Oxford, and the non-profit organization Global Change Data Lab, in December 2019. 5    Surpluses have been a feature of the market since 2009.  Please see Market Stability Reserve published by the European Commission. 6    Please see Value of global CO2 markets hit record 144 billion euros in 2018: report published January 16, 2019 by reuters.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Markets Rally On Lower Allowances Supply Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades EU CO2 Markets Rally On Lower Allowances Supply EU CO2 Markets Rally On Lower Allowances Supply

Highlights Theoretically the US could employ a “Reverse Kissinger” strategy – befriend Russia to isolate China or at least prevent the budding Russo-Chinese alliance.  But Trump has made no headway in relations with Russia. Meanwhile Democrats now see engagement with Putin as a failure and will pursue a more aggressive policy. Competition in Europe’s natural gas market underscores the broader Russo-American geopolitical confrontation. Russia will likely succeed in preserving its share in the European natural gas market in the medium term, but not in the long run. We remain overweight Russian equities and bonds relative to EM benchmarks, but will downgrade if Biden’s election becomes a foregone conclusion. Feature Investors do not need to wait for the US election verdict to assess the general trajectory of US-Russia relations. Some points are clear regardless of whether President Trump or former Vice President Joe Biden prevails: US-Russia engagement had mostly but not entirely failed between the fall of the Soviet Union in 1991 and President Trump’s election in 2016.   President Trump could not break free of the constraints of office and his administration has remained adversarial toward Russia despite his preference for deeper engagement. Whether Democrats or Republicans take the White House in 2021, the result will be confrontation with Russia over the four-year term and likely beyond. The geopolitical risk premium in the Russian ruble will rise relative to its current level. A Trump victory would reduce this risk, but only temporarily.   The Failure Of Engagement Russia’s rise from the ashes of the Soviet Union can be illustrated by our Geopolitical Power Index – it shows Russia’s rise relative to the US in terms of demographic, economic, technological, commercial, and military variables that make a nation strong (Chart 1). Chart 1Russia Rose From Soviet Ashes, But Still Lags US Russia Rose From Soviet Ashes, But Still Lags US Russia Rose From Soviet Ashes, But Still Lags US Russia is a shadow of its Soviet self and lags far behind the US in raw capability. But its recovery from the chaos of the 1998 financial crisis, fueled by a global commodity bull market, has consisted of a systematic removal of domestic political constraints. It is politically unified under the personal rule of Putin, has reformed its economy and modernized its military, and has successfully pushed back against the US and the West in its sphere of influence. Russia punches above its economic weight in the world by means of its military, which it has wielded opportunistically in Georgia, Ukraine, Syria, and Libya (Chart 2). Neither the US nor any other power was willing to fill the power vacuum in these locations. A Trump victory only temporarily reduces the rise in Russian geopolitical risk. The US and Russia have a fundamentally antagonistic relationship over influence in Europe and occasionally the Far East. They have little need to trade with each other. They are both large, independent commodity exporters and advanced weapon-makers separated by vast distances. Russia is threatened by the US’s military and technological superiority, its economic strength and newfound status as an energy exporter (see energy section), and its ability to undermine Russian legitimacy in the former Soviet sphere by promoting democracy.  Russia’s advantage is that the US is internally divided by political factions. Putin’s popular approval has benefited from his restoration of domestic order and Russia’s standing as a great power. Successive American presidents have floundered under domestic partisanship and polarization (Chart 3).   Chart 2Russia’s Military Punches Above Its Economic Weight US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) Chart 3Russia Is Politically Unified, The US is Internally Divided US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet)   Attempts to “reset” relations have failed.1 The Barack Obama administration’s 2009-11 Reset, announced by Biden, saw several concrete compromises, including the New START treaty and Russia’s joining the WTO. But the Bolotnaya Square protests in 2011-12, at the height of the Arab Spring, rekindled Moscow’s fear that the US aimed to foment “color revolutions” not only in Russia’s periphery but even in Russia itself. Faced with losing its control over Ukraine’s geopolitical orientation, Russia invaded parts of Ukraine and seized Crimea, the first military annexation of territory in Europe since World War II. The US and Europe applied extensive sanctions that last to this day and drag on Russian growth.2  True, Moscow cooperated on the 2015 nuclear deal with Iran. Russia does not want Iran to get nuclear weapons. Yet this is not imminent. And Russia gained global oil market share when the US walked away from the deal and restarted sanctions (Chart 4). Either way, Iran survives as a Russian ally capable of exerting influence across the Middle East.   President Trump launched another attempt at engagement with Russia. If there is a strategic basis for this policy – i.e. if it is not just based in Trump’s personal proclivities – then it is the idea of a “Reverse Kissinger” maneuver. During the Cold War, the US befriended Maoist China in order to isolate the Soviet Union. Today, with China posing the clear threat to US hegemony, the US could try to befriend Russia to isolate China or at least prevent the budding Russo-Chinese alliance.  The difference is that in 1972, American and Chinese interests were complementary. China wished to stabilize its borders and the US offered geopolitical relief as well as technology and knowhow. Today American and Russian interests are not complementary other than the political convenience of demonizing each other (Chart 5). The US offers Russia limited investment capital; Russia does not offer cheap labor or a vast consumer market. Chart 4Russia’s Oil Market Share Benefitted From Iran Sanctions US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) Chart 5US-Russo Interests Are Not Complementary US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet)   The Trump administration’s attempt to engage Putin has failed. Putin’s declaration of a global oil market share war this year drove American shale oil companies into bankruptcy during an election year. Barring an “October surprise” engineered by Putin to get Trump reelected, their “alliance” is at best rhetorical and at worst a mirage. Putin might favor Trump because he sharpens US internal divisions, or because he has an isolationist foreign policy preference, but Putin’s actions so far in 2020 suggest a deeper strategic reality: Russia seeks to foment political turmoil in the US, not solidify either of the parties in power, as the latter could backfire against Russia. What Comes After Engagement? Russia lacks the power to create a new world order, but it will continue to leverage its relative power to exercise a veto over affairs in the current global order, in which US influence is weakening. It can hasten the West’s decline by sowing divisions within the West. Chart 6COVID-19 Dented Support For Trump And Putin US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) What happens when US polarization falls and a new political consensus takes shape? This would pose a major threat to Putin’s strategic options. Thus it is relevant if Joe Biden wins the 2020 election with a strong majority and a full Democratic sweep of government. Presidents Trump and Putin, and their political parties, are among the worst performers amid the COVID-19 pandemic and recession (Chart 6). The implication is that Trump will lose the election and Putin will resort to time-tried techniques of confrontation with the West to restore his domestic support. Democrats will pursue a more aggressive policy toward Russia. The Democrats harbor a deep vendetta against Russia over its interference in the 2016 election and will go on the offensive to prevent Russia from trying to undermine their grip on power again. They will also seek to deter Russia from further undermining American strategic interests. Biden will try to revive NATO, expand US troop presence in eastern Europe, and promote democracy and human rights in Russia’s periphery, using the Internet to launch a disinformation campaign against Putin’s regime. Cyber warfare will escalate.  A “Reverse Kissinger” is not achievable until Russia feels threatened by China. The silver lining for Russia is economic: Biden’s policies will help to weaken the dollar and cultivate a global growth recovery. Biden will be less inclined to start disruptive Trump-style trade war with China that could permanently damage China’s potential growth or global growth. Chinese imports are essential to propping up Russia’s sluggish economy. In enabling commodity prices to recover, and reducing global policy uncertainty, Biden would inadvertently aid Russian recovery (Chart 7). Chart 7The Silver Lining Of A Biden Presidency For Russia Is A Weaker Dollar The Silver Lining Of A Biden Presidency For Russia Is A Weaker Dollar The Silver Lining Of A Biden Presidency For Russia Is A Weaker Dollar Ultimately Russia is insecure because the US threatens to undermine its economy and political legitimacy both at home and in its strategic buffers. Putin has re-centralized control while shutting out foreign influence. This approach is not changing anytime soon given the recent constitutional changes to prolong Putin’s rule till 2036. Preliminary reports claim that, with 65% of the public voting, these changes were ratified by 76% of the population.3  What changed is that the US is no longer as optimistic about engaging Russia. If anything, its internal divisions will encourage it to go on the offensive. Sanctions may well be expanded before they are eased, the Ukraine conflict could revive rather than simmer down, and new fronts in the conflict could widen, particularly in cyberspace. This is particularly the case if Biden wins the White House in November. The structural, geopolitical risk premium of US-Russia conflict is priced into Russian assets, but there is room for a cyclical increase if Biden is elected. Our market-based Russian geopolitical risk indicators – which define geopolitical risk as excessive ruble weakness relative to its macro context – show that Russian risk is elevated because of COVID-19, but dropping. The US election should reverse this trend, unless Trump wins (Chart 8). Chart 8Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Alternative measures of political risk that utilize non-market variables support our qualitative assessment, such as the indicator provided by GeoQuant. The implication is that Russian political risk is higher than the market is pricing (Chart 9). Chart 9Market Is Underpricing Russian Political Risk Market Is Underpricing Russian Political Risk Market Is Underpricing Russian Political Risk Kissinger Reversed? Not Yet. If Trump wins, could he not engineer a major détente with Russia? In 2018 the US shifted its national defense strategy to emphasize that “the central challenge to US prosperity and security is the reemergence of long-term, strategic competition,” arguing specifically that “it is increasingly clear that China and Russia want to shape a world consistent with their authoritarian model.4”  Yet US geopolitical power has declined such that taking an offensive approach to Russia and China simultaneously is not practicable.  If the US pursues the Reverse Kissinger strategy, then it will have to make major concessions to Putin’s Russia. It would need to provide substantial sanctions relief, accept the Crimean annexation, allow a high degree of Russian influence in Donbass (Ukraine), abandon hopes of retribution for the 2016 election interference, ask for a return to the 2015 nuclear deal on Iran at best, and settle for arms control agreements that do not cover new technologies. It is not clear that President Trump would concede this much in a second term, though in most cases he would have the power to do so. Yet Moscow cannot downgrade its cooperation with Beijing by much, since US-Russia détente never lasts long and China weighs more heavily in its economic calculus than the West’s sanctions. Chart 10US-Russo Struggle Is Subordinate To US-Sino Conflict US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) The Democrats, by contrast, are not prepared to make these concessions, particularly on 2016. They are more willing to pursue a gradualist approach in dealing with China, which they believe is less urgent due to shared economic interests.5  If the US confronts Russia, then Russia will draw closer to China. The informal alliance between these two powers is well advanced. A closer association provides China with a better position in waging its long-term geopolitical competition with the United States.  Ultimately US grand strategy and public opinion will drive American presidents to take a harder line on China because it rivals the US in economic resilience and technology over the long run (Chart 10). The conflict with Moscow will eventually be subordinate to the US-China struggle. But a “Reverse Kissinger” is not achievable until Russia feels threatened by China, either through its own weakness or Chinese strength. A much stronger trans-Atlantic alliance, or much greater Chinese influence over East Asia and/or the Middle East, could trigger a shift in Russian strategy. We are not there yet. Russia’s cooperation with China will deepen, strengthening China’s hand and making it all the more imperative for the United States to solidify the trans-Atlantic alliance with Europe. Otherwise the risk of a precipitous decline in American power will threaten global stability.  Bottom Line: US-Russian antagonism will continue for the foreseeable future. Russian geopolitical risk is underpriced, particularly if Biden wins the election. A Trump victory would offer only a temporary reprieve.  Direct Competition In Energy Russia can offer low cost natural gas alongside an existing and projected (under construction) network of pipelines into Europe. This capability will help it to sustain and marginally increase its market share in Europe relative to the US in the medium term. In turn, this will help Russia secure vital revenues for its macro stability.  Natural gas exports to Europe represent 2.5% of GDP or 9% of total exports. A Biden presidency is negative for Russian assets, but Russia has room to ease policy. In the long run, however, US LNG will challenge Russia’s share in the European natural gas market. On the whole, the US sees Russia as an economic competitor in the European natural gas market and it will continue to disrupt Russian natural gas exports to Europe through sanctions and/or by other means. A resulting market share war between the US and Russia will lead to low natural gas prices benefitting the consumer, Europe. Competition in Europe’s natural gas market underscores the broader geopolitical confrontation between the US and Russia. The following factors will shape heightened competition: Escalating Competition For European Natural Gas Market Europe will remain a major market for natural gas. The combination of falling domestic production, steady consumption growth and the ongoing structural shift to cleaner sources of energy will require greater imports of natural gas (Chart 11). Critically, Europe’s natural gas consumption might rise faster than its GDP making this market attractive to energy producers. According to the IEA, Europe’s consumption of natural gas will continue to grow at a steady rate over the next 5 years. In a nutshell, European policymakers are promoting cleaner energy such as natural gas over coal and nuclear energy. This push will facilitate rising demand for natural gas.  Yet, European natural gas production is expected to drop by 40%, driven by field closures in the Netherlands and the UK.  As such, the diverging gap between falling production and steady consumption opens up a space for both Russian and US natural gas exports into the continent. Russia Natural Gas Strategy: Russia and its largest natural gas producer, Gazprom, are aiming to increase their share in the European market from their current 36% to 40% (Chart 12). Chart 11Europe's Nat Gas Imports Will Continue Growing... Europe's Nat Gas Imports Will Continue Growing... Europe's Nat Gas Imports Will Continue Growing... Chart 12...Allowing Russia To Grab Market Share ...Allowing Russia To Grab Market Share ...Allowing Russia To Grab Market Share   Table 1Russia’s Pipeline Export Capacity US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) More specifically, Russia’s latest 2035 strategy (known as ES-2035) reaffirms its two-pronged strategy: (i) continue to provide low-cost natural gas to Europe and Asia through pipelines and (ii) developing LNG export capacity for exports to the Far East. Pipelines: Russia’s export capacity to Europe is set to increase to 190 Bcm/y by 2022 excluding existing transit routes passing through Ukraine (Table 1). Two new sources of pipeline routes will be the Nord Stream2, coming online by the end of this year, and Turk Stream, expected to come online by 2022. These pipelines will have an export capacity of 55 Bcm/y and 31.5/y Bcm, respectively (Map 1).   Map 1Russia’s Latest Pipelines Bypass Ukraine US-Russia: No Reverse Kissinger (Yet) US-Russia: No Reverse Kissinger (Yet) Chart 13Russian Natural Gas Exports To Non-CIS Countries Russian Natural Gas Exports To Non-CIS Countries Russian Natural Gas Exports To Non-CIS Countries Meanwhile, pipeline capacity through Ukraine will remain 140 Bcm/y. Ultimately, Russia has been determined to diversify its natural gas transit routes despite pressures from the US.6 In addition, Gazprom natural gas production for transport via pipeline is expected to increase by 35% to 983 Bcm in the next 15 years. The European market is essential to Russia’s export revenues, as it currently represents 56% of Russia’s total gas export volumes compared with 83% total export to non-CIS countries (Chart 13). Lastly, regarding natural gas pricing, Gazprom will continue to move away from oil-indexed long-term contracts to shorter-term spot market contracts. This change of tack will cause deflation in Gazprom’s export prices to Europe but will preserve Russia’s market share in its strategic European market.   LNG: Russia will continue to be one the top four LNG producers alongside Qatar, Australia and the US. According to the latest estimates by the IEA, Russian exports of LNG, currently at 39 Bcm, are set to expand by 20% by 2025. The development of the Yamal peninsula into a major natural gas and LNG hub will allow Russia to produce close to 110 Bcm of LNG by 2035, which will constitute 16% of its overall current gas production. This will lead to continued LNG exports to various markets, particularly Europe, which consumes 50% of Russia’s LNG exports. Imported technology from Europe and external financing from China have allowed Novatek, Russia’s second largest natural gas producer, to become the leader in production and exports of LNG. Russia is also investing heavily in liquefaction. It is now fifth globally in liquefaction capacity. There are currently $21 billion in pre-final investment decision (FID) from the LNG Artic 2 in the Yamal that will increase its liquefaction capacity by over 200% by 2026.  Lastly, it is estimated that 70-80% of total commodity exporters’ costs are sourced locally and are in rubles due to the import substitution policy adopted by Moscow in 2015. This will alleviate cost pressures arising from a potentially weaker ruble in exploiting the Yamal reserves. US Needs To Find A Market For Its LNG: US produces 920 bcm/y of natural gas but consumes only 830 bcm/y. The rest is available for export. The need to export rising excess of natural gas output puts the US in direct competition with other natural gas exporters such as Russia. Chart 14US LNG Exports To Europe To Rise US LNG Exports To Europe To Rise US LNG Exports To Europe To Rise In the medium term, an oversupplied market alongside the COVID-19-induced demand shock in Europe will reduce European natural gas demand, hurting both the US and Russia. US LNG might lose market share in the European market to Russia due to falling production arising from capex cuts and bankruptcies in the US natural gas sector.7 Yet, in the long run, Europe’s geopolitical ties with the US and strategic interest in diversifying away from Russia make US LNG an obvious area of cooperation. The Trump-Juncker agreement in July 2018 led to a 300% increase in US LNG exports to Europe before the COVID-19 pandemic (Chart 14). Since coming into effect, the agreement also resulted in a doubling of EU utilization of LNG regasification capacity, from 30% to close to 60% in early 2020 and is expected to continue expanding in the years to come. Bottom Line: Russia will likely succeed in at least preserving its share in the European natural gas market in the medium term, but will be challenged by US LNG in the long run. Macro And Financial Market Implications For Russia Chart 15Russia: Low Public Debt Burden Russia: Low Public Debt Burden Russia: Low Public Debt Burden Heightened confrontation with the US and new sanctions on Russia will materialize if Biden wins the presidency. All else constant, this is unfavourable for Russian asset prices. It should be noted, however, that years of fiscal conservativism, tight monetary policy, a prudent and pro-active bank regulatory stance as well as some success in import substitution have given Russia the capacity to offset negative external shocks by easing macro policy: Russia has one of the lowest public debt-to-GDP ratios among the largest countries in the world. Its total public debt stands at 13.5% of GDP (Chart 15). Its external public debt is at a mere 4% of GDP. As in many other countries, Russia’s fiscal deficit is widening sharply due to the pandemic and low oil prices. However, we expect the primary and overall fiscal deficits will be only 4.25% and 5% of GDP in 2020, respectively. So far, at 3.5% of GDP, the announced fiscal stimulus in response to the pandemic has been small by global standards. Russia has room to boost fiscal expenditure substantially this year and in the coming years to offset negative external shocks. The Central Bank still has room to reduce interest rates further. The real policy rate is 2.5% compared with 1% for EM ex-China, Korea and Taiwan (Chart 16, top panel). Russia’s local currency government bond yields offer value: their real yield is 2.5% compared with the EM GBI benchmark real yield of 1.5% (Chart 16, bottom panel). The Central Bank of the Russian Federation will refrain from QE-type policies (i.e., public debt monetization). This is a plus for the ruble relative to other EM currencies where central banks are engaged in QEs. Bank lending rates remain extremely elevated in Russia and local currency credit penetration is reasonably low (Chart 17). Companies and banks’ external indebtedness has declined from $1,200 bn in 2014 to $900 bn currently. Chart 16Russian Real Rates Offer Value Russian Real Rates Offer Value Russian Real Rates Offer Value Chart 17Russia: Real Lending Rates Are Too Elevated! Russia: Real Lending Rates Are Too Elevated! Russia: Real Lending Rates Are Too Elevated!   Authorities have cleaned up the banking system. The number of banks has dropped from 1000 in 2010 to 430. Banks have written down and provisioned for a large amount of loans. All of these reduce Russia’s vulnerability to negative shocks. Finally, pressured by US and EU sanctions, Russia has been moderately successful in import substitution as we discussed in a previous report. The nation has expanded its productive capacity, especially in agriculture and some other industries. As a result, it now has more room to deploy fiscal and monetary stimulus to boost demand that will be satisfied by domestic rather than foreign output. In short, fiscal and monetary stimulus will not cause the currency to plunge. On the negative side, the outlook for productivity growth remains lukewarm. Russia’s long-term economic outlook will be characterized by relative stability but low growth, as has been the case in recent years. Combining our geopolitical and macro analysis, two conclusions stand out. First, we remain overweight Russian equities as well as both local currency and US dollar bonds relative to their EM benchmarks. If Trump stages a comeback over the next four months, which is not impossible, then the geopolitical risk premium will continue to fall. Trump would offer a reprieve in tensions for a year or two.  Second, the US election threatens this view because Joe Biden is currently heavily favoured to beat Trump and if he does, he is likely to impose fresh sanctions on Russia, possibly as early as 2021. Therefore, if Biden’s election becomes a foregone conclusion, we will downgrade Russian assets. Matt Gertken  Vice President Geopolitical Strategist  mattg@bcaresearch.com Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1  Michael McFaul, From Cold War To Hot Peace: The Inside Story of Russia and America (London: Penguin, 2018). 2  International Monetary Fund, “Russian Federation: 2019 Article IV Consultation,” IMF Country Report 19/260 (August 2019). 3  Ann M. Simmons and Georgi Kantchev, “Russians Vote for Overhaul That Could Keep Putin in Power Until 2036,” Wall Street Journal, July 1, 2020.  4  “Summary of the 2018 National Defense Strategy of the United States of America: Sharpening The American Military’s Competitive Edge,” Department of Defense, 2018. 5  Victoria Nuland, “Pinning Down Putin: How A Confident America Should Deal With Russia,” Foreign Affairs, July/August 2020. 6  The US has tried to stop Russia’s expansion of pipelines into Europe in the past. Evidenced from both Kennedy and Reagan administration policies directed towards the building of the Friendship oil pipeline in the 1960s and the Brotherhood gas pipeline in the 1980s, respectively. In response, Russia began developing its own technological capacity through import substitution, hurting western firms in the process. 7  "U.S. natural gas giant Chesapeake Energy goes bankrupt,” CBC, June 29, 2020.

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation

...And S&P Energy Performance ...And S&P Energy Performance One of the sectors that benefits from a falling greenback is the S&P energy sector. The energy sector enjoys a tight inverse correlation with the US dollar (top panel) as the sector has 8 percentage points higher foreign sales exposure than the S&P 500. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (third panel). Finally, the S&P energy companies enjoy a boost to their income statements (bottom panel). In fact, the S&P energy sector was the best performing sector during three US dollar bear markets we analyzed in the most recent Special Report.