Energy

Highlights The political economy of oil will become even more complicated, following remarks by Russian Finance Minister Anton Siluanov over the weekend, which suggested policymakers there are considering another market-share war to crash prices to limit the growth of U.S. shales. The logic appears to be that by abandoning OPEC 2.0’s production-cutting deal and pushing Brent prices below $40/bbl once again for a year or so, Russia will severely reduce investment flow to the U.S. shale-oil patch, allowing it to retake global market share ceded mostly to Texas oil producers.1 The threat of a market-share war was proffered on top of stepped-up rhetoric by senior government officials – ranging from Igor Sechin, head of state-owned Rosneft Oil, to Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF) – indicating Russia will be pushing for higher production by OPEC 2.0 in 2H19 at the coalition’s upcoming June meeting. We agree with this assessment: The market will require OPEC 2.0 to lift production in 2H19, given our assessment of supply-demand balances. In our estimation, OPEC 2.0’s position has been strengthened considerably by policy-induced disruptions to the oil market.2 As such, we believe Russia’s threat of a market-share war is a feint, particularly since Russia has benefited greatly from higher prices (see below). Our balances and price forecasts this month are largely unchanged (Chart of the Week). We continue to expect Brent to average $75/bbl this year. For 2020, we expect Brent to average $80/bbl. WTI will trade $7 and $5/bbl lower (Chart 2). The balance of price risk has shifted slightly to the left side of the distribution, driven by policy risk and potential miscalculation by the dramatis personae on the international stage, chiefly leaders in the U.S., Russia and China. Chart of the WeekMarkets Continue To Track BCA Balances... Markets Continue To Track BCA Balances... Markets Continue To Track BCA Balances... Chart 2...While Prices Continue Tracking BCA Forecasts ...While Prices Continue Tracking BCA Forecasts ...While Prices Continue Tracking BCA Forecasts Highlights Energy: Overweight. Tensions in Libya could keep ~ 300k b/d of supply from reaching global markets via its Zawiya port near Tripoli. We closed our long June 2019 $70/bbl vs. short $75/bbl call spread last Thursday with a gain of 87.7%.3 Base Metals: Neutral. China’s latest credit data confirms our view the country’s credit cycle bottomed earlier this year: March Total Social Financing (TSF) increased CNY 2.8 trillion month-on-month vs. consensus expectation of CNY 1.7 trillion. This will support base metals in the coming months. We continue to expect Chinese authorities to expand credit in 2H19.Our long copper trade is up 0.7% since inception on March 7, 2019. We are closing out our tactical iron-ore trade – long 65% Fe vs. short 62% Fe at tonight’s close; it was up 22.9% at Monday’s close. Precious Metals: Neutral. Gold fell 4% from its February high on easing inflation concerns and as fears of an equity correction subsided. March U.S. PCE ex-food and -energy dropped to 1.79% yoy from 1.95% in February, while global equities rose 14% YTD. Our long gold recommendation is down 2.4% since last week, but is still up 3.6% since inception on May 4, 2017. Agriculture: Underweight. U.S. corn and wheat farmers are behind schedule in their spring planting, according to USDA data. The top four American corn-producing states had not started planting by last week, while spring and winter wheat producing states are 11% and 3% behind schedule, mostly due to weather conditions. While delays in planting are always cause for concern, we are still early in the planting season, which gives farmers time to catch up. Feature Policy uncertainty vis-à-vis global oil supply was elevated by Russian Finance Minister Anton Siluanov’s comments indicating policymakers are considering reviving an oil market-share war directed at U.S. shale-oil producers. Siluanov said prices could fall to $40/bbl or less, in the event. Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now His remarks come on the back of statements from Russian government and oil company officials lobbying for higher output. These comments suggest there is a heavyweight Russian contingent fully supporting these demands for OPEC 2.0 to increase production in 2H19 when it meets in June. Otherwise, the threat implies, Russia will seriously consider leaving OPEC 2.0, and will launch its own market-share war against U.S. shale-oil production, led by the fast-growing Permian Basin in Texas. Thus far, Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now – nicely above $70/bbl in the Brent market. He also wants to maintain cooperation with OPEC 2.0, particularly its other putative leader, KSA. We continue to believe, however, KSA and Russia become less comfortable with Brent prices moving sharply above $80/bbl.4 Nonetheless, the threat posed by the U.S. shales is non-trivial: In our latest balances estimates, we raised our 2H19 U.S. output estimates to 12.53mm b/d, and slightly decreased our 2020 estimates to 13.35mm b/d”, led by a 1.17mm b/d and 0.84mm b/d increase in shale output this year and next (Chart 3). Chart 3U.S. Oil Production Estimate Higher For Shales U.S. Oil Production Estimate Higher For Shales And GOM U.S. Oil Production Estimate Higher For Shales And GOM However, Russia – and OPEC 2.0 generally – may be overestimating the rate of growth from U.S. shales going forward: In future research, we will be exploring the extent to which capital markets will restrain growth in the U.S. shales, as investors continue to demand higher returns. The days of growing shale production at any cost may be coming to an end. Russia’s Threat Is A Feint We believe Russia’s threat of a market-share war is a feint: A market-share war would damage the Rodina’s economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or two of their production. The threat needs to be understood in the context of the deterioration of Russia’s position in Venezuela; the increasing tempo of U.S. military operations in its near abroad; and rapidly evolving global oil and gas trade flows, all of which are working against Russian interests and investments.5 The threat appears to be a not-too-subtle reminder of the havoc Russia still can create globally, should it choose to do so, as Vladimir Rouvinski noted recently re Russia’s Venezuela policy.6 Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. Russia’s GDP elasticity to oil prices is more than twice that of KSA’s, which we demonstrated last week.7 This means, from an economic standpoint, it benefits more from higher prices than the Kingdom, based on our modeling. Russia’s oil is exported to refiners and trading companies who pay whatever price is clearing the market, versus KSA, which relies more on direct investments in end-use markets to serve captive demand, and whose GDP has a higher sensitivity to EM economic growth. Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. The coalition’s production-cutting deal this year has reduced global supplies by 1.0mm b/d since the beginning of the year, lifting price from below $50/bbl to more than $70/bbl, in line with our forecast. These production cuts have been supported by strong global demand this year this, which, we expect, will persist in 2020. Of course, Russia could abandon the production-cutting deal with KSA, in the hope of severely reducing investment in U.S. shale-oil production. However, it also would accelerate the loss of foreign direct investment (FDI) in its own hydrocarbons sector, along with those of other OPEC 2.0 member states (Chart 4). Bottom Line: A Russian market-share war aimed at U.S. shale producers would run the very real risk of tanking Russia’s GDP and those of the rest of OPEC 2.0’s member states, as these economies lack the resilience and diversification of the U.S.’s GDP, particularly Texas’s. Even if its fiscal balances are in better shape now, Russia’s economy remains highly sensitive to Brent crude oil prices – moreso than KSA’s, and far moreso the U.S.’s (Chart 5).8 Chart 4Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Chart 5Russia Benefits More Than KSA From Higher Oil Prices Russia Benefits More Than KSA From Higher Oil Prices Russia Benefits More Than KSA From Higher Oil Prices BCA’s Balances Mostly Unchanged Our updated balances reflect the lower Venezuelan and Iranian output reported by OPEC’s survey of secondary sources (Table 1). As we have noted previously, we believe OPEC 2.0’s spare capacity is sufficient to cover the loss of Venezuelan output, and the limited losses on Iranian exports imposed by U.S. sanctions (Chart 6). Beyond that, however, the market will be severely stretched if an unplanned outage removes significant production from global supply. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Russia Posits Oil Market-Share War: Red Herring Or Real Threat? Russia Posits Oil Market-Share War: Red Herring Or Real Threat? On the supply side, we continue to expect OPEC and Russia to lift supply in 2H19, following the successful draining of global inventories (Chart 7). We expect OPEC ex-Iran, Libya and Venezuela, led by KSA, will lift 2H19 supply by ~ 400k b/d vs. 1H19 levels, while we expect Russia’s output to rise 200k b/d. Chart 6 Chart 7Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 We continue to expect oil demand to be supported by the renewed easing of monetary policy globally, which will redound to the benefit of EM demand, which also will benefit from the bottoming of China’s credit cycle. Indeed, the EIA added 130k b/d to its estimate of non-OECD demand for this year, on the back of stronger expected growth. We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, with EM growth accounting for 1.1mm b/d of growth this year and 1.3mm b/d next year. In levels, global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. Waivers On U.S. Iran Sanctions Will Be Extended We continue to expect waivers on U.S. sanctions of Iranian oil imports will be extended on May 2, owing to the still-tight supply conditions globally with Venezuela output collapsing and ~ 1mm b/d of Iranian oil already forced off the market. This has, as we’ve noted in our discussions of the New Political Economy of oil, strengthened OPEC 2.0’s hand. This will become apparent when the coalition meets in June to consider whether to increase production in 2H19, in line with our expectation. KSA, Russia and OPEC 2.0 member states will have sufficient data on hand to determine whether and by how much to lift output, in a manner that supports their GDPs. Indeed, on Wednesday, Russian Energy Minister Alexander Novak said, “We should do what is more expedient for us.”9 KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. We also expect U.S. President Donald Trump to try to jawbone OPEC 2.0 into increasing production again, as he did in 2H18. However, we expect those demands to fall on deaf ears, unless fundamental supply dislocations warrant such action. Bottom Line: OPEC 2.0’s strategy is working – it will have maximum flexibility re how it handles its production in 2H19, following the U.S. decision on waivers to its Iran oil-export sanctions on May 2. As we noted last month, KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      OPEC 2.0 is the name we coined for the OPEC/Non-OPEC oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It agreed in November to remove 1.2mm b/d off the market, in order to balance global supply and demand and reduce inventories.  Please see “Russia, OPEC may ditch oil deal to fight for market share: Russian minister,” published April 13, 2019, for a re-cap of Siluanov’s remarks. 2      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019; and “OPEC 2.0: Oil’s Price Fulcrum,” published March 21, 2019.  It is available at ces.bcaresearch.com. 3      Please see “Oil steadies as market focuses on supply risks,” published April 15 2019 by reuters.com 4      Please see “Putin Says No Imminent Decision on Oil Output Cuts,” published April 10, 2019, by The Moscow Times. 5      Please see for example, “Pentagon developing military options to deter Russian, Chinese influence in Venezuela,” published by cnn.com April 15, 2019; “Destroyer USS Ross Enters Black Sea, Fourth U.S. Warship Since 2019,” published by news.usni.org April 15, 2019; and “U.S. LNG exports pick up, with Europe a major buyer,” published by reuters.com March 7, 2019. 6      Please see “Russian-Venezuelan Relations at a Crossroads” by Vladimir Rouvinski, published by the Wilson Center’s Kennan Institute in its February Latin American digest. 7      Please see “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” published by BCA Research’s Commodity & Energy Strategy April 11, 2019.  It is available at ces.bcaresearch.com. 8      We discuss the impact of higher oil prices on Russia’s economy in last week’s report, which is cited in footnote 6 above.  Russia’s GDP in 2017 was ~ U.S. $1.6 trillion, according to the World Bank, while the GDP of Texas was ~ $1.7 trillion, American Enterprise Institute. 9      Please see “Russia’s Novak: early to speak about options for oil output deal,” published reuters.com April 17, 2019. 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

Takeout Premiums Are Back In E&P Takeout Premiums Are Back In E&P Overweight The S&P oil & gas exploration & production (E&P) index received a much needed boost last week when the blockbuster acquisition of Anadarko by Chevron (at a 37% premium to the stock’s previous close) was announced, triggering a wave of M&A premia being added to stocks in the index. This valuation lift looks reasonably well deserved in our opinion, considering the degree to which the integrated oil majors are moving in to shale gas plays with a focus on the Permian basin. A narrowing of junk bond spreads is confirming the resurgent optimism in the sector (second panel). Our investment thesis is based on our sister publication, BCA’s Commodity & Energy Strategy, and their bullish WTI view, which is the fundamental growth driver in the sector (WTI shown advanced six months, bottom panel). We continue to expect a recovering energy price to drive a reversal of the recent moderation in oil & gas production, delivering a double dose of growth and margin improvement, goosing sector earnings and share prices. Bottom Line: We reiterate our overweight recommendation on the S&P oil & gas E&P index and our high-conviction overweight recommendation on the broader S&P energy index that we added this week.1 The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, CXO, HES, FANG, DVN, MRO, APA, NBL, COG, XEC.   1 Please see BCA U.S. Equity Strategy Weekly Report, “ Show Me The Profits” dated April 15, 2019, available at uses.bcaresearch.com.

Highlights Portfolio Strategy Yield curve dynamics, higher oil prices, recovering balance sheets, and compelling valuations and technicals all suggest that energy stocks will burst higher in the coming months.  Melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Recent Changes Upgrade the S&P managed health care index to overweight today. Add the S&P energy index to the high-conviction overweight list today. Table 1 Show Me The Profits Show Me The Profits Feature On the eve of earnings season, the SPX ended last week higher as bank profits delivered and allayed fears of recession. All-time absolute highs in the S&P tech sector and in the Philly SOX index suggest that global growth will likely reaccelerate in the back half of the year, vaulting the broad market to new highs. In addition, the suppressed Treasury term premium1 signals that the path of least resistance for equities is higher on a cyclical time horizon (term premium shown inverted, Chart 1). Chart 1All Clear... All Clear... All Clear... Nevertheless, some caution is still warranted from a tactical perspective. Since March 4 when we first turned short-term cautious on the broad equity market,2 the SPX has moved roughly 100 points both ways. Internal market moves, financial conditions, fund flows, complacency and the current economic backdrop all signal that stocks are not out of the woods yet. Namely, the S&P high beta versus the S&P low volatility tilt has failed to confirm the slingshot in the SPX (Chart 2). Similar to the small cap underperformance, mega cap tech is trouncing small cap tech stocks (Chart 3). Not only do large cap technology stocks have pristine balance sheets, but they also have earnings. In contrast, from the 89 S&P 600 tech constituents 54 have no forward profits. The weak over strong balance sheet underperformance is emitting the same signal (top panel, Chart 3). Chart 2...But Some... ...But Some... ...But Some... Chart 3...Caution... ...Caution... ...Caution... The bond market is also sending a warning shot. High yield corporate bonds are underperforming long-dated Treasurys (middle panel, Chart 2). And, the junk bond option adjusted spread has not fallen to the 2018 lows, let alone all-time lows (not shown). While a lot has been said on easier financial conditions, they have yet to return to the early-2018 lows. In fact, similar to the non-confirmation of the all-time SPX highs in late-September, the GS financial conditions index (FCI) is tracing a higher low, warning that equities have room to fall (FCI shown inverted, bottom panel, Chart 2). Mutual fund flows on all equity related products are contracting on a net sales basis. Historically, fund flows and equity returns are joined at the hip and the current divergence suggests that equity prices will likely succumb to deficient demand (top panel, Chart 4). Chart 4...Is Warranted ...Is Warranted ...Is Warranted On the economic front, last Wednesday we highlighted in an Insight Report, that lumber – a hyper sensitive economic indicator – failed to corroborate the recent equity market euphoria. The weak Citi Economic Surprise Index, also warns that the economic data has yet to turn the corner and should weigh on equities (bottom panel, Chart 4). What ties everything together is SPX profits. The news on this front is mixed, at least for the next little while: EPS will most likely contract in the first half of the year, but equity investors are looking through this earnings recession. Last year’s U.S. dollar appreciation will dent both revenues and EPS, and Q1/2019 is the first quarter where such greenback strength will subtract from corporate P&Ls (Chart 5). Chart 5Dollar Trouble? Dollar Trouble? Dollar Trouble? What worries us most is the sectorial concentration of 2019 profit growth in one sector, financials. Another source of concern is the heavyweight tech sector’s negative profit path for calendar 2019. Such sudden internal profit moves both in magnitude and in a short time frame are far from reassuring, especially given that overall profit estimates are still trimmed. Chart 6A depicts the current sector profit contribution to 2019 growth, and compares it with the January 22nd iteration (Chart 6B). What a difference three months make. Chart 6 Chart 6 In sum, internal equity and bond market dynamics, financial conditions, the economic soft-patch and the looming profit recession all signal that short-term equity market caution is still warranted. This week we upgrade a health care subsector and reiterate our bullish stance on a deep cyclical sector. Catch Up Phase Looms For Energy Stocks Last week we broadened out our research on the yield curve (YC) inversion beyond the S&P 500 to the GICS1 sectors.3 As a reminder, the SPX peaks following the yield curve inversion and on average the S&P energy sector performs the best from the time the YC inverts until the S&P 500 peters out (please refer to Table 3 from the April 8, Special Report). While every cycle is different, if history at least rhymes, deep cyclical energy stocks will likely outperform as the SPX eventually breaks out to fresh all-time highs. Already, year-to-date the S&P energy sector is the third best performing sector, besting the SPX by over 200bps. More gains are in store, especially given the big dichotomy between the oil price recovery and the relative share price ratio (Chart 7). What is perplexing is the ingrained sell-side analyst pessimism (Chart 6A) and lack of belief that oil prices will remain near current levels or even continue their ascent as our sister Commodity & Energy Strategy (CES) service publication predicts. Not only are EPS forecast to contract in every quarter this year, or 10% year-over-year according to IBES, but also revenues are slated to fall in every quarter in 2019. We would lean against this extreme analyst bearishness. While the $3.5/bbl backwardation in WTI oil futures prices one year out, and more than twice that 24-months out, underpins Wall Street’s gloomy energy sector outlook, U.S. oil extraction productivity reinforces sector profits. As U.S. crude oil production hits new all-time highs this is extracted by fewer oil rigs (bottom panel, Chart 7). If BCA’s CES constructive oil price expectation pans out, then energy stocks will easily surpass the profit and revenue bar that analysts have set extremely low for the sector. Delivering on the profit front will likely serve as a catalyst to rerate these deep cyclical stocks higher (Chart 8) and thus a catch up phase looms for energy stocks, at least up to the current level of WTI crude oil prices (top panel, Chart 7). Chart 7Catch Up Catch Up Catch Up Chart 8Bombed Out Valuation Bombed Out Valuation Bombed Out Valuation Granted, the U.S. dollar is a key determinant of oil prices and if BCA’s view proves accurate that global growth will return in the back half of the year (second panel, Chart 9), that is synonymous with a depreciating greenback, which in turn is bullish the broad commodity complex in general and oil prices (and thus energy stocks) in particular (middle panel, Chart 7). As a reminder, oil prices are an excellent global growth barometer, similar to their sibling Dr. Copper. Recovering global growth will boost energy stocks in an additional way: via a favorable supply/demand crude oil balance. Not only is OPEC rebalancing the global oil market through a reduction on the supply front, but a trio of potential supply shocks from Iranian sanctions, Venezuelan infrastructure and Libyan conflict are providing price support. Further, global growth has historically been tightly correlated with rising non-OECD oil demand (Chart 10). Chart 9Global Growth Beneficiary Global Growth Beneficiary Global Growth Beneficiary Chart 10Favorable Supply/Demand Dynamics Favorable Supply/Demand Dynamics Favorable Supply/Demand Dynamics Meanwhile, the broad energy sector is still licking its wounds from the late-2015/early-2016 manufacturing recession and is stabilizing debt and increasing EBITDA (fifth panel, Chart 11), thus the net debt/EBITDA ratio for the index has collapsed from over 11 to around 2, a level similar to the broad market (second panel, Chart 11). Interest coverage (EBIT/interest expense) is also renormalizing higher and is no longer sending a default warning for the energy space as a whole (third panel, Chart 11). The junk energy bond market corroborates/reflects this balance sheet improvement and is no longer flashing red (bottom panel, Chart 9). Finally, bombed out technical conditions are contrarily positive, and such extreme negative readings have marked the start of playable and sizable relative outperformance periods (Chart 12). Chart 11No Red Flags No Red Flags No Red Flags Chart 12Contrary Alert: Depressed Technicals Contrary Alert: Depressed Technicals Contrary Alert: Depressed Technicals Netting it all out, YC dynamics, higher oil prices on the back of rising global growth and a favorable supply/demand crude oil backdrop, recovering balance sheets, and compelling valuations and technicals suggest that energy stocks will burst higher in the coming months. Bottom Line: We reiterate our above benchmark recommendation in the S&P energy sector and today we are adding it to our high-conviction overweight list. Buy Into Managed Health Care Weakness A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.4 Now the time has come anew to explore this niche health care index from the long side. While we left some money on the table since our late-May 2018 move, relative share prices have come full circle, valuations have fallen roughly 18% from the late-2018 peak and analysts’ euphoria has been reined in (Chart 13). Chart 13Reset Reset Reset The inter- and intra-industry M&A fever has died down from mid-2018 and the rising momentum of a “Medicare For All” bill has weighed negatively on HMO sentiment. With regard to the latter, our geopolitical strategists believe that passage is possible. If the Democrats can unseat an incumbent president in 2020, they will also likely take the Senate and keep the House. This means they will be in the position to pass a major piece of legislation. While Trump is favored to win, barring a recession, the risk of both a Democratic sweep and a push for “Medicare for All” could be as high as 27%, and this would have a dramatic impact on the health care sector.5 Tack on the near 90bps drop in the 10-year U.S. Treasury yield since the November 2018 peak, and factors have fallen into place for a bearish raid in this pure play health insurance index. Thin managed health care margins and profits move in close lockstep with interest rates as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves (Chart 14). While at first sight, the outlook for profits appears grim, BCA’s bond strategists expect a selloff in the bond market to materialize in the back half of the year simultaneously with a pick-up in global growth which will prove a tonic to both margins and EPS. In addition, leading indicators of heath care insurance profit margins are flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels, Chart 15), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel, Chart 15). Chart 14Overdone Overdone Overdone Chart 15Melting Cost Inflation Melting Cost Inflation Melting Cost Inflation On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy (Chart 16). Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market herald a steep decline in the industry’s medical loss ratio. All of this is unambiguously bullish for margins and profits. Finally, relative valuations and technicals have both corrected from previously stretched levels and offer a compelling entry point for fresh capital (Chart 17). Chart 16Full Employment Is Bullish Full Employment Is Bullish Full Employment Is Bullish Chart 17Unloved And Under-Owned Unloved And Under-Owned Unloved And Under-Owned Netting it all out, despite the risks that “Medicare For All” pose, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: Boost the S&P managed health care index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      According to the NY Fed: “Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.” https://libertystreeteconomics.newyorkfed.org/2014/05/treasury-term-premia-1961-present.html 2      Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Seeing The Light” dated May 29, 2018, available at uses.bcaresearch.com. 5      If there is a 60% chance the Democrats nominate a left-wing candidate, and a 45% chance they win the election, then there is a 27% chance that they are in a position to push for “Medicare for All” with fair odds of passage. Everything will depend on the specific outcomes of the Democratic primary, presidential campaign, general election, post-election government policy priorities, and congressional passage. Stay tuned as in the coming months we will be publishing a Special Report on “Medicare For All” and health care sector implications co-authored with our sister Geopolitical Strategy service. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights OPEC 2.0 will meet in June to decide whether to continue its production cuts into 2H19. Once again, the leaders are sending conflicting signals – KSA is subtly indicating OPEC 2.0’s 1.2mm b/d of production cuts will need to be extended to year-end. Russia, not so much. Much will depend on whether the U.S. extends waivers on Iran oil-export sanctions when they expire May 2. Not surprisingly, Trump administration officials also are not providing much in the way of forward guidance to markets, other than to insist they want Iran’s exports at zero. Our modeling indicates OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – will need to raise production in 2H19, as markets tighten on the back of Venezuela’s collapse, continued unplanned outages (most recently in Libya) and still-strong demand. This aligns our view somewhat with that of Russia. That said, OPEC 2.0’s leaders – and member states – all benefit from higher prices, as we show below. Some, like Russia, more so than others – e.g., KSA, hard as that is to reconcile with their respective stances on production cuts. But none benefits if EM demand is crushed by high prices. It’s a delicate balancing act, given the aggregate GDP of EM commodity-importing countries exceeds that of commodity-exporting countries (Chart of the Week).1 Chart of the WeekEM Commodity Importers Dominate Aggregate EM Oil Demand EM Commodity Importers Dominate Aggregate EM Oil Demand EM Commodity Importers Dominate Aggregate EM Oil Demand We continue to expect Brent to trade at $75/bbl this year and $80/bbl next year, given our expectation for global supply and demand. KSA and Russia remain the fulcrum of the oil market, as we argued recently, and anticipating their decision-making process remains the critical task for understanding the new political economy of oil.2 Highlights Energy: Overweight. U.S. Secretary of State Mike Pompeo demanded opposing forces in Libya cease fighting this week. The country recently lifted oil production over 1mm b/d, but renewed fighting threatens this output. Base Metals: Neutral. China’s National Development & Reform Commission (NDRC) earlier this week tee’d up markets to expect higher infrastructure and transportation spending, which lifted steel and iron ore markets. Markets continue to tighten on the back of the Vale high-grade iron-ore supply losses, which could lift prices above $100/MT in the short term. Precious Metals: Neutral. Central banks continued buying gold in February, the World Gold Council reported this week. Central-bank holdings rose a net 51 tonnes in February bringing total additions to 90 tonnes in the first two months of the year. Agriculture: Underweight. The USDA lifted its estimate of global ending stocks for corn by 5.5mm tons for the 2018/19 crop year. With total use estimates unchanged at 1.13 billion tons, this raises ending stocks-to-use estimates, which will continue to exert downward pressure on prices. Feature KSA and Russia share a common feature in that both are petro states, and thus heavily dependent on crude and product exports to fund their governments and economies. Both suffered a near-death experience during the 2014-16 oil-market-share war launched by OPEC, and both have seen their GDPs slowly recover, following the successful production-cutting agreements they jointly engineered to drain excess inventories and restore balance to the market beginning in 2017 and renewed this year (Chart 2). Russia’s GDP gets more than twice the lift from higher Brent prices than KSA’s does. At first blush, it would be logical to assume KSA’s and Russia’s GDPs are driven by the same economic forces of oil supply and demand. In broad terms, they are. Both benefit from higher oil prices, given they are predominantly petro-economies, although Russia tends to benefit more as prices rise (Chart 3). In the post-GFC era, we find that a 1% increase in Brent prices lifts Russia’s GDP ~ 0.07%, while KSA’s goes up ~ 0.03%. Another way of saying this is Russia’s GDP gets more than twice the lift from higher Brent prices than KSA’s does. Chart 2KSA, Russia GDPs Recover, Following OPEC 2.0 Production Cuts KSA, Russia GDPs Recover, Following OPEC 2.0 Production Cuts KSA, Russia GDPs Recover, Following OPEC 2.0 Production Cuts Chart 3Russia Benefits More From Higher Brent Prices Russia Benefits More From Higher Brent Prices Russia Benefits More From Higher Brent Prices Looking a bit deeper into KSA’s and Russia’s GDPs’ sensitivities to Brent prices, we modeled income growth for both using our Brent forecast (Table 1), the futures markets’ forward curve and compare both to the World Bank’s expectation (Chart 4, bottom panel). KSA tends to benefit more from higher EM oil demand, with its GDP rising almost 1% for every 1% increase in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions Given our expectation for EM GDP growth (Chart of the Week), we expect KSA’s GDP to show relatively strong growth with GDP up ~ 5.4% this year and ~ 3.5% next year, propelled partly by higher oil prices (Chart 4, top panel). KSA tends to benefit more from higher EM oil demand, with its GDP rising almost 1% for every 1% increase in EM oil demand. Russia’s GDP goes up ~ 0.25% for every 1% increase in EM oil demand. We expect Russia’s GDP to dip then recover in 4Q19, then rise 3.5% by the end of 3Q20 before tapering off toward the end of 2020. This is not surprising given the trajectory for Brent prices in our forecasts and in the futures curves, and the sensitivity of Russia’s GDP to oil prices.We found a similar impact of EM oil demand on Russia and KSA GDPs when controlling for EM FX rates instead of Brent prices (Chart 5).3 Chart 4Higher Oil Prices Will Lift KSA's And Russia's GDPs Higher Oil Prices Will Lift KSA's And Russia's GDPs Higher Oil Prices Will Lift KSA's And Russia's GDPs Chart 5While KSA Benefits More From Higher EM Demand While KSA Benefits More From Higher EM Demand While KSA Benefits More From Higher EM Demand U.S. Waivers Dictate OPEC 2.0’s Decision On Production KSA has indicated it sees a need to extend OPEC 2.0’s production-cutting deal into 2H19, when the coalition’s ministers meet in June. Of late, Khalid al-Falih, KSA’s oil minister, is indicating no further cuts in the Kingdom’s output are needed, however. Russia’s a bit of a cipher. President Vladimir Putin this week stated Russia will continue to cooperate with KSA vis-à-vis managing production, although his energy minister, Alexander Novak, has indicated he sees no reason for extending OPEC 2.0’s production deal. Both sides are waiting on fundamental data, and the decision of the U.S. on its waivers on Iranian oil-export sanctions. There’s also the ever-likely collapse of Venezuela to consider, and renewed violence in Libya, both of which argue against letting the waivers expire. The Trump administration has no incentive to risk inducing an oil shock on the global economy. The countries granted waivers on U.S. sanctions against Iranian crude oil imports appear to be exercising their option to lift additional barrels, based on data showing loadings out of Iran increased for the fourth consecutive month (Chart 6 and Table 2).4 Loadings out of Iran rose to 1.30mm b/d in March, from 1.24mm b/d in February. Chart 6 Table 2Iran Exports By Country 2018-2019 (‘000 b/d) Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions Bottom Line: We continue to expect U.S. waivers on Iranian oil sanctions will be extended to year end in some form. The collapse of Venezuela and renewed violence in Libya show how tenuously balanced oil markets are at present. Going into a general election in the U.S. next year, the Trump administration has no incentive to risk inducing an oil shock on the global economy. When they meet in June, ministers from OPEC 2.0 member states will be ideally set up to respond to the Trump administration’s decision on waivers for Iranian oil imports, which expire May 2. We are closing our June 2019 $70 vs. $75/bbl call spread, as the position is close to expiry.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      In the post-GFC world, we find total EM oil demand rises ~ 0.4% for each 1% rise in EM commodity-importers’ GDP, while it only rises ~ 0.3% for each 1% rise in EM commodity exporters’ GDP, based on our modeling. According to World Banks’ constant 2010 USD series, EM commodity importers’ GDP represented 66% of total EM GDP in 2018, up from 56% in 2010. The EM income elasticity of oil demand has remained at roughly ~ 0.60 from 2000 to now, meaning a 1% increase in EM GDP – hence EM income – lifts oil demand by ~ 0.6%. This has been remarkably stable pre-GFC, post-GFC and from 2000 to now. 2      The new political economy of oil is a continuing theme in our research. For an extended discussion of this theme, please see “The New Political Economy of Oil,” and “OPEC 2.0: Oil’ Price Fulcrum,” published by BCA Research’s Commodity & Energy Strategy on February 21 and March 21, 2019. Both are available at ces.bcaresearch.com. 3      When using EM FX rates instead of Brent prices as an explanatory variable, we find KSA’s GDP still increases a little more than 1% for every 1% increase in EM oil demand, but Russia’s rises closer to 0.6%. NB: All GDP measures use historical World Bank data, and BCA Research estimates using the Bank’s projections in constant 2010 USD.  We proxy EM oil demand using non-OECD oil consumption.  KSA’s production is crude oil only, while Russia’s production is crude and liquids. 4      For a discussion of the waivers’ optionality, please see our BCA Research’s Commodity & Energy Strategy Weekly Report “OPEC 2.0: Oil’ Price Fulcrum,” published on March 21, 2019, 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

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Quarterly - April 2019 Quarterly - April 2019 Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Market Doesn't Believe The Fed's Target Market Doesn't Believe The Fed's Target Table 1Fed Won’t Be Able To Cut This Much Next Time Quarterly - April 2019 Quarterly - April 2019   Chart 2Financial Conditions Now Much Easier Financial Conditions Now Much Easier Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Housing Market Bottoming Out Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth Some "Green Shoots" For Global Growth Some "Green Shoots" For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Fed Still Below Neutral Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus Ex US Equities Driven By China Stimilus Ex US Equities Driven By China Stimilus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Oil, Positioning, And Housing Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Declining Quality In Investment Grade Declining Quality In Investment Grade Chart 11 Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound? A Value Rebound A Value Rebound Chart 14   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Watch Earnings Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Warming Up To The Euro Area Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Becoming Less Defensive Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Rates: Likely More Upside Risk Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers Favor Inflation Linkers Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit Tactical Upside Remains For Credit Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Prefer Oil, Watch Metals Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market The End Of The Dollar Bull Market The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Yield Curve Inversion Yield Curve Inversion Chart 27How Much Is China Reflating? How Much Is China Reflating? How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

A Catchup Phase For Oil Majors A Catchup Phase For Oil Majors Overweight Energy prices in 2019 have been bouncing off the recent lows touched at the end of 2018 when global markets melted down. It appears that fears over a global slowdown in energy demand have been replaced by a focus on reduced crude inventories that point to a tight market (bottom panel), aided in large part by OPEC supply cuts and reduced Iranian and Venezuelan production. Nevertheless, the S&P integrated oil & gas energy index has not kept pace with the underlying commodity as their historically tight correlation has broken down in recent years and the index has moved laterally (top panel). Still, relative forward earnings estimates in this sector, that has seen its cost base dramatically rationalized, have been gaining steam relative to the broad market (second panel). The current message from sell-side earnings revisions is that profits have fallen out of their year-end funk (third panel). Bottom Line: Stock prices in the heavyweight S&P integrated oil & gas energy subindex should catch up to the index’s earnings power, particularly if BCA’s Commodity & Energy Strategy service forecast of higher oil prices in 2019 plays out; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY.