Energy

Highlights We’ve searched in vain for imminent domestic weakness in the U.S. economy, … : Much of our work this spring has focused on trying to poke holes in our view that the equilibrium fed funds rate remains above the target fed funds rate, but we haven’t found any evidence of overheating in the real economy, or worrisome excesses in financial markets. … but an exogenous shock could well precipitate a recession if it were serious enough: The U.S. is a comparatively closed economy, but there’s no such thing as full-on decoupling. The U.S. may react more slowly than other major economies to what’s going on in the rest of the world, but it’s not immune to it. A trade war would threaten global growth, … : U.S.-China trade negotiations have taken center stage over the last couple weeks, and escalating tension between the world’s two largest standalone economies will surely cast a pall over the global outlook. … but there are other potential threats that bear monitoring: Tensions with Iran could be the catalyst for an oil price shock, while a significant rollback of globalization could crimp corporate profit margins. Either would hasten the end of the equity bull market and the expansion. Feature Tight monetary policy is a necessary, if not sufficient, condition for a recession. We deem policy to be tight if the fed funds rate exceeds our estimate of the equilibrium fed funds rate, and easy if it is below our estimate of equilibrium. Over the six decades for which we compute an estimate of the equilibrium fed funds rate, the U.S. has only ever experienced recessions when the fed funds rate has exceeded our estimate of equilibrium (Chart 1). Tight policy isn’t always tantamount to a recession – nothing came of tight settings in 1984 or 1995 – but recessions don’t occur without it. Chart 1Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight We currently estimate that the equilibrium fed funds rate, a.k.a. the neutral rate, is about 3⅛%, and we continue to project that it will be around 3⅜% by the end of the year. Those estimates leave the Fed with plenty of headroom before it materially slows the economy. If our estimate is on the money, it will take four more rate hikes to induce an inflection in the business cycle. We have not seen anything in the ongoing flow of macro data, or evidence of excesses in the financial markets, that would suggest a recession is already under way or is lurking around the corner. Internal dynamics should continue to support the expansion, but threats from outside the U.S. are growing. We therefore conclude that the next recession may well not arrive for another two years, in the absence of a significantly adverse exogenous event. This week, we extend our focus beyond the U.S. to try to uncover the external threats that could stop the U.S. economy, and the bull markets in risk assets, in their tracks. Beyond the tariff fireworks, we also contemplate the possibility that conflict with Iran could lead to an oil price shock, and the impact of a significant rollback of globalization. It is not our base case that any of the various external threats will tip the U.S. into a recession, but investors should keep tabs on the biggest ones. Tariffs The U.S.-China trade saga has unfolded in three pairs of moves and counter-moves (Diagram 1). While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories included not only commodities such as base metals, chemical products and mineral fuels and oils, but also a broad swath of foods, textiles, electronics, vehicles and spare parts. After a three-month cease-fire, the developments of the last two weeks arguably marked the most significant escalation of tensions on both sides. The U.S. is now threatening to levy tariffs on the remaining $325bn of Chinese goods that have so far been spared. Diagram 1Anything You Can Do External Threats External Threats Our colleagues at BCA’s Geopolitical Strategy service suggest that recent foreign policy initiatives indicate that the White House does not feel any particular pressure to minimize economic risk this far ahead of the election. The risk of market-disruptive measures has therefore increased, and they see a 50-50 chance that the U.S. and China will fail to reach an accord (Table 1). Although the administration has delayed any action on autos and auto parts for now, Europe could be the next trade partner in its cross hairs. The odds that Section 232 (national-security-threat) tariffs will be levied on European auto imports is rising (Chart 2). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 External Threats External Threats Chart 2 These heightened trade tensions may delay the global growth recovery that we were expecting to bloom in the summer, and they may also allow the dollar to keep advancing. The greenback is a countercyclical currency, moving inversely with global activity (Chart 3), and a bump in the road for global growth would likely extend its upward run. Chart 3The Countercyclical Dollar The Countercyclical Dollar The Countercyclical Dollar Although a strong dollar would be a headwind for exporters, the U.S. economy is comparatively closed. Tariffs are likely to exert the greatest pressure on the economy via softer consumption and investment. So far, the available evidence suggests that U.S. consumers and corporations have borne the brunt of higher tariffs in the form of higher retail prices and lower profit margins.1 Iran Our geopolitical strategists contend that investors have underrated conflict with Iran as a market risk for a while. Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more delicacy than the more hawkish elements of the administration realize. In their view, the potential for a misstep increases the odds of a recession and poses a significant risk to the equity bull market. In a joint Special Report by our Commodity and Energy Strategy and Geopolitical Strategy services at the beginning of the month, our in-house experts stressed that there are multiple moving parts driving the supply-demand balance in the global oil market.2 Investors should realize that the world faces the prospect of the loss of Venezuelan production (approximately 600,000 barrels per day (b/d)) and significant outages in Libya (~600,000 to 800,000 b/d), in addition to our strategists’ base-case estimate of 700,000 b/d from Iran’s current 1.3 million b/d output. BCA does not expect that all of that output will be lost, but the key point is that Iran is not the only potential source of a supply shortfall. Our energy strategists believe that OPEC 2.0 – the producer coalition led by Saudi Arabia and Russia, and supported by Saudi Arabia’s OPEC allies – has the capacity to make up for even their larger shortfall scenarios (Chart 4). The problem is that OPEC 2.0 may not have the will to do so in a timely fashion. Saudi Arabia and the rest of the OPEC 2.0 coalition were caught completely off guard by the administration’s issuance of import waivers in November, after they had ramped up production at its request to limit the market disruptions that would have ensued when Iran’s output was taken off the market. The last-minute waiver decision caused oil prices to crater in the wake of a supply glut that OPEC 2.0 has been working to sop up ever since (Chart 5). Chart 4 Chart 5... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight   OPEC 2.0’s members may feel that they were badly used last fall, and may not be inclined to move proactively now. Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s estimates. If rising oil prices are often viewed as a tax on American consumers, a late summer/early fall release of holdings could be viewed as an election rebate, courtesy of the skilled economic managers in the White House. Our team expects that OPEC 2.0 will likely guard against an oversupply-driven swoon in oil prices by managing its production on something akin to a just-in-time inventory strategy. Our energy and geopolitical strategists caution that there are two other ways the administration may overplay its hand. First, it might overestimate U.S. shale drillers’ ability to export their production. While new pipeline construction will relieve the transportation bottleneck limiting the Permian Basin output that reaches the Gulf of Mexico, oil exports from the Gulf are limited by a shortage of deep-water harbor facilities. If global trade tensions do worsen, both the dollar and U.S. equities may attract safe-haven flows. There is also the possibility that Iran might strike at Iraq, putting some of its 3.5 million b/d output at risk. It could also make good on its repeated threat to close the Straits of Hormuz, through which nearly a fifth of global oil supplies travel daily. Either of these options would dramatically escalate the conflict, but a desperate Iran might pursue them if it felt cornered. The bottom line is that the probability of an oil price shock is not negligible. Brinkmanship with Iran could upset a delicate supply-demand balance in global oil markets, and a delicate geopolitical balance in the Middle East. If the Volcker double-dip is treated as a single event, a surge in oil prices has preceded every recession in the last 45 years, except for the 2001 recession precipitated by the bursting of the dot-com bubble (Chart 6). Chart 6Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Significant Rollback Of Globalization Our Geopolitical Strategy and Global Asset Allocation services have cited peak globalization as an important long-term investment theme for the last several years. The tariff tensions between the U.S. and its trading partners would seem to have borne out their predictions, especially if one views them as having been inspired by unskilled workers’ losses from globalization. Taking on foreign exporters is likely to play well in the electorally decisive Rust Belt states, where manufacturing job losses have hit especially hard. We fully subscribe to the theory of comparative advantage as formulated by David Ricardo in the early 19th century. By allowing individual countries to specialize in what they do best, free trade increases the size of the global economic pie. Empirical evidence suggests that globalization also re-slices the pie, however. In the developed world, outsourcing manufacturing has operated to the benefit of investors and the detriment of less-skilled workers. For U.S.-based multinationals, tariffs are a minor irritant compared to the prospect of having to reroute supply chains around China. The modest headwinds to globalization observed before the U.S. began engaging in serial bilateral trade conflicts did not undermine corporate profit margins in any material way. A bigger anti-globalization push that forced global supply chains to be rerouted or partially unwound would have much more negative effects. The U.S. is a comparatively closed economy, but the multinationals that dominate equity market capitalization rely heavily on interactions with the rest of the world. Unwinding the global supply chains that have been carefully constructed over the last 30 years would be disruptive and costly. The worst-case scenario envisioned by our geopolitical strategists, in which U.S.-China relations dramatically worsen and the tariff back-and-forth escalates in a major way, would hit equities hard, especially if supply chains had to be rebuilt. As a proxy for what globalization has meant for investors’ and blue-collar workers’ share of the pie, we consider the path of real wages relative to productivity over the last 50 years. From 1970 through 2001, U.S. wages generally kept pace with productivity gains, observing a fairly narrow, well-defined range (Chart 7). Once China entered the WTO (as denoted by the vertical line on the chart), productivity-adjusted wages fell precipitously, and even their periodic bounces have fallen well short of the level that marked the lower end of the previous range. Chart 7The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk Bottom Line: Temporary barriers to free trade, implemented as a negotiating tactic, are not a big deal for equities. A significant rollback of globalization would be, however, and a need to divert global supply chains away from China could stop the bull market in its tracks. Investment Implications Along with our Global Investment Strategy colleagues, we are somewhat more sanguine than our Geopolitical Strategy service that a worst-case outcome between the U.S. and China can be averted. We therefore continue to believe that the U.S. expansion, and the bull markets in risk assets, will persist until the Fed tightens monetary conditions enough to spark the next recession. We reiterate our recommendations that investors should maintain at least an equal weight position in equities and spread product. Enough is at stake in the conflicts with China and Iran, however, that a worsening of either could cause us to change our view, and we will be watching developments on each front closely. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com   Footnotes 1      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 2      Please see Commodity & Energy Strategy/Geopolitical Strategy Special Report, “U.S.-Iran: This Means War?,”dated May 3, 2019, available at ces.bcaresearch.com.

Highlights So What? The Trump administration’s decision to apply maximum pressure to Iran fundamentally changes the investment landscape in 2019-20. Why? The impact of the Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity. However, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. Policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Feature What are the Trump administration’s foreign policy objectives? First, to confront the U.S.’s greatest long-term competitor, China, by demanding economic reforms and greater market access. Second, to force a decision-point upon rogue regimes with significant ballistic missile programs and nuclear-weapon aspirations: North Korea and Iran. Third, to maintain credible deterrence in Russia’s periphery. Fourth, to reassert the Monroe Doctrine through regime change in Venezuela. The common thread, even with Russia, is confrontation. It is not necessary for President Trump to pursue all of these objectives at once. So his decision last November to issue waivers for eight importers of Iranian oil suggested to us that he was prioritizing – and becoming more risk averse ahead of the 2020 election. Full enforcement of the oil sanctions at that time threatened to push oil prices up at the same time as the Fed was raising rates, a pernicious combination late in the cycle (Chart 1). Thus, after walking away from the 2015 nuclear accord with Iran, it made sense for Trump to delay any confrontation with Iran until his hoped-for second term in office. He could focus on building the border wall, resolving trade tensions with China, and making peace with North Korea instead. Chart 1Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Chart 2Sanctions Will Raise Risk Sanctions Will Raise Risk Sanctions Will Raise Risk   This view has now been proved wrong. The oil waivers apparently represented only a temporary delay in the administration’s hawkish Iran policy. Now that financial conditions have eased and growth has stabilized, Trump has declared the Iranian Revolutionary Guard Corps a foreign terrorist organization and announced that he will discontinue the waivers, demanding full compliance on energy sanctions from all states by the end of May. Volatility will move higher (Chart 2). Trump is emboldened by America’s newfound energy independence (Chart 3). While the shale boom can be used to reduce U.S. strategic commitments in the Middle East, it can also encourage Washington to believe it is invulnerable to traditional Middle Eastern risks. Trump’s advisers, Secretary of State Mike Pompeo and National Security Adviser John Bolton, apparently have won the Iran policy debate on this basis. Since Trump’s reelection is far from guaranteed, it would appear his advisers view re-imposing sanctions against Iran as a rare opportunity to achieve long-term strategic objectives. They may not have the chance in 2021. Chart 3The U.S. Is Energy Independent The U.S. Is Energy Independent The U.S. Is Energy Independent Chart 4Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes All the same, the problem for Trump is that, while the U.S. will survive any chaos ensuing from an Iran confrontation, his presidency may not. Full enforcement of the sanctions could spiral out of control and, through the oil price channel, come back to hurt Trump’s economy – and hence his re-election odds (Chart 4). The implication is that Trump has either been misled about the risks of his Iran policy, or he does not care as much about his re-election odds as we believed. Either way, the result is aggressive policy, which increases the geopolitical risk premium in oil prices. We can see this in our simulations (below), which are based entirely on spare capacity and compliance by consumers to the sanctions. We did not include an Iran-retaliation scenario in this modeling. Therefore, any threat to Iraqi supplies, or talks of disrupting the Strait of Hormuz will add to our prices forecasts. U.S. Administration Sailing Close To The Wind From their public comments, it would appear the U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of production in Iran and Venezuela. For the Trump administration, this view is supported by growing U.S. shale-oil supplies, and the administration’s belief the Kingdom of Saudi Arabia (KSA) and its Gulf allies stand ready to increase production to cover any losses arising from the re-imposition of Iranian oil-export sanctions by the U.S. This belief supports the administration’s end-game, which appears to be regime change in Iran, a position long favored by Trump’s national security advisor John Bolton. Frank Fannon, U.S. Assistant Secretary of State for Energy Resources, succinctly captured the administration’s view when he declared, “We are doing this ... in a favorable market condition with full commitment from producing countries.” He further stated, “We think this is the right time.”1 We believe the Trump administration is sailing close to the wind here. The U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of oil production in Iran and Venezuela. While increasing U.S. shale output does provide something of a cushion to global oil markets, it is not a substitute for the heavy-sour crude produced by Iran and Venezuela (and others), which is favored by refiners with complex units. The loss of Iranian exports hits these refiners harder than those able to process lighter, sweeter crude of the sort exported by the U.S. (Chart 5).2 As Iranian and Venezuelan barrels are lost to the market, these heavier crudes are getting more scarce relative to the crude produced in U.S. shales – typically classified as West Texas Intermediate (WTI) crude oil. This can be seen in tighter light-versus-heavy crude oil spreads, and the wider Brent-WTI spreads, which indicate WTI is relatively more plentiful (Charts 6A & 6B). Chart 5 Chart 6AWTI Relatively More Plentiful… WTI Relatively More Plentiful... WTI Relatively More Plentiful... Chart 6B…As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce It is true U.S. production continues to grow, which is causing crude oil inventories to increase as sanctions on Iran are being re-imposed. We expect U.S. shale-oil output to grow 1.2mm b/d this year – taking it to a record 8.4mm b/d on average – and 800k b/d next year. Caution is required regarding inventories, however: U.S. refiners are in the thick of their plant maintenance – known as turn-around season – and have loaded a lot of the maintenance they would normally have done in the Fall into Spring. As a result, U.S. refiners are running at reduced rates preparing for the Northern Hemisphere’s summer driving season and the January 1, 2020, implementation of the U.N. IMO 2020 regulations, which will require shippers to use lower-sulfur fuel to power their vessels worldwide.3 OPEC 2.0 Gains Control Of Brent Forward Curve Growing U.S. production and inventories might give the Trump administration comfort the market can absorb the loss of Iran’s exports – some 1.3mm b/d at present. However, our base case holds that Iran’s exports will stabilize at ~ 600k b/d after sanctions fully kick in. In most of the scenarios we run (Table 1), the impact of Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity (Chart 7).4 Indeed, many of the low-probability scenarios we run – including the “maximum pressure” scenario, in which the Trump administration succeeds in removing all of Iran’s exports – can be accommodated by current supply and spare capacity without sending Brent prices through $100/bbl (Chart 8). OPEC 2.0 holds ~ 1.5mm b/d of what we would describe as readily available spare capacity – mostly in KSA – that can be brought to market fairly quickly, as the ramp-up last year ahead of the first round of sanctions in November amply demonstrated. Another 1.5mm b/d or so is held by the Kingdom and its GCC allies, but it would take longer to bring on line. Table 1BCA Oil Market Scenarios U.S.-Iran: This Means War? U.S.-Iran: This Means War? Chart 7OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses Chart 8Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 In reality, once refiners are up and running at max capacity in the U.S. in a few weeks, U.S. inventories will begin to draw hard. This will support what we believe to be OPEC 2.0’s goal of backwardating the Brent curve – perhaps sharply. This will allow it some breathing space to gradually add barrels to the market in 2H19 as needed, as our balances and forecasts assume. It is important to remember OPEC 2.0 was formed to drain the massive storage overhang that resulted from the 2014-16 market-share war launched by KSA. The Kingdom’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. Throughout the ramp to renewed sanctions, he has steadfastly maintained the Kingdom will provide oil as Aramco’s customers need it, following the blind-side hit KSA took from the Trump administration in November when it granted Iran’s largest customers waivers on its export sanctions. U.S. Pressure On OPEC To Raise Output Will Grow We expect the Trump administration to continue to pressure OPEC – the old cartel, not OPEC 2.0 – to boost production post-sanctions. However, it is not entirely clear that this time OPEC’s – particularly KSA’s – interests are 100% aligned with President Trump’s. KSA and other producers were shocked by the administration’s decision to grant waivers after lifting supply sharply in response to Trump’s demands. This time around, we believe OPEC – KSA in particular – will be more cautious lifting output, even as the U.S. Navy very publicly displays its ability to project and sustain force in the Mediterranean and Persian Gulf regions (Map 1). With good reason: The U.S. holds ~ 650mm barrels of oil in its Strategic Petroleum Reserve (SPR), which can be released at a rate of 1mm to 1.3mm b/d for a year or so. Realistically, it is probably more like six to nine months, since, by the time much of the oil has been released to the market the reserves that are left likely will have higher concentrations of contaminants (e.g., metals and solids that migrated to the bottom of the storage while it was sitting idle), making buyers way more leery of using it. Chart After the shock of the waivers, KSA likely will minimize its exposure to another surprise from the U.S. as sanctions take hold. The risk to OPEC – KSA in particular – is that Trump again will pull a fast one as the U.S. general election approaches. Given Trump’s demonstrated sensitivity to U.S. gasoline prices approaching elections, it is not unlikely that he would hold on to the SPR barrels until mid to late summer 2020, then release them in time to reduce prices further. If, in the run-up to U.S. elections, OPEC has steadily increased production to build precautionary inventories then it runs a non-trivial risk the crude oil price would once again crash as SPR barrels are released. The Kingdom of Saudi Arabia’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. In this iteration of Iranian export sanctions, we expect KSA to adopt a just-in-time inventory management strategy, so that it is not caught out once again over-supplying the market ahead of a U.S. surprise. U.S. Shales Will Figure Into OPEC 2.0’s Calculus Chart 9U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained The other big fundamental OPEC 2.0 will be considering is the rate at which U.S. shale oil can be exported. Export capacity still is constrained by the shortage of deep-water harbor facilities in the U.S. Gulf. This is being addressed, but it has been slowed by additional requests for environmental impact statements from the federal and state governments. If prices start moving higher because KSA and OPEC 2.0 are responding to tightening markets with caution (and slowly), we’d likely see WTI production increase – it’ll have 2mm b/d of new pipe in the Permian to fill by end-2019 – but that crude could start backing up as storage in the U.S. Gulf fills. This would again widen the Brent vs. WTI - Houston spread, which will benefit refiners in the U.S. Gulf, but will lower prices received by U.S. shale producers (again) (Chart 9). Bottom Line: Trump’s decision not to extend the Iranian oil waivers suggests that he has plenty of risk appetite ahead of the 2020 election. His Iran policy is now the biggest geopolitical risk to the late-cycle bull market. It also risks tightening the oil market considerably as the election approaches. Can Iran’s Regime Withstand The Sanctions? Iran’s economic weakness was an added inducement for the Trump administration to take an aggressive turn. The sanctions against Iran’s crude oil exports have not yet been implemented in full force, but the economy is already showing signs of distress. For one, inflation is back near 40% – levels only reached during the previous round of sanctions (Chart 10). Given that food, beverages, and transportation are among the sectors experiencing the fastest growing prices, lower income groups – which the World Bank estimates spend almost half their income on food alone – will suffer disproportionately. Economic dissatisfaction has catalyzed protests in Iran in the past, and the squeeze from the U.S. sanctions could propel further unrest. Chart 10Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Chart 11 Moreover, soaring prices are coinciding with a slowdown in activity and consumption. On the surface Iran appears relatively well protected given that its economy is not as directly correlated with oil exports as some of its peers (Chart 11). However, Iran’s oil and non-oil sectors are actually closely intertwined. This is evident from weakness in the non-oil sector during the previous round of sanctions (Chart 12). The IMF expects the economy to contract by 6% this year – faster than its 3.9% estimate for last year – leaving Iranians to face a period of deepening stagflation. Chart 12 The jump in consumer prices is a reflection of the ongoing collapse of the currency. Despite the government’s best efforts to stabilize the foreign exchange market, heightened demand for foreign currencies caused a nearly 30% depreciation in the unofficial exchange rate vis-à-vis the U.S. dollar since the beginning of the year (Chart 13). Chart 13Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Chart 14Debt Burden Is Manageable Debt Burden Is Manageable Debt Burden Is Manageable To soften the impact of the weaker currency and the potential shortage of essential goods, authorities have introduced a three-tier exchange rate system, and banned the export of several products including grains and seeds, powdered milk, butter, and tea. Since the level of external debt remains manageable (Chart 14) the weak currency will pressure the economy through its impact on prices (highlighted above), with imported inflation eroding purchasing power. Furthermore, Iran will not benefit from any additional export competitiveness due to currency depreciation. The current account surplus is expected to deteriorate and eventually flip to a deficit amidst weak exports, and despite declining imports (Chart 15). The fact that Iran runs a non-energy trade deficit does not help. Chart 15Trade Surplus At Risk Trade Surplus At Risk Trade Surplus At Risk Chart 16Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint In terms of the fiscal purse, under normal circumstances, a weaker rial would raise government revenue from oil exports. However, given the restrictions on oil exports, the fiscal budget will not benefit from this relationship. Instead, the dominant impact will be greater government spending. Historically, expenditures tend to be countercyclical, aiming to mitigate the impact of the deteriorating economic environment on Iranian households (Chart 16). In the past, the Iranian government’s healthy fiscal balance allowed policymakers to implement social protection schemes to combat poverty and revitalize the economy. Now, however, the fiscal coffers are no longer so well-cushioned and the deficit will constrain this option. Stimulative fiscal policy in this environment would only raise inflation further. Furthermore, given that the lion’s share of Iran’s imports are capital and intermediate goods, the currency depreciation will spill over into the domestic industry and weaken demand, even for domestically produced goods. Investments have been lacking in many of the most essential services. The electricity sector is a prime example: while demand is rising, spare capacity is dwindling and causing recurring outages. Similarly, foreign direct investment will likely fall in this uncertain political environment. With the economy on the brink, Iran is not in a position to confront the United States directly. It must take total sanctions enforcement as a very grave risk and seek delaying actions and negotiations. However, this vulnerability will turn into desperation if the Trump administration proceeds with a full embargo without any “off ramp” for negotiations. Bottom Line: Full enforcement of sanctions threatens to destabilize Iran’s already vulnerable economy. Inflation is soaring, the currency is plunging, and the economy will likely be plagued by a twin deficit going forward. The implication is that Iran will eschew direct confrontation unless forced. Will Iran Retaliate In Iraq? Iran is also at risk of losing one of its great sources of leverage: Iraqi stability. Given its gloomy economic outlook, Iran is looking to expand ties with its neighbors in an attempt to soften the blow from the sanctions. Earlier this year president Hassan Rouhani and Iraqi prime minister Adel Abdul Mahdi signed several preliminary trade deals, with the ultimate aim to boost bilateral trade to $20 billion from its current ~$12 billion. However, natural gas exports to Iraq – a major traded good – are covered by the sanctions, so this target is probably unattainable. Although Iran is currently the only foreign supplier of natural gas and electricity to Iraq, the temporary halt in electricity supplies last summer coincided with violent protests in Southern Iraq.5 Growing anger over Iran’s inability to satisfy its commitments to Iraq highlights the tensions in the Iraq-Iran relationship. What’s more, the U.S. is pressuring Iraq to turn to other neighbors such as Saudi Arabia, Jordan, and Kuwait for its electricity needs.6 In March, it renewed a three-month waiver allowing Iraq to import Iranian gas. Then Saudi Arabia promised to connect Iraq to the Saudi electricity grid during a visit by its economic delegation to Baghdad on April 4.7 At that meeting, the Saudi delegation also agreed to provide Iraq with $1 billion in loans, $500 million to boost exports, and a sporting complex as a gift. Additionally, the Saudi consulate in Baghdad – which had been closed for almost 3 decades – reopened last month. Saudi Arabia and Iraq are starting to cooperate. Iraq’s new government is clearly taking a pragmatic approach to its regional relationships. This is also largely in line with growing domestic opposition to Iranian interference within Iraq. Influential Shia leaders such as Muqtada al-Sadr and Ayatollah Ali al-Sistani have been voicing concerns about Iran’s influence in Iraqi politics. As such, the new Iraqi government is attempting to walk a tight rope between placating Iran and taking advantage of new opportunities with its Arab neighbors to rebuild its economy. This trend raises the risk that Iran will strike rapidly in Iraq if it believes Trump’s maximum pressure strategy is succeeding in bringing oil exports to zero. Iraq is the logical target as Iran has great political and sectarian influence there, it is the geographic buffer with Saudi Arabia, and it is the necessary launchpad for Iran’s strategic opponents to undermine or attack the Iranian regime (Map 2). Chart Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a fullfledged conflict. Chart 17 Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. About 85% of Iraq’s crude exports flow through the southern port city of Basra (Chart 17). It is already home to recurrent protests and any disruptions there threaten around 3.5mm bbl shipping to international markets daily. Bottom Line: Iraq is caught in the strategic tug-of-war between Iran and Saudi Arabia, with the latter gaining influence at present. Sanctions could compel Iran to retaliate in Iraq, jeopardizing up to 3.5mm b/d of supply. What Comes Next? The latest data suggest that Japan is in full compliance with the U.S. sanctions against Iran as of April and that China has been front-running the sanctions and is now reducing imports, as it was at the time the waivers were first introduced. China may not go to zero, but it is apparently complying. This is important given that the Trump administration has essentially introduced a bold new demand – cut off all energy imports from Iran – at the eleventh hour of the U.S.-China trade negotiations. Our projections of spare capacity suggest that the Trump administration will believe it has room to enforce the sanctions fully (Chart 18). This is a risky approach, as a fairly standard unplanned outage anywhere else in the world could bring spare capacity much lower, but the data suggest that Trump’s team will not see it as a hard constraint. If necessary, the administration can later choose to soft-pedal enforcement on black market activity so as to calibrate the global impact. Chart 18 The Iranians, for their part, are unlikely to leap to the most aggressive forms of retaliation immediately – such as fomenting unrest in Iraq – because of their economic vulnerability. Small acts of sabotage or subversion are a way to send the U.S. a warning signal, but generally Iran will want to signal defiance while shifting the emphasis to negotiations. Hence it will primarily retaliate through diplomatic actions and calculated displays of force. A limited response enables Iran to appear innocent, divide the U.S. and EU, and thus isolate the U.S. over its belligerent policies. Previously, Trump has sought to negotiate with Iranian President Hassan Rouhani. The Iranians have so far rebuffed him, but Foreign Minister Mohammad Zarif’s initial response to the waiver announcement was to blame Trump’s advisers, instead of Trump himself, and offer an exchange of prisoners (And release of detained Americans happen to be one of the Trump administration’s key demands – see Table 2.) Negotiations could begin through back channels and an uneasy period of tensions could thus ensue without a full-blown war. Table 2Trump Administration’s 12 Demands On Iran U.S.-Iran: This Means War? U.S.-Iran: This Means War? The problem is that negotiations cannot work if Trump fully and immediately enforces the sanctions without offering Iran an “off ramp.” If the administration backs Iran into a corner it will have no option but to strike out forcefully. Negotiations also cannot work if Iran joins the U.S. in withdrawing from the 2015 deal and reactivating its nuclear program, specifically the suspected military dimensions of that program. This would force Trump to respond (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree U.S.-Iran: This Means War? U.S.-Iran: This Means War? In short, a period of “fire and fury” is about to ensue between Trump and Rouhani. It will be even more uncertain and disruptive than the summer 2017 showdown between Trump and Kim Jong Un of North Korea (Chart 19), which drove a 35 bps decline in the 10-year Treasury yield. Chart 19Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Kim Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown There is a pathway for Trump’s pressure tactics to succeed: Iran is vulnerable and the United States and its allies are in a position of relative strength in terms of global oil supply. Therefore, it is possible that Trump could fully enforce the sanctions and yet avoid any uncontrollable crisis or oil shock. However, this pathway, at a subjective 26% probability, is less likely than the combined 48% probability of the alternatives: either escalation short of war, or ultimatums leading to Middle Eastern instability and much higher odds of war. Bottom Line: The geopolitical risk of U.S.-Iran confrontation is not contained. But we do not expect Iran to overreact unless Trump plows forward with full and immediate sanctions enforcement and offers no realistic “off ramp” for negotiations. At that point Iranian retaliation will be concrete and escalation could spiral out of control. Investors should keep in mind that Iran is not North Korea. Unlike the hermit kingdom, Iran has the ability to retaliate with a number of different levers. Indeed, it has threatened to shut the Strait of Hormuz in the past, and could, at the limit, be backed into that corner. While the risk of this is extremely low, should it occur the consequences would be huge – close to 20% of the world’s daily oil supply passes through the Strait daily. Indeed, just this week Iran’s Oil Minister Bijan Zanganeh again threatened to take action against any OPEC member working against its interests. Following a meeting with the Cartel’s president, he is reported to have said, “Iran is a member of OPEC because of its interests, and if other members of OPEC seek to threaten Iran or endanger its interests, Iran will not remain silent.”8 Investment Conclusions The Trump administration’s decision to apply maximum pressure to Iran is a significant and unexpected injection of geopolitical risk that we believe fundamentally changes the investment landscape in 2019-20. While our base case is that the U.S. will enforce the oil sanctions gradually and in such a way as to avoid causing an oil shock, policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1 Please see Humeyra Pamuk and Timothy Gardner, “How Trump’s hawkish advisors won debate on Iran oil sanctions,” Reuters, May 1, 2019, available at reuters.com. 2 Heavy-sour crudes are those with low API gravity (a measure of how easily a crude flows) and higher sulfur content. Light-sweet crudes have higher API gravity and lower sulfur content. 3 Please see BCA Commodity & Energy Strategy Weekly Report, “IMO 2020: The Greening Of The Ship-Fuel Market,” February 28, 2019, available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition led by KSA and Russia, which was formed in 2016 to manage global crude oil output. Its goal is to drain the massive storage overhang caused by the market-share war launched by KSA in 2014. 5 Iran cited dissatisfaction with Iraq over the accumulation of unpaid bills as the cause of the halt in electricity exports to Iraq. This prompted Iraqi authorities – under pressure from domestic unrest – to send a delegation to Saudi Arabia in attempt to negotiate an electricity agreement. 6 Please see Edward Wong, “Trump Pushes Iraq to Stop Buying Energy From Iran,” The New York Times, February 11, 2019, available at nytimes.com. 7 Please see Geneive Abdo and Firas Maksad, “Iraq’s Place in the Saudi Arabian-Iranian Rivalry,” The National Interest, April 15, 2019, available at nationalinterest.org. 8 Please see Babk Dehghanpisheh, “Iran will respond if OPEC members threaten its interests: oil minister,” Reuters, May 2, 2019, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights Oil & Bond Yields: Global growth indicators are starting to rebound, risk assets have returned to previous cyclical highs, and oil prices remain buoyant. This is a combination that will eventually result in rising global bond yields, but more through higher inflation expectations that will bear-steepen yield curves. Stay below-benchmark on overall portfolio duration, but enter new reflationary trades in core Europe (long inflation breakevens) and Australia (yield curve steepeners). EM vs DM Credit: Signs of a pickup in Chinese growth will be more supportive for growth in EM economies. Hedging against an extended downturn in China is no longer needed. Upgrade EM U.S. dollar denominated sovereign and corporate debt to neutral (3 of 5), at the expense of a smaller overweight position in U.S. investment grade corporates. Feature Chart of the WeekA Consistent Message On Rebounding Growth A Consistent Message On Rebounding Growth A Consistent Message On Rebounding Growth Evidence is starting to point to a bottoming in global economic momentum. Credit growth has notably picked up in China, global leading economic indicators are stabilizing and sentiment measures like our Duration Indicator have started to climb (Chart of the Week). While it is still early in this reflation process, the leading data is now moving in a direction that bodes well for continued gains in global equities and growth-sensitive spread product. The sharp rallies across risk assets seen so far this year have merely retraced the stinging losses incurred in the final months of 2018. Those moves were fueled by a combination of slowing global growth and overly hawkish central bankers. Now that policymakers have “course corrected” towards dovishness, led by the Fed’s 180-degree turn on the outlook for rate hikes in 2019 that drove U.S. Treasury yields lower, the next leg of the risk rally can begin, led by improving global growth. At some point, looser financial conditions – higher equity prices, tighter credit spreads and lower market volatility – will require global central bankers to retreat from dovish forward guidance (Chart 2). Policymakers who have been focused on sluggish global growth, “persistent uncertainty” (as ECB President Mario Draghi has described it), and falling inflation expectations will eventually have to adjust their policy bias once those factors reverse. On that front, the combination of improving global growth, rising oil prices and an increasingly likely U.S.-China trade deal will help boost global bond yields through rising inflation expectations first and higher interest rate expectations later (Chart 3). Chart 2A Full Unwind Of Late-2018 Moves...Except For Inflation A Full Unwind Of Late-2018 Moves...Except For Inflation A Full Unwind Of Late-2018 Moves...Except For Inflation Chart 3Get Ready For A Bond-Bearish Turn In Growth Get Ready For A Bond-Bearish Turn In Growth Get Ready For A Bond-Bearish Turn In Growth We continue to recommend a high-level fixed income portfolio construction that will benefit from these trends: below-benchmark on overall duration exposure with overweights on global corporate debt versus government bonds. We also see a case to selectively position for steeper yield curves and higher inflation expectations in countries more sensitive to higher oil prices and where central banks will be less hawkish/more dovish. Most importantly, we no longer see a need to maintain a defensive underweight in emerging market (EM) hard currency spread product, as we discuss later in this report. Yes, Oil Prices Still Matter For Bond Yields Global oil prices hit a new 2019 high last week on news that the Trump administration was letting waivers expire on U.S. sanctions of Iranian oil exports. Coming on top of the lost output from Venezuela, increased tensions in Libya and persistent production discipline from the major oil players (OPEC, the so-called “OPEC 2.0” of Russia and Saudi Arabia, and even U.S. shale producers), a boost to global oil demand from faster global growth is likely to result in even higher oil prices in the next 6-9 months. The combination of improving global growth, rising oil prices and an increasingly likely U.S.-China trade deal will help boost global bond yields. Our colleagues at BCA Commodity & Energy Strategy remain steadfast bulls on oil prices, with a year-end price target of $80/bbl on the Brent crude benchmark. They view the supply constraints as large and persistent enough to cause oil prices to continue rising alongside firmer global demand. Our most optimistic forward-looking growth indicator, the diffusion index of global leading economic indicators, is now calling for a sharp rebound in cyclical data like the global manufacturing PMI in the latter half of 2019. A move back to the 55-60 range for the global PMI, which the diffusion indicator is pointing towards (Chart 4, bottom panel), would be consistent with the +50% year-over-year growth rates in oil prices implied by BCA’s bullish oil forecasts (middle panel). Chart 4The 2019 Oil Rally Is Not Over Yet The 2019 Oil Rally Is Not Over Yet The 2019 Oil Rally Is Not Over Yet Over the past several years, there has been a strong correlation between oil prices and government bond yields in most developed economies (Chart 5). Since the most recent bottom in global yields back on March 27, that behavior has persisted. Longer-term bond yields have risen more than shorter-dated yields, alongside higher inflation expectations further out the yield curve (Table 1). Chart 5Inflation Expectations Still Driving Bond Yields Inflation Expectations Still Driving Bond Yields Inflation Expectations Still Driving Bond Yields Such “bear-steepenings” do not usually last for long periods of time. Inflation targeting central banks typically look at the reflationary implications of higher oil prices – faster economic growth with more future inflation as energy costs seep into core inflation measures – as a sign to maintain a more hawkish bias for monetary policy. That is not the case today, though, as data dependent central bankers have been more focused on past soft readings on both growth and inflation momentum. This should support a growth-driven rise in global oil prices in the coming months, as policymakers will be reluctant to alter the current dovish guidance without signs of both faster growth and higher realized inflation. Within the major developed markets, the recent correlations between oil prices (in local currency terms) and inflation expectations have been weakest in regions where central banks are most likely to keep policy interest rates stable. In the euro area, Japan and Australia – where core inflation rates are well below central bank targets and money markets are discounting flat-to-lower interest rate expectations over the next 1-2 years – market-based measures of inflation expectations like CPI swap rates have diverged from the rising path of local-currency denominated oil prices (Chart 6). In the U.S. and Canada, which have only recently paused their rate hike cycles, the correlation between oil prices and inflation expectations has been a bit more in line with the experience of the past several years. The same goes for the U.K., although inflation expectations there seem more driven by currency weakness stemming from the Brexit uncertainty rather than a central bank that is perceived to be too hawkish (even though the Bank of England only recently shifted away from its past language signaling a desire to start normalizing very low interest rates). Table 1A Reflationary Bear-Steepening Of Yield Curves Since Yields Troughed In March It's Time To Break Out The Fine China It's Time To Break Out The Fine China Correlations between longer-term inflation expectations and the slopes of government bond yield curves have also become less consistent across countries (Chart 7). In particular, 2-year/10-year yield curves been more positively correlated to inflation expectations in the euro zone, Australia and even Japan (where the BoJ is actively targeting the yield curve) than in the U.S., U.K. and Canada. Chart 6Higher Oil, Higher Inflation Expectations Higher Oil, Higher Inflation Expectations Higher Oil, Higher Inflation Expectations Chart 7Position For Reflationary Yield Curve Steepening Position For Reflationary Yield Curve Steepening E Position For Reflationary Yield Curve Steepening E Given BCA’s bullish oil forecast, we recommend positioning for higher inflation expectations and steeper yield curves in selected countries based on the above correlations. We are already doing this in the U.S., where we are running a long position in U.S. 10-year TIPS breakevens. This week, we are entering the following new positions in our Tactical Trade portfolio (see page 15): Long 10-year CPI swaps (or inflation-linked bonds versus nominal debt) in Germany A 2-year/10-year government bond curve steepener in Australia We are not confident enough about the growth outlook in Canada and Japan, and the political outlook in the U.K., to recommend inflation-focused trades in those markets at the present time. We recommend positioning for higher inflation expectations and steeper yield curves in selected countries. Bottom Line: Global growth indicators are starting to rebound, risk assets have returned to previous cyclical highs, and oil prices remain buoyant. This is a combination that will eventually result in rising developed market global bond yields, but more through higher inflation expectations that will bear-steepen yield curves. Stay below-benchmark on overall portfolio duration, but enter new reflationary trades in core Europe (long inflation breakevens) and Australia (yield curve steepeners). Upgrade EM U.S. Dollar Denominated Debt To Neutral Chart 8A Cyclical Rebound In China Is Underway A Cyclical Rebound In China Is Underway A Cyclical Rebound In China Is Underway Back in January, we upgraded our recommended allocation for global corporate debt to overweight, while downgrading developed market government bonds to underweight.1 That decision was in response to the Fed’s dovish turn, which lowered the risk of a monetary policy-induced U.S. recession that spooked investors in late 2018. Yet while a more accommodative Fed meant an extension of the U.S. business cycle expansion, it did not solve the problems of slowing growth elsewhere in the world – most notably in China and Europe. For that reason, we have maintained a preference for U.S. investment grade and high-yield corporate debt relative to European and EM spread product, even within an overall overweight recommended allocation to global corporates. In particular, we maintained an outright underweight stance on EM U.S. dollar denominated sovereigns and corporates within our model bond portfolio. That tilt served as a hedge to the risk of persistent softening growth in China – the nation to which EM economies remain most highly levered. It is the pickup in the China credit impulse that is most relevant for EM growth and asset markets. Now, amid signs that Chinese policy stimulus is starting to show up in faster credit growth – a reliable precursor to greater Chinese domestic demand (Chart 8) – that EM hedge to our overweight stance on global corporates is no longer needed. Thus, this week, we are upgrading our recommended exposure on EM USD-denominated sovereign and corporate debt to neutral, while reducing the size of our recommended overweight in U.S. investment grade corporates in our model bond portfolio (see the changes on page 14). The broadening rebound in Chinese economic data makes us more confident that growth there has turned the corner (Chart 9): Aggregate government spending is up 15.5% on a year-over-year basis. Infrastructure spending is now starting to grow again after the sharp slowdown seen in 2018. The China manufacturing PMI rose sharply in March, with the surge in the import sub-component of the overall PMI suggesting that domestic demand may be improving. In addition, with all signals pointing to a U.S./China trade deal being signed by the end of May, a major source of uncertainty weighing on the Chinese (and global) economy will soon be lifted. It is the pickup in the China credit impulse that is most relevant for EM growth and asset markets. Over the past decade, the credit impulse has led both the EM (ex-China) manufacturing PMI and annual growth in overall EM corporate earnings by around 9-12 months (Chart 10). The credit impulse bottomed back in October 2018, which means EM growth should begin to improve in the third quarter of 2019. Financial markets will discount that improvement in advance, however, which is why it makes sense to increase EM credit allocations today. Chart 9The Arrows Are Pointing 'Up' For Chinese Growth The Arrows Are Pointing 'Up' For Chinese Growth The Arrows Are Pointing 'Up' For Chinese Growth Chart 10EM Growth Is Highly Dependent On China EM Growth Is Highly Dependent On China EM Growth Is Highly Dependent On China   As can be seen in the bottom panels of Chart 11 and Chart 12, there is a strong correlation between Chinese credit (as a % of GDP) and the relative performance of EM U.S. dollar denominated spread product versus U.S. investment grade corporates. Our colleagues at BCA China Investment Strategy recently noted that if the pace of China’s credit expansion seen in Q1 were to be maintained over the rest of 2019, this would imply a credit overshoot beyond the stated medium-term goal of Chinese policymakers to avoid significant further increases in leverage.2 Such additional stimulus would very beneficial for EM growth (via strong Chinese import demand), supporting continued EM credit market outperformance. Chart 11Upgrade EM USD Sovereigns Vs U.S. IG Corporates Upgrade EM USD Sovereigns Vs U.S. IG Corporates Upgrade EM USD Sovereigns Vs U.S. IG Corporates Chart 12Upgrade EM USD Corporates Vs U.S. IG Corporates Upgrade EM USD Corporates Vs U.S. IG Corporates Upgrade EM USD Corporates Vs U.S. IG Corporates By moving our EM credit allocation only to neutral, we are merely responding to the pickup in Chinese credit growth seen over the past several months. The increasingly positive cyclical story is not yet bullish enough to justify a full-blown overweight stance on EM credit, however, for several reasons: Past periods of EM credit market outperformance have typically occurred during periods of U.S. dollar weakness. Chart 13A Weaker USD Is Good For EM Markets A Weaker USD Is Good For EM Markets A Weaker USD Is Good For EM Markets The amount of policy stimulus likely to be delivered in China in 2019 will be more limited than in past cycles, given policymakers’ concerns over high Chinese debt levels and excess industrial capacity. A U.S.-China trade deal may not involve the swift reduction in U.S. tariffs on Chinese imports, if the White House chooses to use tariffs as the mechanism to ensure Chinese compliance with the terms of an agreement. “Hard data” in China that measures private sector spending (retail sales, autos sales, etc.) has yet to bottom, which may indicate that the improvement seen in the credit aggregates and survey data like the manufacturing PMI is overstating the growth rebound. The U.S. dollar remains firm, and past periods of EM credit market outperformance have typically occurred during periods of dollar weakness (Chart 13). We do anticipate moving to an overweight position sometime in the next several weeks, after getting more Chinese economic data to confirm the improvement seen in March. This also lines up with the timetable for a potential trade deal, the details of which will be critical for boosting investor sentiment towards assets sensitive to Chinese demand, like EM credit. We will also look for signs of the U.S. dollar breaking to the downside to confirm any decision to upgrade EM credit. One final point – we are only reducing our recommended overweight on U.S. investment grade credit in our model bond portfolio as part of this EM upgrade. We are leaving our U.S. high-yield credit overweights untouched, as U.S. investment grade is much closer to the spread targets laid out by our colleagues at BCA U.S. Bond Strategy than U.S. high-yield. Bottom Line: Signs of a pickup in Chinese growth will be more supportive for growth in EM economies. Hedging against an extended downturn in China is no longer needed. Upgrade EM U.S. dollar denominated sovereign and corporate debt to neutral (3 of 5), at the expense of a smaller overweight position in U.S. investment grade corporates.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th, 2019, available at gfis.bcaresearch.com. 2 Please see BCA China Investment Strategy Weekly Report, “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem”, dated April 17th, 2019, available at cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It's Time To Break Out The Fine China It's Time To Break Out The Fine China Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The upturn we anticipated in China’s industrial output in the wake of fiscal and monetary stimulus is becoming more visible. Accommodative central banks, along with a likely resolution of the Sino – U.S. trade war, will continue to be positive for Chinese growth, which will bolster trade and commodity demand in general, base metals’ demand in particular. However, not all base metals will benefit equally from this fortuitous confluence of fiscal and monetary stimulus, and the renewed credit growth directed at China’s small and mid-sized enterprises (SMEs). Of the metals we follow, copper likely will benefit most from Chinese stimulus and the knock-on effects from increased trade, with aluminum running a close second. Zinc and nickel will not enjoy as much of a lift, based on our analysis. We are adding a tactical long aluminum position to our open long copper position. Highlights Energy: Overweight. The Trump administration’s decision to let waivers expire on U.S. oil-export sanctions leveled on Iran will give OPEC 2.0 greater control over the Brent forward curve. In the near term, markets will not tighten sharply. However, longer term, the continued loss of Iran’s and Venezuela’s exports, further increases in Libyan tensions and unplanned outages will lift the odds refiners will have to draw inventories harder than expected going into the high-demand Northern Hemisphere summer. We expect this to backwardate the Brent curve further, and accelerate the full backwardation of the WTI forward curve. Presently, OPEC 2.0 holds ~ 1.5mm b/d of ready spare capacity, due to recent production cuts made to drain global inventory. There is ~ 1.5mm b/d of additional spare capacity in the Kingdom of Saudi Arabia (KSA) that would take longer to bring on line. The ready spare capacity can cover the ~ 1.3mm b/d or so that could be removed by the Iran waivers’ expiration. But, with global commodity demand remaining robust (see base metals analysis below), further unplanned outages – on top of the falling Venezuelan output and mounting tensions in Libya – will stress the supply side of the market. KSA this week communicated it would coordinate with other producers to keep oil markets balanced.1 Russia’s recent threat to reignite a market-share war also reminded the market OPEC 2.0 has capacity it can quickly bring to the market should it choose to do so. The expiration of waivers on the Iran export sanctions strengthens OPEC 2.0’s hand by allowing it to calibrate the rate of growth in flowing oil supply at a level that forces refiners and traders to draw inventory. The growing backwardation will lift implied volatilities in crude and products markets. Iran’s reaction remains to be seen.2 This geopolitical uncertainty also will contribute to price volatility as well. We will be publishing a Special Report on the implications of the Trump administration’s waivers decision next week with our colleagues at BCA’s Geopolitical Strategy. Base Metals: Neutral. We expect copper to benefit from Chinese fiscal and monetary stimulus, moreso than the other base metals we follow (aluminum, nickel and zinc). We explore this in depth below. Precious Metals: Neutral. Gold prices continue to face downward pressures, the latest coming from Venezuela’s sale of ~ $400 million worth of the metal (~ 9 tons) last week, despite international sanctions.3 Going forward, China’s credit stimulus should revive global growth, which will negatively affect the counter-cyclical U.S. dollar. Our Global Investment strategists closed their long U.S. dollar recommendation last week. This will support gold in the 2H19. Feature The evolution of China’s credit cycle is key to our base-metals view, and integral to our high-conviction call commodity demand will surprise to the upside. Globally, the real economy is once again finding its groove. Maybe not as groovy as 2017, but still better than 2018. China is implementing tax cuts amounting to almost $300 billion (~ 2 trillion RMB), and loosening the credit screws that last year ground economic activity lower.4 Central banks around the world either are accommodative, or are not aggressively tightening. The evolution of China’s credit cycle is key to our base-metals view, and integral to our high-conviction call commodity demand will surprise to the upside beginning in the current quarter and extending into 2H19. And China’s credit growth has been stout this year. Aggregate China financing came in stronger than expected for March, registering a 12.3% year-over-year gain, versus an increase of 11.6% in February, based on calculations made by our colleagues in BCA’s Global Investment Strategy (GIS) service.5 The pick-up in the rate of growth – the so-called credit impulse – typically leads the import component of China’s manufacturing PMI, according to our GIS colleagues. This is good news for firms exporting to China, as well, as it indicates industrial activity ex-China also will pick up as fiscal and monetary stimulus take hold in the Middle Kingdom. So, putting it together: China’s fiscal and monetary stimulus will radiate outward to EM markets generally and DM export-oriented economies, which will lift base metals markets generally. China’s demand still dominates global demand, which means it also impacts prices globally (Chart of the Week). Chart 1 Base Metals Sensitivity To Fundamental Information Given its importance to global growth, we again look at China’s effect on base metals prices – via demand – by ranking the metals we closely follow based on their sensitivity to China’s industrial activity and credit, along with our BCA Global Industrial Activity (GIA) Index. Table 1 shows the relationships between the year-on-year (y/y) percent changes in base metals, and the LME index versus the big correlates we have identified over the years with these metals: BCA’s GIA Index, our China credit policy gauge, China construction proxy, internally developed risky-versus-safe haven currency ratio and the Li Keqiang Index (LKI) of domestic Chinese industrial activity. We look at these from 2000 to now, and in the post-GFC period (2010 to now). Table 1Correlations Of Base Metals’ Prices (y/y % Change) Vs. Key Economic Variables Copper Will Benefit Most From Chinese Stimulus Copper Will Benefit Most From Chinese Stimulus Two things stand out in this analysis: The GIA index, which is heavily weighted to EM demand, is a key driver for all of the LME base metals prices, and the LME Index itself;6 Copper is the most sensitive to all of these variables vs. the other base metals. The LME Index (LMEX) is the next-most-sensitive gauge. In the case of the latter, it likely is copper’s weight in the index driving this result (copper is 31.2% of the LMEX), and the fact that other metals tend to follow copper’s lead. Post-GFC, the correlations with BCA’s GIA index, our China Construction proxy and the LKI index all become stronger, suggesting rising Chinese demand and the global quantitative easing have had a fundamental effect on base metals prices.  The weakening of the correlations once the analysis moves beyond copper and the LMEX indicates either the other base metals are not processing information from the market – supply-demand fundamentals and global monetary data – or these commodities’ fundamentals are more opaque than those available from the copper market. The other outstanding feature of this analysis is that post-GFC, the correlations with BCA’s GIA index, our China Construction proxy and the LKI index all become stronger, suggesting rising Chinese demand and the global quantitative easing have had a fundamental effect on base metals prices. We will be examining this in future research. Bottom Line: China’s impact on base metals prices is complex. Its internal demand obviously is significant, which is not unexpected for the market that accounts for ~ 50% of base metals demand globally. We also see evidence China’s economy influences EM ex-China, and DM economies – most likely those heavily reliant on exports to China. Fiscal and monetary stimulus in China will radiate outward and influence global growth – in EM and DM economies. This is a positive fundamental for base metals.     Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Appendix: Global Base Metals Balances Image Image Image Image   Footnotes 1      Please see “Saudi Arabia says to coordinate with other producers to ensure adequate oil supply,” published by reuters.com April 22, 2019. 2      According to the state-run Fars news agency, Iran’s head of the Revolutionary Guard Corps Navy force threatened it will close the Strait of Hormuz if the country is prevented from using it. Please see “Iran Raises Stakes in U.S. Showdown With Threat to Close Hormuz,” published April 22, 2019 by bloomberg.com. 3     Please see “Venezuela Is Said to Sell $400 Million in Gold Amid Sanctions,” published April 15, 2019 by bloomberg.com. 4      We added a measure of China’s credit cycle to our Global Industrial Activity (GIA) index last month. We noted China’s credit cycle was showing signs of bottoming. We now are expecting to see growth in the current quarter.  Please see “Bottoming Of China’s Credit Cycle Bullish For Copper Over Near Term,” published by BCA Research’s Commodity & Energy Strategy March 14, 2019.  It is available at ces.bcaresearch.com. 5      GIS’s aggregate financing measure excludes equity financing and other items but includes local government bond issuance. Please see “Chinese Debt: A Contrarian View,” published by BCA Research’s Global Investment Strategy April 19, 2019. It is available at gis.bcaresearch.com. 6      This is because the index is constructed to be sensitive to EM industrial-commodity demand growth.  Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index.  The article was published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Closed Trades Image

Refinery Pessimism Is Misplaced Refinery Pessimism Is Misplaced Overweight We upgraded the S&P oil & gas refining & marketing index last month all the way from underweight to overweight based on the dramatic divergence between improving fundamentals and a zealously pessimistic sell-side. While the index has moved sideways since we made the change, our thesis has been reinforced by industry dynamics. The Wall Street Journal reported yesterday that domestic gasoline prices have been rising uninterrupted for the past 69 days, a 15-year record. This is confirmed by rapidly declining gasoline inventories (inventories shown inverted, second panel) and, in combination with higher prices, are driving a surge in refiner crack spreads (second panel). Refining margins have historically defined the direction of relative profit growth and the current message is positive. However, sell-side estimates continue to point to relative earnings underperformance despite the brightening outlook (bottom panel). Bottom Line: A gap between fundamentals and estimates has opened in the S&P oil & gas refining & marketing index and has created a compelling buying opportunity. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR – PSX, MPC, VLO, HFC.