Energy

Venezuela’s stability is deteriorating rapidly along the lines of our projections in recent years. Regime failure is at this point a high probability and poses immediate risks to global oil production. Our conviction is high because of the unprecedented combination of internal and external factors working against the regime: Economic collapse: Economic collapse has translated into total social collapse, as indicated by the large-scale emigration from the country (Chart 1). The current mass protests are the largest ever and are gaining momentum, while the opposition movement is coalescing into a single force against the regime as a whole for the first time. Political illegitimacy: What remained of the Maduro administration’s political legitimacy has eroded with his decision to ignore the results of the 2015 election and rig the election of 2018. The President of the National Assembly, Juan Guaidó, has declared himself President of the Republic based on an interpretation of the Venezuelan constitution and his leadership of the democratically elected National Assembly.1 International opposition: The erosion of Maduro’s legitimacy is reinforced by a rapidly changing international environment, with several countries becoming more assertive in opposing the regime. The United States and Colombia, on January 23, formally recognized Guaidó as president. They are joined by Canada and several other Latin American states, including Brazil, which is taking a more confrontational posture under the newly inaugurated President Jair Bolsonaro. This marks a rare coordination of North and South American states in pursuing a harder policy toward Venezuela. U.S. intervention: The United States, in particular, is taking a more interventionist stance through tighter sanctions. Indeed a limited U.S. military intervention is one of our top five geopolitical “Black Swans” for this year. Such an intervention could be further motivated by President Donald Trump’s need to distract from his domestic woes (Chart 2). His weak popular approval is comparable to that of President Ronald Reagan at this stage in Reagan’s first term, when he intervened in the small island state of Grenada. Venezuela is not Grenada, but the U.S. is also not considering outright invasion. Trump is facing a serious risk of becoming a “lame duck” due to the fall in his popularity amid the government shutdown and gridlock in Congress. A foreign policy response to a humanitarian crisis is an obvious way for him to try to increase his influence over the remainder of his term. Moreover, the U.S. diplomatic and defense establishment may agree on the need to reinforce the Monroe Doctrine against anti-democratic politics and growing Chinese (and Russian) influence in Venezuela. Chart 1 Chart 2Trump May Distract From His Woes Trump May Distract From His Woes Trump May Distract From His Woes What remains is to see whether the U.S. adds force (tougher sanctions) to its more aggressive diplomatic posture, and whether the Venezuelan opposition remains mobilized and unified in rejecting anything except a transition to a new government. The U.S. is already considering expanding sanctions, including a likely deathblow that would involve sanctioning Venezuelan oil imports and the export of diluents necessary to process Venezuela’s heavy sour crude. Within Venezuela, the opposition’s momentum and the role of the National Bolivarian Armed Forces will be decisive: so far there are small signs of fracture (Table 1), but no sign of a substantial turn against the Maduro regime.Sufficient popular pressure can create a “tipping point,” however, after which the military and security forces are no longer effective in executing the government’s writ and the socio-political situation declines beyond the ability of the regime to stay in power. Persistent large-scale protests concentrating on Maduro’s departure and/or a split in the security forces could precipitate the final stage of transition to a new interim government in the short to medium term. Table 1Military Insurgencies Have Been Small And Unsuccessful … So Far Venezuelan Production Near Collapse Venezuelan Production Near Collapse Impact On The Oil Market In this context, we are raising the likelihood of a collapse of that state to an 80% probability, from our prior assessment (33%). We use the word “collapse” to stand for Venezuela’s production falling to 250k b/d to feed domestic refineries, from ~ 1mm b/d at present. In our simulation of how a collapse could affect oil prices, we make the following assumptions based on recent history – i.e., the run-up to the re-imposition of U.S. sanctions against Iranian oil exports. These assumptions are driven by our prior belief that the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which we’ve dubbed OPEC 2.0, and the Trump administration will attempt to hold Brent crude oil prices at or below $80/bbl in the event of a collapse in Venezuela’s oil production. Here are our assumptions: Venezuela collapses next month; OPEC 2.0 responds with a one-month lag, and increases production by 500k b/d in March 2019. If Brent spot prices trade to $85/bbl, OPEC 2.0 raises production an additional 100k b/d. If prices continue to rise toward $100/bbl, OPEC 2.0 adds another 300k b/d to global supply. Further increases lead to the U.S. Strategic Petroleum Reserve (SPR) releasing 100k b/d as needed to reduce Brent prices to $80/bbl or less. If spot Brent prices rise toward $100/bbl, we assume there will be 200k b/d of demand destruction globally. Chart 3 shows how Brent and WTI prices would evolve per these assumptions. Because Venezuela’s production has fallen so much, we believe the collapse of that country’s oil industry can be managed by OPEC 2.0, and, if necessary, via U.S. SPR releases. Of course, a similar trajectory likely would occur in the event Venezuela’s oil industry collapses later.2 Chart 3A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses In our simulation, the Brent spot price trades to $85/bbl in December 2019, and OPEC 2.0 adds an additional 100k b/d to global supply. Prices continue to rise, and we assume OPEC 2.0 member states release a combined 300k b/d in March 2020. The U.S. release 100k b/d of SPR in 2020. In addition, we do see demand destruction of 200k b/d in 2020, as prices reach close to $100/bbl. With all of this, prices are contained and start decreasing in mid-2020. Of course, whether these surges can be maintained indefinitely – i.e., until Venezuela comes back on line, or comparable crude grades can be shipped south from Canada – is an open question. Even so, there is no doubt that the leaders of OPEC 2.0 silenced more than a few critics by means of their 4Q18 production surge. KSA stands out in this regard, taking its November 2018 production over 11mm b/d from ~ 10mm b/d in 1H18 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Venezuelan Production Near Collapse Venezuelan Production Near Collapse As a practical matter, we have no way of knowing how OPEC 2.0 or the U.S. SPR would respond to a collapse in Venezuela’s oil industry. In these simulations, we’re making a call on how and when OPEC 2.0 might choose to release its spare capacity once again, as they did in the run-up to the U.S.’s Iran oil export sanctions last year (Chart 4). Chart 4 As the members of OPEC 2.0 – mostly KSA, when it’s all said and done – dig deeper into spare capacity, less is available to meet another unplanned outage – e.g., Libya or Nigeria lose significant barrels to civil unrest. That is, we are sure, a discussion OPEC 2.0 is and will be having among its members, and with the U.S. SPR. The global oil market still is exposed to a sharp loss of Iranian barrels on top of the loss of Venezuela’s supplies in the event that country’s oil industry collapses. This argues strongly for an extension of the waivers granted by the Trump administration in November for anywhere from 90 to 180 days, depending on how the Venezuela situation evolves. These waivers expire at the end of May. This would require us to change our balances assessment, should it occur.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1 Please see Articles 233, 333, 350 of the Venezuelan constitution. The domestic and international legal debate is beside the point: the effective power of the people, the security forces, and the international community will determine the outcome. 2 For more information on global supply and demand balances, and our most recent oil price forecasts, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy today. It is available at ces.bcaresearch.com.  

OPEC 2.0 is building physical optionality, to deal with different possible moves the U.S. can make on Iranian oil export sanctions and waivers. This comes despite an apparent break in the sense of urgency Saudi Arabia and Russia feel re production cuts. The coalition’s market monitoring committee meets in April, followed by a full gathering in May, when U.S. waivers expire. If the U.S. extends waivers, OPEC 2.0 can extend production cuts; if it doesn’t, it can add supply as needed.1 On the demand side, markets appear to be overly concerned about a sharper-than-expected slowdown in China, which, if borne out, would restrain EM growth. We believe these fears are overdone, and expect a slight improvement in EM demand generally this year and next. In our new balances estimates, we see the OECD commercial oil inventory overhang clearing in 1H19, on the back of resilient demand, OPEC 2.0 discipline, and a more moderate level of growth in U.S. shale oil output. This keeps Brent on track to average $80/bbl this year and $85/bbl next year, with WTI trading $74/bbl this year, and $82/bbl next year. Highlights Energy: Overweight. Mandatory cuts of 325k b/d, coupled with additional exports of ~ 190k b/d due to additional train and pipeline capacity out of Canada, will drain the 35mm barrels of excess crude oil inventories targeted by the Alberta government in December by 1H19. The WCS – WTI spread narrowed to -$10/bbl from -$50/bbl on these mandatory cuts. By 2H19, we expect Canadian production cuts to average 95k b/d. Base Metals: Neutral. Aluminum output in China surged 11.3% y/y in December, hitting 3.05mm MT, according to Metal Bulletin. Total output for 2018 was 35.8mm MT, a 7.4% y/y increase. Precious Metals: Neutral. Gold is holding its recent gains, as markets become more comfortable with the Fed pausing on its rates-normalization policy until 2H19. Agriculture: Underweight. Hot and dry weather in Brazil is threatening crop yields there. The unfavorable weather is expected to affect three-quarters of cotton-growing regions, half of sugar areas, a third of first-crop corn acreage, and a quarter of soy regions. Feature The first signs of fraying in the relationship between the putative leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA), which cut production ~ 450k b/d m/m in December, and Russia, which raised output – are emerging, as world leaders meet in Davos. While this casts doubt on the leadership’s carefully cultivated amity, and their shared willingness to abide by the recently agreed output cuts, we do not believe it signals the end of the historic cooperation between these states. Total OPEC output – estimated by production-tracking sources outside the Cartel – stood at 31.6mm b/d in December, a prodigious 751k b/d reduction m/m. We expect continued oil production cuts from core OPEC states and decline-curve losses among non-Gulf OPEC and non-OPEC states within the coalition this year to remove at least 1.2mm b/d from the market, per the quotas agreed by members in December (Chart of the Week, Table 1). On top of this, mandatory Canadian production cuts of 325k b/d in 1H19 and 95k b/d in 2H19 will keep average production cuts at ~ 1.4mm b/d this year. Chart of the WeekOPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts Table 1OPEC 2.0 Production Cuts Could Exceed Quotas OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC 2.0’s cuts could persist into 2020, depending on how the U.S. deals with Iranian oil-export sanctions and waivers. Even though KSA and Russia apparently do not share the same sense of urgency re production cuts right now, we believe OPEC 2.0 is committed to draining oil inventories, particularly in the OECD.2 To do so, they’re increasing their operational flexibility – creating physical options, in a manner of speaking – to deal with a range of uncertain outcomes when U.S. waivers on Iranian export sanctions expire in May. Sanctions And OPEC 2.0’s Physical Options Despite the waivers granted to its eight top consumers shortly after U.S. sanctions took effect in November, Iranian exports plunged below 0.5mm b/d in December. As of December, China had substituted almost all of its Iranian imports for alternative barrels.3 This coincided with a production surge by OPEC 2.0 at the behest of the U.S. leading up to the November sanctions deadline of November 4, 2018, which swelled OECD inventories and took them above their rolling 5-year average level (Chart 2). India retained 30% of its May import levels from Iran, while Europe complied at 100% with U.S. sanctions (Table 2). Chart 3 shows the decrease in exports in preparation for the sanctions over the course of 2018. Chart 2OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In Table 2Iran Exports By Destination 2018 (‘000 b/d) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Chart 3 Whether or not the waivers are extended is anyone’s guess. It is possible waivers will be extended for 90 or 180 days, as a way to counter OPEC 2.0 production cuts, and to offset the lag between filling new pipeline takeaway capacity in the Permian. We expect importers to queue up for Iranian barrels as the market tightens in 1H19. OPEC 2.0’s market monitoring committee will meet in April, followed by a ministerial meeting in May, just ahead of the expiration of the waivers.4 If the U.S. extends them, OPEC 2.0 can extend production cuts after it meets in May; if waivers are not extended, the Cartel can calibrate an appropriate supply response. Either way, we expect OPEC 2.0 will closely align its production schedule with any U.S. action on the sanctions and waivers. This will, we believe, keep change in the overall market’s supply side relatively constant, except for the month or two required to adjust OPEC 2.0 output. Permian Will Drive OPEC 2.0 Policy The larger issue for OPEC 2.0 comes in 4Q19, when ~ 2mm b/d of new pipeline takeaway capacity comes on line in the Permian Basin in West Texas. With additional takeaway capacity due to come on in 2020, the Cartel will have its work cut out for it next year.5 Our models show a slight decrease then flattening in U.S. rig counts over the coming months, as a result of the 4Q18 sell-off in WTI, with a rebound around mid-year (Chart 4). This is because rig count lags oil prices by ~4 months. Chart 4U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) We are expecting production in the Big 5 shale basins to average 8.4mm b/d in 2019 and 9.0mm b/d next year, a somewhat higher level than projected by the EIA. Growth in the shales accounts for close to 80% of the 2.3mm b/d of growth in the U.S. over 2019 – 2020. Globally, U.S. shales will continue to provide the bulk of y/y crude oil production growth, accounting for 73% of the 2.5mm b/d of growth we will see over the next two years. Given the near-death experience OPEC 2.0 member states had in the price collapse of 2014 – 2016, we remain convinced OPEC 2.0 member states will once again have to embark on a strategy to backwardate the Brent forward curve as they did in 1H18, to moderate the growth of shale-oil production in the U.S. (Chart 5). Reducing production in the short term will force refiners to draw inventories to supply their units and produce products like gasoline, diesel, jet fuel and a wide range of petrochemicals. Chart 5OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards This will backwardate the Brent forward curve – i.e., prompt-delivery barrels will be more expensive than deferred-delivery barrels. A backwardated forward curve means OPEC 2.0 member states with term contracts indexed to spot prices receive higher prices for their oil than shale producers hedging 2 years forward, all else equal. The trick for OPEC 2.0 will be to keep the Brent forwards backwardated when the Permian takeaway capacity starts to fill, and exports from the U.S. rise in the early 2020s, as deep-water harbors are brought on line. If OPEC 2.0 is successful in keeping the Brent forwards in backwardation, this will, over time, moderate the growth of shale production: Hedgers’ revenue is constrained by lower forward prices.6 We would not be surprised if OPEC 2.0 states started announcing final investment decisions on select investments in spare capacity to augment existing resources, so they are able to quickly bring production to market in the event of unplanned outages that could lift the entire forward curve and incentivize hedging at higher prices. Demand Still Looks Good Oil markets continue to fret over a possible hard landing in China – resulting either from an internal policy error or a ratcheting up of tensions in the Sino – U.S. trade war. This is causing markets to extrapolate into the wider EM space, and take oil-demand projections lower on an almost-daily basis. In a word, markets are overwrought. Chinese policymakers are sensitive to the tight financial conditions that prevailed in 2H18, which, along with the trade war with the U.S., slowed growth and fostered uncertainty among households and firms in China. We agree with our Geopolitical Strategy and China Investment Strategy groups that presidents Trump and Xi are pragmatists dealing with restive populations, and want to deliver a deal ahead of U.S. elections and the 100th anniversary of the founding of the Chinese Communist Party in 2021.7 We’ve been expecting the government to deploy a modest amount of stimulus in 1H19, which will begin having an effect on the Chinese economy in the second half of this year. Toward the end of the year and into 2020, we expect the larger stimulus to be deployed in the run-up to put a bid under industrial commodities – oil, base metals and bulks in particular. Overall, we are seeing signs global growth may be reviving over the next few months via an apparent bottoming in our Global LEI Diffusion index (Chart 6). The diffusion index measures the proportion of countries where Leading Economic Indicators (LEIs) are rising relative to those in which LEIs are falling. As is apparent in Chart 6, the diffusion index suggests the downturn in the global LEI has bottomed. The index leads the global LEI by a few months. Chart 6BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming In our latest supply-demand balances, we are expecting Chinese oil demand to average 14.3mm b/d this year, and 14.8mm b/d next year. Along with India – expected to consume 5.0mm b/d this year, and 5.2mm b/d next year – these two states account for 36% of the total 54.3mm b/d of EM demand we expect in 2019 and 2020 (Table 3).8 Table 3BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Overall EM demand, the powerhouse of global oil-demand growth led by China and India, is expected to increase 1.1mm b/d this year – slightly more than we estimated last month – and 1.3mm b/d in 2020. DM demand growth, as always, comes in lower, at 390k b/d this year and 280k b/d next year. Oil Supply-Demand Balances Will Tighten We expect global oil production to average 100.9mm b/d this year and 102.9mm b/d in 2020. Consumption is expected to average 101.8mm b/d this year and 103.4mm b/d next year, respectively (Chart 7). This puts OECD inventories back on a downward trajectory, as storage draws resume (Chart 2). Chart 7Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening On the back of these estimates, we expect Brent to average $80/bbl this year and $85/bbl next year, with WTI averaging $74/bbl and $82/bbl, respectively. Given our expectation for higher prices in Brent and WTI, we continue to favor being long crude oil exposure. We are long outright WTI spot futures; long July 2019 Brent vs. short July 2020 Brent; long call spreads along the 2019 forward Brent curve, and long the S&P GSCI. Bottom Line: Markets will continue to tighten as a combination of lower supply growth and rising consumption allows OECD commercial oil inventories to resume their downward trajectory. The apparent lack of a shared sense of urgency by OPEC 2.0’s leaders – KSA and Russia – will be resolved, in our view. OPEC 2.0 will once again focus on backwardating the Brent forward curve, in order to gain some control over the rate at which U.S. shale oil production grows. We continue to favor long exposures to the crude oil futures.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      In last week’s Commodity & Energy Strategy we noted these upcoming meetings, and OPEC 2.0’s resolve to drain the market.  Please see “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. 2      Bloomberg reported this week KSA’s and Russia’s oil ministers cancelled a planned meeting in Davos, following al-Falih’s criticism of the pace at which Russian oil production is being cut.  Please see “Saudi, Russian Energy Ministers Cancel Planned Davos Meeting,” published by bloomberg.com January 22, 2019.  KSA cut its crude oil output 450k b/d m/m in December to 10.64mm b/d from 11.09mm b/d in November.  Russia increased crude and liquids production to a record 11.65mm b/d in December, an 80k b/d increase m/m, according to OPEC Monthly Oil Market Report published January 17, 2019.  OPEC expects Russian oil output to average 11.47mm b/d in 1H19, and 11.49mm b/d in 2019.  We are carrying something close to this in our balances (11.51mm b/d) for 2019 and 2020. 3      China imported 10.3mm b/d of crude oil in December after posting a record 10.4mm b/d of imports in November 2018, just as sanctions were kicking in. 4      In our base case estimate, we assume Iran’s crude oil output will average ~ 2.8mm b/d, down ~ 1.0mm b/d from its 3.8mm b/d production level in 1H18, which was prior to the U.S.’s announcement it intended to re-impose export sanctions.  One way or another, we expect OPEC 2.0 to adjust production to compensate for whatever production is lost due to sanctions.  5      Please see “Permian tracker: Production growth slowing as pipeline race still on,” published by S&P Global Platts July 2, 2018, for a discussion of the new takeaway capacity planned for the Permian Basin by midstream companies in 2019 and 2020. 6      The Permian basin is closely tied to hedging activity in the WTI futures market.  It is the only basin for which WTI commercial short open interest is an explanatory variable for rig counts in our modeling.  Commercial short open interest in the WTI futures also Granger causes Permian rig counts. 7      Please see the Special Report entitled “Is China Already Isolated,” published by BCA Research’s Geopolitical Strategy and China Investment Strategy January 23, 2019.  It is available at gps.bcaresearch.com and cis.bcaresearch.com. 8      Our EM demand assumptions are driven by the IMF and World Bank EM GDP forecasts. This week the IMF lowered its global growth forecast for 2019 and 2020 by 0.2 and 0.1 percentage points to 3.5% and 3.6%, respectively. This is only slightly down from our lower estimate last month, but still above the World Bank’s expectation. We are using these variables directly in regressions to estimate prices and EM consumption. This replaced our earlier income-elasticity models used to calculate EM oil consumption.  We proxy EM demand with non-OECD oil consumption. We discuss this in “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4q18 Image Commodity Prices and Plays Reference Table Insert table images here Summary Of Trades Closed In 2018 Image

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Chart 1 Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring ...Sending Multiples Soaring ...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... A Utilities Proxy No More... A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead ...An Energy Proxy Instead ...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7). Chart 7   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations... Cheap Valuations... Cheap Valuations...   Chart 10...Amid Recovering Profit Margins ...Amid Recovering Profit Margins ...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Chart 11 Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe MLPs: Not Your Typical Yield Play MLPs: Not Your Typical Yield Play Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale. Chart 13   Chart 14   Chart 15 Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

The Fed’s near-term capitulation on its rates-normalization policy highlighted by our fixed-income desks will provide a tailwind for EM oil demand this year by weakening the USD. This will reduce refined-products’ costs in local-currency terms ex-U.S., as it buoys EM growth prospects.1 If, as we expect, Chinese policymakers also deploy modest stimulus, global oil demand still will remain on track to grow 1.4mm b/d this year, per our forecast. We are mindful of potential upside surprises on the demand side, particularly, if, as we noted in our last balances update, the 100th anniversary of the Chinese Communist Party in 2021 provokes policymakers to deploy large-scale stimulus in 2H19 or 2020.2 The odds of this occurring before 2H19 are low, and we are not yet raising our demand estimates. A partial defusing of the Sino – U.S. trade war is possible, as the 90-day negotiating window agreed at the December G20 meeting starts to close next month. This could trigger a short-term rally in commodities, but, absent durable agreements on the technology front, this potential thawing will be transitory. Highlights Energy: Overweight. China’s crude oil imports surged 30% y/y in December 2018, which helped lift total 2018 imports by 10% vs. 2017 levels. This partly was the result of independent refiners scrambling to use up 2018 import quotas at year-end, so that they could retain those levels this year, according to S&P Global’s Platts.3 Base Metals: Neutral. China’s copper ore and concentrate imports were down 11.5% y/y in December – the largest y/y decline since May 2017 – in line with slowing growth there. Precious Metals: Neutral. We expect gold to continue to rally over the next 3 – 6 months on the back of a weaker USD in 1H19, as the Fed likely pauses on its rate-hiking schedule. Ags/Softs: Underweight. Grains likely will get a short-term price lift as the Fed dials back its rates-normalization policy. Feature For the moment, the Fed’s apparent capitulation on its rates-normalization policy reduces the risk the U.S. central bank will err on the side of being overly aggressive, which would have thrown a spanner into EM growth prospects this year. An easier Fed monetary policy will buoy EM GDP and weaken the USD over the short term, which will, support oil prices via stronger demand (Chart of the Week). Chart of the WeekEM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track On the supply side, we remain convinced OPEC 2.0 is resolved to drain the global inventory overhang as quickly as possible. This unintended inventory accumulation resulted from OPEC 2.0’s production surge and the granting of waivers on U.S. export sanctions against Iran by the Trump administration in November (Chart 2). This conviction was strengthened earlier this week, following the announcement of a proposed earlier-than-expected meeting of the coalition’s market monitoring committee in Baku, Azerbaijan, in mid-March to assess global supply and demand conditions. This could be followed by a full OPEC 2.0 meeting in Vienna in mid-April, following up on their December meeting in Vienna, according to S&P Global Platts.4 Chart 2OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang Pieces Of The Price Puzzle Falling Into Place The Fed is signaling it has put its rates normalization policy on hold, given indications global economic growth is slowing in a manner similar to what occurred in 2014 – 15. Then, the U.S. central bank was attempting to escape the zero lower bound of its monetary policy, following the end of its QE program. In the event, the Fed only raised rates once in December 2015, as the slowdown in growth stayed its hand. Our colleagues at BCA’s Global Fixed Income Strategy note, “the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) … reached levels last seen after that 2014/15 episode” as 2019 unfolded (Chart 3).5 The slowdown in global growth could stabilize, as the LEI diffusion index suggests, but the Fed, at least for now, appears to be comfortable waiting for clear evidence this is the case. Chart 3Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint In and of itself, the Fed’s near-term capitulation to the market will not be sufficient to reverse the “darkening prospects” foreseen by the World Bank in its most recent forecast, but it will be supportive of oil prices.6 On the back of our expectation the Fed will take a break from its rate-normalization, we are expecting a weaker USD over the short term, which will support oil demand and EM GDP growth. All else equal, this will create a tailwind for oil prices, given EM is the main driver of demand growth (Chart 4). Chart 4USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices The Chart of the Week introduces a new model we developed to understand the effect of EM GDP growth on oil prices. The level of EM demand is mean reverting to a linear trend, and anchors other variables – oil prices and FX rates, for example – that oscillate randomly with the arrival of new information to the market. Our modeling indicates Brent and WTI prices can be expected to increase (decrease) 94bp and 73bp for every 1 percent increase (decrease) in EM GDP, assuming the broad trade-weighted index (TWIB) for the USD remains unchanged. A 1 percent decrease (increase) in the USD TWIB (holding EM GDP constant) translates into an increase (decrease) in Brent and WTI prices of ~ 4.0% and 3.6%, respectively. We have found EM GDP levels to be as useful an explanatory variable for Brent and WTI prices as non-OECD oil consumption, our proxy for EM demand. Indeed, it is perhaps even cleaner, since using it directly in our models does not require us to estimate an income elasticity of demand for EM economies, in order to forecast prices.7 We are not raising our expectation for demand growth on the back of the Fed’s apparent moderation in its rates policy. We are keeping our 2019 demand growth estimate at 1.4mm b/d, with 1.0mm b/d of that coming from EM and the remainder from DM. Should the Fed signal a further pause in its rates-normalization policy – extending perhaps deep into 2H19 – we would be inclined to raise our demand-growth estimates. Additional Stimulus Coming From China? China is not the be-all and end-all of EM growth. All the same, next to the U.S., it is the second-largest consumer in the world, accounting for ~ 14% of the 103.75mm b/d of global demand we expect this year. Next in line is India, which accounts for ~ 5% of global demand. The news coming out of China at the moment is confusing. While the Xi administration prosecutes its “Three Tough Battles” – i.e., deleveraging, pollution and poverty – it also is pulling policy levers to counter the economic damage inflicted by its trade war with the U.S.8 Government policymakers are signaling fiscal and monetary stimulus will be forthcoming via tax cuts and bond issuance this year, to counter these headwinds.9 However, we do not expect a massive deployment of stimulus. More than likely, the big stimulative measures arrive in 2H19 or next year. The key target dates for policymakers are further in the future, and are focused on the upcoming 100th Anniversary of the Communist Party in 2021. By 2020, the Xi administration is targeting a doubling of real GDP vs. 2010 levels, and a doubling of rural and urban incomes (Chart 5). Chart 5China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" So the real stimulus out of China likely comes later this year or next year. As our Geopolitical Strategy service notes: “If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021.” There is, as we noted in our last balances update, a low-probability chance stimulus could surprise to the upside if growth – particularly employment – falls precipitously. For now, we are comfortable with our House view that the more extensive fiscal and monetary stimulus will be saved for later this year or next in the run-up to the Communist Party’s anniversary.10 Bottom Line: The Fed appears to have capitulated to markets in the short term, and likely will hold off on another rate hike in 1H19. All else equal, this will weaken the USD and buoy EM GDP over the short term. Together, these effects will keep oil demand on track to growth 1.4mm b/d, per our forecast. Markets are reacting to news of fiscal and monetary stimulus coming out of China. We have been expecting modest stimulus to be deployed this year, most likely in 2H19. We continue to expect a larger package of fiscal and monetary stimulus later in the year and next year in the run-up to the Communist Party’s 100th anniversary.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see “Enough With the Gloom: Upgrade Global Corporates On A Tactical Basis,” published January 15, 2019, by BCA Research’s Global Fixed Income Strategy. It is available at gfis.bcaresearch.com. See also “Buy Corporate Credit,” published by BCA’s U.S. Bond Strategy January 15, 2019. It is available at usbs.bcaresearch.com. 2      Please see “Oil Volatility Will Persist; 2019 Brent Forecast Lowered to $80/bbl,” published January 3, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see “China’s 2018 crude oil imports rise 10% to 9.28 mil b/d,” published by S&P Global Platts January 14, 2019, online. 4      OPEC 2.0 ministerial meetings usually are held in May/June and again November/December. Please see “OPEC eyes mid-March monitoring committee meeting, mid-April full ministerial,” published by S&P Platts Global January 14, 2019. The cartel also will meet in early February to put the finishing touches on a charter formalizing the coalition. We will be delving deeper into the supply side next week, when we update our balances. 5      Please see footnote 1 above. 6      The World Bank’s most recent forecast can be found in its Global Economic Prospects, published January 8, 2019. The lead article is entitled “Darkening Skies.” 7      We use forecasts of EM GDP and GDP growth published by the World Bank and IMF in our modeling. This is useful for us for a number of reasons, particularly since it is calculated externally by well-regarded global institutions tasked with this function. Like other estimates and projections – e.g., the EIA’s, IEA’s and OPEC’s supply/demand estimates – we can take a view on these data relative to our House view or our own Commodity & Energy Strategy view. NB: Because these are cointegrated systems, regressions in levels is appropriate. 8      This campaign is discussed in depth in “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 9      Please see “China signals more stimulus as economic slowdown deepens,” published by uk.reuters.com January 15, 2019. 10     Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018 Image

The oil rout that began in October appears to have run its course, based on positioning, sentiment and technicals. All the same, several cross-market gauges we designed to assess investors’ conviction on global macro conditions continue to support a cautious view over the short term. This dichotomy in the markets’ internal dynamics supports our view volatility will remain elevated over the next month or two. After that, we expect clear evidence the global oil market is tightening, as strong OPEC 2.0 compliance with production cuts and robust demand – albeit weaker than that of the past two years – drains inventories in 1H19. This is the basis of our $80/bbl Brent forecast for this year. Highlights Energy: Overweight. Our oil recommendations made last week in the wake of the oil-price vs. fundamentals disconnect – long spot WTI and long July 2019 Brent vs. short July 2020 Brent spread – are up 5.7% and 0.7%. Base Metals: Neutral. Asia trade-volume growth likely will move lower in the short term, even if Sino – U.S. trade talks are fruitful. With or without such an outcome, precautionary inventories built on both sides will have to be drawn down, an outcome we believe is priced into base metals prices. A rapprochement would be supportive for these markets, but these inventories still have to be worked through. Precious Metals: Neutral. Gold’s rally is intact, as markets gain conviction the Fed will deliver one rate hike this year. We are aligned with our House view calling for three hikes, which would present a headwind. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Insiders report China made three large purchases of soybeans from the U.S. over the past month, as trade negotiators met in Beijing this week. Optimism on the trade front is buoying optimism in ag markets.1 Feature The rout in oil prices over the course of 4Q18 appears to have run its course, based on a composite indicator we created to assess technical and sentiment information in the crude oil market, and other metrics designed to gauge internal market dynamics (Chart of the Week). Chart of the WeekBCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude The individual components of the composite at the end of last year all had taken a sharp down leg, indicating investors were seriously concerned about a global slowdown and perhaps even an unexpectedly early recession (Chart 2).2 This concern also was noted by the World Bank, which this week revised its EM growth outlook – the key driver of commodity demand – for 2018 lower, and shaved its global 2019 growth estimate as well.3 Chart 2Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Ordinarily, there is not a lot of econometric support for technical indicators. Nonetheless, we found this composite indicator does a good job of explaining y/y changes of Brent crude oil prices, and vice versa. That’s right: there is two-way Granger-causality between the BCA WTI Composite indicator and y/y crude prices (Chart 3).4 Chart 3Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Given this two-way relationship, it is plausible speculative positioning, investor sentiment and price momentum can help forecast short-term price movements. In turn, the movement in prices feeds back to the components of our composite indicator, and can help anticipate positioning, sentiment and momentum. Indeed, it is likely the fundamental supply-side shock arising from the higher-than-expected waivers on Iranian imports granted by the Trump administration in November – separate and apart from the selling pressure in October – set off one of these feedback loops. Given the paucity of data at the time, market participants had to guess the extent of the physical surplus arising from the waivers as OPEC 2.0 rapidly increased production and filled inventories ahead of U.S. sanctions, and at the same time fears over the strength of demand were becoming more pronounced.5 As we noted last week, we do not think the oil price rout was evidence of an as-yet undetected collapse in demand or run-away supply. OPEC 2.0 and Canadian producers will cut ~ 1.4mm b/d of production; decline-curve losses of ~ 200k b/d from states that cannot maintain or increase their supply will persist, and slower U.S. shale growth resulting from price-induced capex declines will reduce output growth there. These supply cuts, plus still-strong demand growth of 1.4mm b/d, are driving our forecast the physical oil overhang will clear in 1H19, and that Brent prices will average $80/bbl this year, with WTI trading $6/bbl below that.6 Based on the most recent “oversold” reading of the BCA WTI Composite indicator, we believe the oil rout has run its course, given the indicator is in deeply oversold territory. By now, we think the negative sentiment and spec positioning components of prices have been exhausted. Unless we see a fundamental shock – a truly unexpected collapse in demand, e.g., or a complete breakdown in OPEC 2.0 production discipline – it is difficult to foresee another sell-off.  As the uncertainty clears and inventory starts to draw, speculators will re-enter the market (allowing producers to hedge), and sentiment will turn more bullish as visible evidence of lower inventories continues to be reported in weekly and monthly data. Some Indicators Still Urge Caution While the case can be made the oil rout has run its course, there still are cautionary signals flashing in our other indicators that assess internal market dynamics within and across EM and commodities. This likely will keep volatility high over the short term (Chart 4). Chart 4Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated BCA’s Emerging Market strategists’ Risk-on vs. Safe-Haven currency ratio has rolled over. This ratio picked up the degradation of demand expectations and rise in recession fears, which then spilled into global bond yields. With the benefit of hindsight, the case can be made this presaged a rise in global risk aversion in currency markets (Chart 5).7 Chart 5Warning Signs Flashing bca.ces_wr_2019_01_10_c5 bca.ces_wr_2019_01_10_c5 In addition, our gold ratios, which serve as growth-versus-safe-haven indicators – i.e., the copper/gold and oil/gold ratios – sagged, as industrial commodities weakened and gold rallied by 7% since November 2018.8 Together, these indicate markets were revising down their growth expectations, and reducing their risk in 4Q18. Even with the recent pick up in EM trade volume – a proxy for EM income growth – our short-term models suggest this likely will not be sustained, and that import volume growth will contract in 2H19 (Chart 6). Chart 6Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Our EM trade-volume models are driven by the broad trade-weighted USD (TWIB) and other FX and financial variables.9 The USD had been rallying as the U.S. domestic economy outperformed the rest of the world, and markets remained concerned over the Fed’s rates-normalization policy, which was pressuring expectations for EM trade growth lower. With the oil-price collapse of 4Q18 in the rear-view mirror, it is not inconceivable the Fed will not feel compelled to raise rates in 1H19, as inflation expectations are re-calibrated in the wake of this most important expectations driver. If this takes some of the steam out of the USD, or even causes it to retreat from its recent highs, oil – and commodities generally – will rally on the tailwind. Indeed, a depreciation in the USD of 5% from current levels could lift prices by ~18%, holding everything else constant (Chart 7). Chart 7USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance Bottom Line: Our intra- and inter-market indicators are throwing off conflicting signals regarding the current state of global oil markets. On the one hand, our WTI Composite indicator shows oil is oversold, which supports our bullish outlook. On the other hand, markets currently are signaling a larger decline in global growth than we currently have in our oil forecast models. A larger-than-expected slowdown in oil demand growth – e.g., an additional loss of 200k b/d that took growth to 1.2mm b/d – would push our Brent forecasts down by ~ $4/bbl to $76/bbl this year. Nevertheless, uncertainty about the future path of oil supply and demand is elevated, and the distribution of possible price outcomes is wide, as our most recent forecast illustrates (Chart 8). We believe the combination of OPEC 2.0 production discipline and robust demand support a rebound in oil prices in 2019. We are keeping our 2019 Brent price target at $80/bbl. Chart 8Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “China buys more U.S. soy as officials meet for trade talks,” published by reuters.com January 7, 2019.com. 2      Each of the individual components is standardized to create the WTI composite indicator. We lack CFTC open-interest data to update the open-interest series, due to the U.S. government’s shutdown. 3      This is in line with our expectation, which is contained in our most recent balances and forecast update published last week.  Please see “Oil Volatility will Persist; 2019 Brent Forecast Lowered to $80/bbl.”  It is available at ces.bcaresearch.com.  The World Bank’s latest forecast can be found in its Global Economic Prospects, which is titled “Darkening Skies.”  It can be found at http://www.worldbank.org/en/publication/global-economic-prospects. 4      Clive Granger used standard statistics to show information contained in past realizations of one variable can be used to predict another variable’s value. Two-way causality indicates lagged values of both variables contain statistically significant information that allows past realizations of both to be used to predict the other’s value.  There is a huge literature on this topic.  For an excellent intuitive explanation of Granger causality, please see the discussion beginning on p. 365 of “Time Series Analysis, Cointegration, and Applications,” Clive Granger’s Nobel lecture delivered December 8, 2003 (https://www.nobelprize.org/uploads/2018/06/granger-lecture.pdf). 5      Please see “All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  It is available at ces.bcaresearch.com. 6      We would not be at all surprised if OPEC 2.0 overdelivered on production cuts, as it did in 2017 – 1H18. 7      Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 8      These gold ratios are discussed in detail in “Gold Ratios Wave Off ‘Red October’ … Iran Export Waivers Highlight Tight Market,” published by BCA Research’s Commodity & Energy Strategy November 8, 2018.  It is available at ces.bcaresearch.com. 9      For in-depth discussions of these models and our general approach to modeling EM trade volumes, please see “Trade, Dollars, Oil & Metals … Assessing Downside Risk,” published by BCA Research’s Commodity & Energy Strategy August 23, 2018.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2018 Image ​​​​​​​

Getting right to the point: Oil fundamentals are, and could remain, disconnected from benchmark prices, as they were in the waning days of 2018, when markets were forced to recalibrate global supply-demand balances in the dark. Four factors will drive this disconnect and keep volatility elevated (Chart of the Week): Chart of the WeekPrice-Fundamentals Disconnect Will Persist Price-Fundamentals Disconnect Will Persist Price-Fundamentals Disconnect Will Persist Continuing uncertainty over how much oil Iran will export this year; A lack of precise information about individual production cuts from OPEC 2.0; Uncertainty over EM demand; and Illiquid markets, brought about by a diminution of speculators’ risk-bearing capacity, which is largely the result of the price-fundamentals disconnect. Nonetheless, we do not believe markets are responding to an as-yet undetected collapse in demand or run-away supply, which recent price action would suggest. To the contrary, we expect OPEC 2.0 and Canadian production cuts of ~ 1.4mm b/d, continued decline-curve losses and slower U.S. shale growth resulting from price-induced capex declines, will face off against stout demand to rebalance markets in 1H19. We are, therefore, getting long spot WTI, and long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close. Highlights Energy: Overweight. We ended 2018 with an average gain of 24% on recommendations we closed or were stopped out of. Open positions going into 2019 – mostly Brent call spreads with stop-losses of -$1.00/bbl – were down 49%. Base Metals: Neutral. Chile’s national statistics agency INE reported copper output was 5.3mm MT over the January – November 2018 period, its highest level since December 2005, and 6% higher than year-ago levels.1 Precious Metals: Neutral. Gold markets appear to be pricing less than the four rate hikes we’re expecting this year from the Fed. We remain long as a portfolio hedge. Ags/Softs: Underweight. U.S. negotiators head to Beijing next week to continue trade talks. We remain bearish soybeans all the same, given our expectation the current crop year will end with record-high stocks-to-use ratios worldwide. Feature The last time WTI oil futures traded this close to $40/bbl, OECD crude and products inventories stood at ~ 3.1 billion barrels, and OPEC 2.0 had just begun its output cuts in Jan17 (Chart 2). OECD inventories now stand under 2.9 billion barrels, and are on course to fall to ~ 2.5 billion by year-end, as the physical surplus is drained by a combination of falling production and still-strong demand (Chart 3). Chart 2OECD Inventories Will Draw, Taking Crude Prices Higher OECD Inventories Will Draw, Taking Crude Prices Higher OECD Inventories Will Draw, Taking Crude Prices Higher Chart 3Supply Cuts, Demand Strength Will Rebalance Markets Supply Cuts, Demand Strength Will Rebalance Markets Supply Cuts, Demand Strength Will Rebalance Markets Brent and WTI prices have fallen 39% and 41% from their October 2018 highs, following the about-face by the U.S. on Iranian oil-export sanctions in November. On the back of this, we expect OPEC 2.0 to follow through on its 1.2mm b/d production cuts – possibly even exceed them, as they did over the 2017 – 1H18 period. OPEC 2.0’s track record on production discipline is strong, hence our expectation the group’s 2019 output will fall to 31.14mm b/d vs. 2018’s 32.40mm b/d level.2 The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as unlikely the administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and expect they will be extended at least for 90 days. We expect Iranian production to fall from ~ 2.80mm b/d in 1H19 to an average 2.60mm b/d from June – December 2019, resulting in the loss of 1.25mm b/d of exports. We expect Saudi Arabia to raise production from 10.15mm b/d to 10.30mm b/d to offset most of this incremental loss of Iranian production. Government-mandated production cuts of 325k b/d in Alberta, Canada – undertaken to drain a persistent inventory overhang and loosen the flow of oil pipeline-transport-constrained production – also will remove actual production from the market this year.3 In addition, we continue to model the loss of 190k b/d of decline-curve losses in OPEC 2.0 member states that are incapable of maintaining or lifting output due to low prices and a lack of investment (Chart 4). The contribution of these states to the OPEC 2.0 cuts is to “manage” their depletion rates per their November 2016 accord (Table 1). Chart 4Production Outside Gulf OPEC Continues Decline, Led By Venezuela Production Outside Gulf OPEC Continues Decline, Led By Venezuela Production Outside Gulf OPEC Continues Decline, Led By Venezuela Table 1Table 1 BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Oil Volatility Will Persist; 2019 Brent Forecast Lowered To $80/bbl Oil Volatility Will Persist; 2019 Brent Forecast Lowered To $80/bbl Net, we have world supply growth at 0.5mm b/d this year vs. the 1.4mm b/d estimated by the EIA. Most of this again comes from the U.S., where we expect 1.3mm b/d growth. Due to the price rout following Iranian import waivers, we lowered our rig count projections – the main input of our U.S. production forecast – which took our Lower 48 U.S. (i.e., ex GOM) production growth to 1.2mm b/d from the 1.4mm b/d rate we estimated last month. Despite pipeline bottlenecks in the Permian Basin, which will be fully alleviated by 4Q19 when the last of ~ 2mm b/d of new takeaway capacity comes on line, U.S. shales still account for most of the net growth in U.S. ouput (Chart 5).4 If WTI prices remain in the mid- to low-$40/bbl range, however, rig counts will be driven lower, which will, all else equal, lower U.S. shale-oil output this year. Chart 5Lower WTI Prices Slow U.S. Shale Growth Lower WTI Prices Slow U.S. Shale Growth Lower WTI Prices Slow U.S. Shale Growth Lower Prices Will Support Demand The price collapse since October will keep global oil demand from breaking down, leading us to expect consumption to grow ~ 1.40mm b/d this year. This is down slightly from our previous estimate of 1.45mm b/d of growth, and falls 200k b/d short of the ~ 1.6mm b/d of growth we expect for 2018.5 Forecasting demand is notoriously difficult. This is particularly true for forecasting EM demand, the source of most of the growth in the world. We have non-OECD demand – our proxy for EM oil consumption – growing 1.0mm b/d this year, down from 2018’s rate of 1.2mm b/d. This reflects our expectation the IMF will lower its growth expectation for EM GDP to 4.6% this year, from its October 2018 estimate of 4.7% growth. This will take global GDP growth to 3.6% to 3.7% previously estimated. EM demand continues to be led by China and India, which we expect will grow 450k b/d and 210k b/d, respectively, this year, again accounting for more than half of EM growth. China’s oil consumption is expected to average 14.3mm b/d, while India’s will average just over 5mm b/d. We continue to expect modest stimulus coming from China in 2H19, which will support oil demand and consumer spending. However, this could surprise to the upside, with the 100th anniversary of the Chinese Communist Party coming up in 2021. Our colleagues at BCA Research’s Geopolitical Strategy (GPS) noted that if China’s government is to launch another large-scale stimulus package (not a foregone conclusion), then the likeliest time frame is 2H19 or 2020. Indeed, this is more probable than anytime earlier, due to the desire of Chinese policymakers to dispel any doubts about stability in 2021 for the Party’s centenary. GPS’s Matt Gertken observed the average gap between the bottom of China’s credit impulse and the top of nominal GDP growth is ~ 1.5 to 2 years. Policymakers will not want to stimulate too aggressively in early 2019 and risk having a flagging economy in the midst of 2021 celebration.6 Investment Implications Over the short term, oil prices could remain disconnected from market fundamentals, which we believe remain broadly supportive. Indeed, the balance of risks still favors the upside, despite the epic volatility over the past 3 months brought about by the larger-than-expected waivers to importers of Iranian oil just before U.S.-imposed sanctions were due to kick in in November (Chart 6). Chart 62019 Brent, WTI Price Forecasts: Slightly Lower at And /bbl 2019 Brent, WTI Price Forecasts: Slightly Lower at $80 And $74/bbl 2019 Brent, WTI Price Forecasts: Slightly Lower at $80 And $74/bbl We have lowered our average 2019 Brent forecast to $80 this year from $82/bbl, and our WTI forecast to $74 from $76/bbl, given our assessments of production and consumption.7 Markets continue to re-calibrate supply and demand balances largely in the dark, and will continue to do so until greater clarity is gained on actual OPEC 2.0 production cuts and the state of EM demand. On the supply side, we expect sharp production cuts from OPEC 2.0 and Canadian producers of ~ 1.4mm b/d; falling output in non-Gulf OPEC states from continuing decline-curve losses; and slower U.S. shale growth resulting from lower capex in the wake of the price collapse. On the demand side, we lowered our EM growth estimate slightly ahead of an expected downgrade of EM growth this year, but we still expect consumption to show relatively strong growth of 1.4mm b/d. Net, the combination of supply cuts plus still-strong demand will remove the current global surplus, and rebalance the market by the end of 1H19. Thus, in our view, the balance of risks – as seen in our ensemble scenarios – still is to the upside (Chart 7). Chart 7Balance of Risks Favors Upside Balance of Risks Favors Upside Balance of Risks Favors Upside In line with our expectation for higher prices, we are getting long spot WTI, believing prices in the low- to mid-$40s extending beyond 1Q19 will cause a 5 – 10% slowdown in U.S. production growth later this year, which will set up a rally later in the year. We also are getting long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close, in the expectation of a return to backwardation by the end of 1H19, as OECD inventories draw. We have touched on 3 of the 4 drivers of volatility in this week’s research. Next week we will examine the effect of this volatility on speculators’ risk-bearing capacity, and the implications for price discovery. Contrary to popular and received political opinion, speculation is a necessary and vital activity for the efficient functioning of commodity markets, particularly those used by commercial participants to hedge untoward price risks.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1      Please see “UPDATE 1-Chile monthly copper output highest in 13 years,” published December 31, 2018, by reuters.com. 2      Our estimates include continued production declines ex OPEC Gulf states and in other non-OPEC members like Mexico that are covered by the OPEC 2.0 agreement (Table 1). Under the production-cutting accord agreed at OPEC 2.0’s December meeting in Vienna, October 2018 is the benchmark against which new quotas – yet to by made public – are assessed. We note here that OPEC 2.0 has not published any official quota schedule following its December 2018 meeting, where it agreed to the 1.2mm b/d of production cuts.  Our supply estimates use data from the U.S. EIA, IEA and OPEC, along with trade press reports. 3      We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the Alberta government is attempting to draw down by its action over the course of 2019 at a rate of ~ 96k b/d.  4      By year-end, we expect U.S. crude oil production of 12.6mm b/d, which will keep the U.S. the largest crude oil producer in the world. U.S. crude oil exports can be expected to continue to grow as a result, after hitting 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data. U.S. product exports likely will run ~ 6mm b/d this year. 5      The IEA and OPEC are expecting 2019 demand growth of 1.3mm and 1.29mm b/d, respectively, while the U.S. EIA is expecting consumption will grow 1.5mm b/d. 6      Please see “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 7      This puts us above the consensus Brent forecast of $69.13/bbl reported by Reuters. Please see “Oversupply, faltering growth to weigh on oil prices in 2019: Reuters poll,” published by reuters.com December 31, 2018. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 3Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017 Image

Highlights Investors ran for cover in December as they succumbed to a litany of worries regarding the outlook. The key question is whether the pessimism is overdone or an extended equity bear market is underway. Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. There are some tentative signs that the two U.S. weak spots, housing and capital spending, are bottoming out. However, our global leading economic indicators continue to herald a soft first half of 2019 outside of the U.S. The dollar thus has more upside in the near term. The political risks facing investors have not diminished either. In particular, we expect turbulence related to the U.S./China trade war to extend well beyond the 3-month “truce” period. The returns to stocks, corporate bonds and commodities historically have not been particularly attractive on average when the U.S. yield curve is this flat. Nonetheless, the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies back to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. The upgrade to stocks in the developed markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now, but be prepared to upgrade sometime in 2019. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil prices have overshot to the downside. Supply is adjusting and, given robust energy demand in 2019, we still expect prices to rise to $82. Feature Investors ran for cover in December as they succumbed to concerns regarding the U.S./China trade war, corporate leverage, global growth, rising U.S. interest rates and the shift toward quantitative tightening. Some equity indexes, such as the Russell 2000, reached bear market territory, having lost more than 20%. Losses have been even worse outside the U.S. Earnings revisions have plunged into the “net downgrade” zone. Implied volatility has spiked and corporate bond spreads are surging (Chart I-1). The key question is whether the pessimism is overdone or an extended equity bear market is underway. Chart I-1A Flight To Quality A Flight To Quality A Flight To Quality We laid out our economic view in detail in the BCA Outlook 2019 report, published in late November. Not enough has changed on the global economic front in the three weeks since then that would justify such a violent shift in investor sentiment. That said, our favorite global leading economic indicators continue to erode (Chart I-2). The only ray of hope is that the diffusion index constructed from our Global Leading Economic Indicator appears to have bottomed. Nonetheless, the actual LEI will keep falling until the diffusion index shifts into positive territory.   Chart I-2Global Leading Indicators Still Weak Global Leading Indicators Still Weak Global Leading Indicators Flashing Red Global Leading Indicators Still Weak Global Leading Indicators Flashing Red For China, a key source of investor angst, the latest retail sales and industrial production reports reinforced that economic momentum continues to recede. We will not be convinced that growth is bottoming until we see an upturn in our credit impulse indicator (Chart I-3). Its continued decline in November suggests that the outlook for emerging market assets and commodity prices is poor for at least the next quarter. Global industrial output appears headed for a mild contraction. The manufacturing troubles are centered in the emerging Asian economies, but Europe and Japan are also feeling the negative effects. Chart I-3China: No Bottom Yet China: No Bottom Yet China: No Bottom Yet In the U.S., November’s bounce in housing starts and permits is a hopeful sign that the soft patch in this sector is ending. However, it is not clear how the devastating wildfires on the west coast have affected the housing data (Chart I-4). The downdraft in capital goods orders may also be drawing to a close, based on the latest reading from the Fed’s survey of capital spending intentions. The U.S. leading economic indicator dipped slightly in November, but remains consistent with above-trend real GDP growth in the months ahead. Chart I-4U.S.: Some Hopeful Signs U.S.: Some Hopeful Signs U.S.: Some Hopeful Signs The bottom line is that our outlook for growth has not been significantly altered. We see little risk of a U.S. recession in 2019. The global economy continues to weaken, but we expect enough policy stimulus out of China to stabilize growth in that economy in the second half of the year. We highlighted in the BCA Outlook 2019 that, while the risks appeared elevated, we would consider shifting back to overweight in stocks if they cheapened sufficiently. Valuation has indeed improved in recent weeks and sentiment has turned more cautious. Global growth will likely continue to decelerate in the first half of 2019, but markets have largely discounted this outcome. In other words, the shift toward pessimism in financial markets appears overdone. The fact that the Fed has signaled a move away from regular quarter-point rate hikes adds to our confidence in playing what will likely be the last upleg in risk assets in this cycle. Fed: Rate Hikes No Longer On Autopilot The Fed lifted rates by a quarter point in December and signaled that any additional tightening will be data-dependent. The FOMC also trimmed the expected peak in the funds rate and its estimate of the long-run, or neutral, level. Policymakers were likely swayed by some disappointing U.S. economic data, the pullback in core PCE inflation, and the sharp tightening in financial conditions (Chart I-5). Chart I-5Financial Conditions Have Tightened Financial Conditions Have Tightened Financial Conditions Have Tightened Monetary conditions are not tight by historical yardsticks, such as the level of real interest rates. The problem is that investors fear that the neutral level of the fed funds rate, the so-called R-star, remains very depressed. If true, it could mean that the Fed is already outright restrictive, which would signal that the monetary backdrop has turned hostile for risk assets. The OIS curve signals that the consensus believes that the Fed is pretty much done the tightening cycle (Chart I-6) Chart I-6Investors Believe The Fed Is Done! Investors Believe The Fed Is Done! Investors Believe The Fed Is Done! We believe that R-star is higher than the current policy setting and is rising, as the growth headwinds related to the Great Financial Crisis fade with the passage of time. The problem is that nobody knows the level of the neutral rate. Thus, we need to watch for signs that the fed funds rate has surpassed that level, such as an inverted yield curve. The 10-year/3-month T-bill spread is still in positive territory, but barely so. Meanwhile, our R-star indicator is also flashing yellow as it sits on the zero line (Chart I-7). It is a composite of monetary indicators that in the past have been useful in signaling that monetary policy had become outright restrictive, leading to slower growth and trouble for risk assets. The lead time of this indicator relative to economic activity and risk asset prices has been quite variable historically, but a breakdown below zero would send a powerful bearish signal for risk assets if confirmed by an inverted yield curve. Chart I-7Worrying Signs Of Tight Money Worrying Signs Of Tight Money Worrying Signs Of Tight Money The Implications Of Four Fed Scenarios It is not surprising that investors are struggling with a number of different possible scenarios on how the R-star/Fed policy nexus will play out. We can perhaps boil down discussion of the Fed and the implications for financial markets to a matrix of four main outcomes, based on combinations related to the level of R-Star (high or low) and the pace of Fed rate hikes in 2019 (pause or continue increasing rates by 25 basis points per quarter). Policy Mistake #1: R-star is still very low, but policymakers do not realize this and the FOMC continues to tighten into restrictive territory in 2019. By definition, the economy begins to suffer in this scenario, inflation and inflation expectations decline and long-bond yields are flat-to-lower. The yield curve inverts. However, current real rates are still so low that the fed funds rate cannot be very far above R-Star, which means it would represent only a small policy mistake. As long as the Fed recognizes the economic slowdown early enough and truncates the rate hike cycle, then there is a good chance that a recession would be avoided. Investors would initially fear a recession, however, which means that risk assets would be hit hard in absolute terms and relative to bonds and cash until recession fears fade. The direction of the dollar is perhaps trickiest part because there are so many potential cross currents. To keep things simple we will assume that global growth follows our base-case view and remains lackluster in the first half of 2019, followed by a modest re-acceleration. We believe the dollar would likely rally a little as the Fed continues tightening, but then would fall back as the FOMC is forced to turn dovish in the face of a U.S. growth scare. Policy Mistake #2: R-Star is high and rising but the Fed fails to hike rates fast enough to keep up. The economy accelerates in this scenario because monetary policy remains stimulative through 2019, at a time when the 2018 fiscal stimulus will still be providing a demand tailwind. Core PCE inflation moves above 2% and long-term inflation expectations shift up, signaling to investors that the Fed has fallen behind the inflation curve. Risk assets rip for a while and the yield curve bear-steepens as the 10-year Treasury yield moves gradually higher at first. Belatedly, the FOMC realizes it has underestimated the neutral rate and signals a hawkish policy shift. A 50-basis point rate hike at one FOMC meeting causes risk assets to buckle on the back of surging Treasury yields. The yield curve begins to bear-flatten. Eventually the curve inverts and the economy enters recession. The dollar weakens at first because higher inflation lowers U.S. real interest rates relative to the rest of the world. Global growth prospects would initially get a boost from the acceleration in U.S. growth, which is also dollar-bearish. However, in the end the dollar would likely rise as global financial markets turn risk-off. Fed Gets It Right (1): R-star is high and rising. The Fed continues to tighten in line with the increase in the neutral rate. Treasurys sell off hard and the yield curve shifts higher, but remains fairly flat (parallel shift). The curve could mildly invert temporarily, but market worries about a recession eventually recede as economic momentum remains robust, allowing the curve to subsequently trade in the 0-50 basis point range. As discussed below, risk assets tend to outperform Treasurys and cash when the yield curve is in this range, but not by much. The Treasury market would suffer significant losses. This is the most dollar-bullish of the four scenarios, given our global growth view (tepid) and the fact that the market is not even priced for a full quarter-point rate hike in 2019. Fed Gets It Right (2): R-Star is actually still quite low, but the Fed correctly sees recent economic data disappointments and the tightening in financial conditions as signs that policy is close to neutral. The Fed pauses the rate hike cycle, followed by a slower and more data-dependent pace of tightening. The yield curve stays fairly flat and flirts with inversion as investors try to figure out if the Fed has overdone it. Risk assets are volatile and deliver little return over cash. Treasurys rally a bit as the chance of any further rate hikes is priced out of the market, but the rally is limited unless the economy falls into recession (which is not part of this scenario because we are assuming the Fed “gets it right”). The dollar fluctuates, but delivers no real trend since U.S. yield differentials versus the rest of the world do not change much. As we go to press, financial markets are moving in a way that is consistent the Policy Mistake #1; the consensus appears to believe that the Fed has already lifted the fed funds rate too far, causing financial conditions to tighten. But if U.S. real GDP growth remains above-trend as we expect, then the market view could eventually transition to a belief in Mistake #2; the Fed falls behind the inflation curve. The curve would re-steepen and risk assets could have one last hurrah before the Fed gets hawkish again and the 2020 recession arrives. The transition from Mistake #1 to Mistake #2 is essentially our base-case outlook. Nonetheless, obviously the risks around this central scenario are high, especially given how late it is in the U.S. economic and policy cycle. Asset Returns And The Yield Curve Our 2018 late-cycle investing theme focussed on historical asset return and policy dynamics after the U.S. unemployment rate fell below the full-employment level in past cycles. We found that risk assets tend to run into trouble once the U.S. S&P 500 operating margin peaks. As we highlighted in the BCA Outlook 2019, our margin proxies are still not heralding that a peak is at hand. Given the recent investor obsession with the U.S. yield curve, this month we look at historical asset returns at different levels of the 10-year/3-month T-bill yield curve slope: Phase I, when the slope is above 50 basis points; Phase II, when the curve is between 0 and 50 basis points; and Phase III, when the curve is inverted (Table I-1). The data are presented as (not annualized) monthly average returns. It may be surprising that risk asset returns are for the most part positive even in when the curve is inverted. However, keep in mind that we are focussing on the curve, not on recession periods. The curve can be inverted for a long time before the subsequent recession occurs. Risk asset returns often remain positive during this period. The broad conclusions are as follows: Unsurprisingly, risk assets perform their best, in absolute terms and relative to government bonds and cash, in Phase I when the yield curve is steep. Returns tend to deteriorate as the curve flattens. This includes equities, corporate bonds and commodities. Small caps underperform large caps when the curve is between 0 and 50 basis points, but the reverse is true when the curve is flatter or steeper than that range. The ratio of cyclical stocks to defensives has not revealed a consistent pattern with respect to the yield curve, although this may reflect the short historical period available. Value stocks shine versus growth when the curve is inverted. Hedge fund and private equity returns have not varied greatly across the three yield curve environments. Structured product, such as CMBS and ABS, have enjoyed their best performance when the curve is inverted. Timberland and Farmland have also rewarded investors during Phase III. We suspected that asset returns when the curve is in the 0-50 basis point range would vary importantly with the direction of the curve. In Table I-I we split Phase II into two parts: when the curve is steepening after being inverted, and when the curve is flattening after being steep. In other words, when the consensus is either transitioning from quite bullish to very bearish, or vice-versa. Chart I- Risk assets such as equities (U.S. and Global) and U.S. investment-grade corporate bonds indeed perform much better in absolute terms when the curve is flat but is steepening rather than flattening. The same is true for U.S. structured product. In terms of excess returns relative to government issues, both U.S. IG and HY corporates have tended to underperform when the curve is in the 0-50 basis point range. Surprisingly, the underperformance is worse when the curve is steepening than when it is flattening. This appears to reflect an anomalous period in early 2006 when the curve was flattening but corporate bonds enjoyed strong excess returns. Emerging market equities show very strong returns in all three curve phases. This reflects the inclusion of the pre-2000 period in the mean calculations, a time when EM equities were much less correlated with U.S. financial conditions. EM equity returns have been significantly lower on average since 2000 when the curve is in the 0-50 basis point range (and especially when the curve is flattening) The bottom line is that risk assets can still reward investors with positive returns during periods when the yield curve is flat. However, it is a dangerous time, especially when the global economy is up to its eyeballs in debt. This month’s Special Report beginning on page 17 argues that, although regulation has made the global financial system more resilient to shocks compared to the pre-Lehman years, the number of potentially destabilizing shocks has increased. Moreover, the trade war and Brexit risks make the investment backdrop all the more precarious. No Quick End To The Trade War The honeymoon following the trade ceasefire between the U.S. and China, agreed at the G20 summit in early December, did not last long. The arrest of the chief financial officer of Chinese telecom maker Huawei and continuing hawkish tweets from the U.S. president dampened hopes that a trade agreement can be negotiated by March. Even news that China intended to cut tariffs on U.S. auto imports did not help much. We highlighted in the BCA Outlook 2019 that negotiations will prove to be protracted and testy. It will take a lot more than some token market-opening action on the part of China to placate the U.S. Our geopolitical team emphasizes that “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance.1 For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart I-8). While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Chart I-8R&D Expenditure By Country R&D Expenditure By Country R&D Expenditure By Country U.S. demands will also be hard for China to swallow. Most importantly, the U.S. is requesting that China rein in its hacking and spying, shift its direct investment to less tech-sensitive sectors, adjust its “Made in China” targets to allow for more foreign competition, and lower foreign investment equity restrictions. These stumbling blocks will make it difficult to strike a deal on trade. We continue to believe that a final trade deal between the U.S. and China will not arrive in the 90-day timeframe of the ceasefire. Thus, global risk assets will be subject to swings in sentiment regarding the likelihood of a trade deal well beyond March. Meanwhile, as previously discussed, Chinese policy stimulus has not yet become aggressive enough to spark animal spirits in the private sector. The Chinese authorities are proceeding cautiously so as to avoid adding significantly to private- and public-sector’s debt mountain. This month’s Special Report also discusses the risks that the surge in debt over the past decade poses for the global financial system, including escalating risk in China’s shadow banking system. Brexit Pain Continues Politics surrounding the torturous Brexit process will also remain a source of volatility for global markets in 2019. Prime Minister May survived a leadership challenge, but this is hardly confidence-inspiring. The question is whether any deal can get through Westminster. The votes appear to be in place for the softest of soft Brexits, the so-called Norway+ option, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to essentially pay for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election (which may usher the even less pro-Brexit Labour Party into power), or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the failure of the Tories to endorse May’s proposed agreement means that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear; the median voter is turning forcefully towards Bremain (Chart I-9). It will soon become untenable to delay the second referendum. The bottom line is that, while a soft Brexit is the most likely outcome, the path from here to the end result will be punishing. We do not recommend Brexit-related bets on the pound, despite the fact that it is cheap. Chart I-9A Shift Toward Bremain A Shift Toward Bremain A Shift Toward Bremain 2019: A Tale Of Two Halves For EM, Commodities And The Dollar One of our key themes in the BCA Outlook 2019 is that the growth divergence between China and the U.S. will persist at least for the first half of 2019. The result will be weak EM asset prices and currencies, little upside for base metals and a strong U.S. dollar. We expect the Chinese authorities will do enough to stabilize growth by mid-year, providing the impetus for a playable bounce in EM and commodity prices in the second half of 2019, coinciding with a peak in the U.S. dollar. Nonetheless, the dollar still has some upside potential in broad trade-weighted terms in the first half of 2019. Our Central Bank Monitors continue to show a greater need for policy tightening in the U.S. than in the rest of the major countries. The dollar has usually strengthened when this has been the case historically. In particular, the ECB’s Central Bank Monitor has slipped back into “easy money required” territory, reflecting moderating economic momentum and still-depressed consumer price inflation (Chart I-10). Chart I-10Our CB Monitors Support A Stronger Dollar Our CB Monitors Support A Stronger Dollar Our CB Monitors Support A Stronger Dollar The ECB announced the well-anticipated end of its asset purchase program in December. The central bank will now focus on forward guidance as its main policy tool outside of setting short-term interest rates. Lending via targeted LTROs will also be considered under certain circumstances. Policymakers retained the latest forward guidance after the December MPC meeting, that rates are on hold “through the summer of 2019”. The latest reading from our ECB Monitor suggests that the central bank could be on hold for longer than that. We expect Eurozone growth to improve somewhat through the year, but we still believe that interest rate differentials will move further in favor of the dollar relative to the euro and the other major currencies. Periods of slow global growth also tend to favor the greenback. The bottom line is that, while a correction is possible in the very near term, investors with at least a six-month horizon should remain long the dollar. Investment Conclusions: Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. The risks facing investors have not diminished either, especially given the precarious nature of late-cycle investing and the uncertainty regarding the neutral level of the fed funds rate. Historically, the returns to stocks, corporate bonds and commodities have not been particularly attractive on average when the yield curve is this flat. Nonetheless, we believe that the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. Despite our more positive view on equities, we remain cautious on credit. Spreads have widened recently to more attractive levels, but we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009. Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  Credit is an asset class that is likely to perform particularly poorly in the next recession. Our upgrade to stocks in the advanced markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil markets are still in the process of re-adjusting to an extraordinary policy reversal by the Trump Administration on its Iranian oil-export sanctions in November, as last-minute waivers were granted to Iran’s largest oil importers. We believe that oil prices have overshot to the downside. Following OPEC 2.0’s decision to cut 1.2mm b/d of production to re-balance markets in the first half of the year, we continue to expect prices to recover on the back of solid global energy demand. Canada also mandated energy firms to trim production. Our energy experts expect oil prices to reach $82/bbl in 2019. We also like gold as long as the fed funds rate remains below its neutral level. Mark McClellan Senior Vice President The Bank Credit Analyst December 21, 2018 Next Report: January 31, 2019 II. (Part II) The Long Shadow Of The Financial Crisis This is the second of a two-part Special Report on the structural changes that have occurred as a result of the Great Recession and financial crisis. We look at three issues: asset correlation, the safety of the financial system, and the level of global debt. First, correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. Some believe that the underlying level of correlation among risk assets has shifted permanently higher for two main reasons: (1) trading factors such as the increased use of exchange-traded funds and algorithms; and (2) the risk-on/risk-off environment in which trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. We have sympathy for the second explanation. The equity risk premium (ERP) was forced higher on a sustained basis by the financial crisis, driven by fears that the advanced economies had entered a ‘secular stagnation’. Elevated correlation among risk assets was a result of a higher-than-normal ERP. The ERP should decline as fears of secular stagnation fade, leading to a lower average level of risk asset correlation than has been the case over the last decade. Second, regulators have been working hard to ensure that the financial crisis never happens again. But is the financial system really any safer today? Undoubtedly, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. The propensity for contagion among banks has diminished and there has been a dramatic decline in the volume of complex structured credit securities. The bad news is that the level of global debt has increased at an alarming pace. The third part of this report highlights that elevated levels of debt could cause instability in the global financial system. Choking debt levels boost the vulnerability to negative shocks. The number and probability of potential shocks appear to have increased since 2007, including extreme weather events, sovereign debt crises, large-scale migration, populism, water crises and cyber & data attacks. The lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide any fiscal relief in the event of a negative shock. Moreover, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend more in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. The Great Recession and Financial Crisis cast a long shadow that will affect economies, policy and financial markets for years to come. Rather than reviewing the roots of the crisis, the first of our two-part series examined the areas where we believe structural change has occurred related to the economy or financial markets. We covered the changing structure of the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. We highlighted that the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. We made the case that the prolonged inflation undershoot is sowing the seeds of an overshoot in the coming years, in part related to central bank policymakers that are doomed to fight the last war. Finally, we argued that the forces behind the structural and cyclical bull market in bonds reached an inflection point in 2016/2017. In Part II, we examine the theory that the financial crisis has permanently lifted market correlations among risk assets. Next, we look at whether regulatory changes implemented as a result of the financial crisis have made the global financial system safer. Finally, we highlight the implications of the continued rise in global leverage over the past decade in the context of BCA’s Debt Supercycle theme. The bottom line is that the global financial system still faces substantial risks, despite a more highly regulated banking system. (1) Are Risk Asset Correlations Permanently Higher? Correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. For example, risk assets became more highly correlated, suggesting little differentiation within or across asset classes. Chart II-1 presents a proxy for U.S. equity market correlations, using a sample of current S&P 100 companies. The average correlation was depressed in the 1990s and 2000s relative to the 1980s. It spiked in 2007 and fluctuated at extremely high levels for several years, before moving erratically lower. It has jumped recently and is roughly in the middle of the post-1980s range. Chart II-1Two Factors Driving Correlation bca.bca_mp_2019_01_01_s2_c1 bca.bca_mp_2019_01_01_s2_c1 Correlations will undoubtedly ebb and flow in the coming years and will spike again in the next recession. But a key question is whether correlations will oscillate around a higher average level than in the 1990s and 2000s. The consensus seems to believe that the underlying level of correlation among risk assets has indeed shifted higher on a structural basis for two main reasons: Market Structure Changes: Many investors point to trading factors such as the increased use of index products (exchange-traded funds for example), and high-frequency/algorithmic trading as likely culprits. Macro “theme” investing has reportedly become more popular and is often implemented through algorithms. The result is an increase in stock market volatility and a tendency for risk-asset prices to move up and down based on momentum because they are all being traded as a group. These factors would likely be evident today even if the financial crisis never happened, but the popularity of algorithm trading may have been encouraged by the fact that the macro backdrop was so uncertain for years after Lehman collapsed. Risk On/Off Trading Environment: Trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. Even after the recession ended, the headwinds to growth were formidable and many felt that the sustainability of the recovery hinged largely on the success or failure of unorthodox monetary policies. The general feeling was that either the policies would “work”, the output gap would gradually close and risk assets would perform well, or it would fail and risk assets would be dragged down by a return to recession. Thus, markets traded on an extreme “risk-on/risk-off” basis, as sentiment swung wildly with each new piece of economic and earnings data. While the market structure thesis has merit on the surface, the impact should only be short term in nature. It is difficult to see how a change in the intra-day microstructure of the market could have such a fundamental, wide-ranging and permanent impact on market prices. Previous research suggests that any impact on market correlation beyond the very short term is likely to be small. For the sake of brevity, we won’t present the evidence here, but instead refer readers to two BCA Special Reports.2 The risk on/off trading environment thesis is a more plausible explanation. However, we find it more useful to think about it in terms of the equity risk premium (ERP). A higher ERP causes investors to revalue cash flows from all firms, which, in turn, causes structural shifts in the correlation among stocks. A lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious are an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Shifts in the ERP are sometimes structural in nature, but there is also a strong cyclical element in that persistent equity declines historically have had the effect of temporarily raising the ERP and correlations. A simple model based on the ERP and volatility explains a lot of the historical variation in equity correlation, including the elevated levels observed in the years after 2007 (Chart II-2).3 The shift lower in correlations after 2012 reflects both a lower equity risk premium and a dramatic decline in downside volatility. Chart II-2Simple Model Explains Correlation Simple Model Explains Correlation Simple Model Explains Correlation It is tempting to believe that the lingering shell-shock related to the financial crisis means that the underlying equity risk premium has shifted permanently higher. The ERP is still elevated by historical standards, but this is more reflective of extraordinarily low bond yields than an elevated forward earnings yield. Investors evidently believe that the U.S. and other developed economies are stuck in a “secular stagnation”, which will require low interest rates for many years just to keep economic growth near its trend pace. In other words, the equilibrium interest rate, or R-star, is still very low. The ERP and correlations among risk assets will undoubtedly spike again in the next recession. Nonetheless, in the absence of recession, we expect fears regarding secular stagnation to fade further. If the advanced economies hold up as short-term interest rates and bond yields rise, then concerns that R-star is extremely low will dissipate and expectations regarding equilibrium bond yields will shift higher. The ERP will move lower as bond yields, rather than the earnings yield, do most of the adjustment. The underlying correlations among risk asset prices should correspondingly recede. This includes correlations among a wide variety of risk assets, such as corporate bonds and commodities. While this describes our base case outlook, there is a non-trivial risk that the next recession arrives soon and is deep. This would underscore the view that R-star is indeed very low and the economy needs constant monetary stimulus just to keep it out of recession (i.e. the secular stagnation thesis). The ERP and correlations would stay elevated on average in that scenario. What About The Stock/Bond Correlation? Chart II-3 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and the early-2000s. Bond yields tended to rise whenever the S&P 500 was falling. Over the past two decades, however, bond yields have generally declined when the stock market has swooned. Chart II-3Structural Shifts In The Stock/Bond Correlation Structural Shifts In The Stock/Bond Correlation Structural Shifts In The Stock/Bond Correlation Inflation expectations can help explain the shift in stock/bond correlation. Expectations became unmoored after 1970, which meant that inflationary shocks became the primary driver of bond yields. Strong growth became associated with rising inflation and inflation expectations, and the view that central banks had fallen behind the curve. Bond yields surged as markets discounted aggressive tightening designed to choke off inflation. And, given that inflation lags the cycle and had a lot of persistence, central banks were not in a position to ease policy at the first hint of a growth slowdown. This was obviously a poor backdrop for stocks. When inflation expectations became well anchored again around the late 1990s, investors no longer feared that central banks would have to aggressively stomp on growth whenever actual inflation edged higher. Central banks also had more latitude to react quickly by cutting rates at the first sign of slower economic growth. Fluctuations in growth became the primary driver of bond yields, allowing stock prices to rise and fall along with yields. The correlation has therefore been positive most of the time since 2003. Bottom Line: A negative correlation between stocks and bond yields reared its ugly head in the last quarter of 2018. The equity correction reflected several factors, but the previous surge in bond yields and hawkish Fed comments appeared to spook markets. Investors became nervous that the fed funds rate had already entered restrictive territory, at a time when the global economy was cooling off. We expect more of these episodes as the Fed normalizes short-term interest rates over the next couple of years. Nonetheless, we see no evidence that inflation expectations have become unmoored. This implies that the stock-bond correlation will generally be positive most of the time over the medium term. In addition, the average level of correlation among risk assets has probably not been permanently raised, although spikes during recessions or growth scares will inevitably occur. (2) Is The Global Financial System Really Safer Today? The roots of the great financial crisis and recession involved a global banking and shadow banking system that encouraged leverage and risk-taking in ways that were hard for investors and regulators to assess. Complex and opaque financial instruments helped to hide risk, at a time when regulators were “asleep at the switch”. In many countries, credit grew at a much faster pace than GDP and capital buffers were dangerously low. Banking sector compensation skewed the system toward short-term gains over long-term sustainable returns. Lax lending standards and a heavy reliance on short-term wholesale markets to fund trading and lending activity contributed to cascading defaults and a complete seizure in parts of the money and fixed income markets. A vital question is whether the financial system is any less vulnerable today to contagion and seizure. The short answer is that the financial system is better prepared for a shock, but the problem is that the number of potential sources of instability have increased since 2007. Since the financial crisis, regulators have been working hard to ensure that the financial crisis never happens again. Reforms have come under four key headings: Capital: Regulators raised the minimum capital requirement for banks, added a buffer requirement, and implemented a surcharge on systemically important banks. Liquidity: Regulators implemented a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR) in order to ensure that banks have sufficient short-term funds to avoid liquidity shortages and bank runs.4 Risk Management: Banks are being forced to develop systems to better monitor risk, and are subject to periodic stress tests. Resolution Planning: Banks have also been asked to detail options for resolution that, hopefully, should reduce systemic risk should a major financial institution become insolvent. Global systemically-important banks, in particular, will require sufficient loss-absorbing capacity. A major study by the Bank for International Settlements,5 along with other recent studies, found that systemic risk in the global financial system has diminished markedly as a result of the new regulations. On the whole, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. Lending standards have tightened almost across the board relative to pre-crisis levels, particularly for residential mortgages. Additional capital and liquid assets provide a much wider buffer today against adverse shocks, allowing most banks to pass recent stress tests (Chart II-4). Financial institutions have generally re-positioned toward retail and commercial banking and wealth management, and away from more complex and capital-intensive activities (Chart II-5). The median share of trading assets in total assets for individual G-SIBs has declined from around 20% to 12% over 2009-16. Chart II-4 Chart II-5 Moreover, the propensity for contagion among banks has diminished. The BIS notes that assessing all the complex interactions in the global financial system is extremely difficult. Nonetheless, a positive sign is that banks are focusing more on their home markets since the crisis, and that direct connections between banks through lending and derivatives exposures have declined. The BIS highlights that aggregate foreign bank claims have declined by 16% since the crisis, driven particularly by banks from the advanced economies most affected by the crisis, especially from some European countries (Chart II-6). It is also positive that European banks have made some headway in diminishing over-capacity, although problems still exist in Italy. Finally, and importantly, there has been a distinct shift toward more stable sources of funding, such as deposits, away from fickle wholesale markets (Charts II-7 and II-8). Chart II-6Less Cross Border Lending (Until Recently) Less Cross Border Lending (Until Recently) Less Cross Border Lending (Until Recently)   Chart II-7 Chart II-8 Outside of banking, many other regulatory changes have been implemented to make the system safer. One important example is that rules were adjusted to reduce the risk of runs on money market funds. What About Shadow Banking? Of course, more could be done to further indemnify the financial system. Concentration in the global banking system has not diminished, and it appears that the problem of “too big to fail” has not been solved. And then there is the shadow banking sector, which played a major role in the financial crisis by providing banks a way of moving risk to off-balance sheet entities and securities, and thereby hiding the inherent risks. Shadow banking is defined as credit provision that occurs outside of the banking system, but involves the key features of bank lending including leverage, and liquidity and maturity transformation. Complex structured credit securities, such as Collateralized Debt Obligations, allowed this type of transformation to mushroom in ways that were difficult for regulators and investors to understand. A recent study by the Group of Thirty6 concluded that securitization has dropped to a small fraction of its pre-crisis level, and that growing non-bank credit intermediation since the Great Recession has primarily been in forms that do not appear to raise financial stability concerns. Much of the credit creation has been in non-financial corporate bonds, which is a more stable and less risky form of credit extension than bank lending. Other types of lending have increased, such as corporate credit to pension funds and insurance companies, but this does not involve maturity transformation, according to the Group of Thirty. There has been a dramatic decline in the volume of complex structured credit securities such as collateralized debt obligations, asset-backed commercial paper, and structured investment vehicles since 2007 (Chart II-9). While the situation must be monitored, the Group of Thirty study concludes that the financial system in the advanced economies appears to be less vulnerable to bouts of self-reinforcing forced selling, such as occurred during the 2008 crisis. Chart II-9Less Private-Sector Securitization Less Private-Sector Securitization Less Private-Sector Securitization One exception is the U.S. leveraged loan market, which has swelled to $1.13 trillion and about half has been pooled into Collateralized Loan Obligations. As with U.S. high-yield bonds, the situation is fine as long as profitability remains favorable. But in the next recession, lax lending standards today will contribute to painful losses in leveraged loans. The Bad News That’s the good news. The bad news is that, while the financial system might have become less complex and opaque, the level of debt has increased at an alarming rate in both the private and public sectors in many countries. Elevated levels of debt could cause instability in the global financial system, especially as global bond yields return to more normal levels by historical standards. We discuss other pressure points such as Emerging Markets and China in the next section, although the latter deserves a few comments before we leave the subject of shadow banking. The Group of Thirty notes that 30% of Chinese credit is provided by a broad array of poorly regulated shadow banking entities and activities, including trust funds, wealth management products, and “entrusted loans.” Links between these entities and banks are unclear, and sometimes involve informal commitments to provide credit or liquidity support. The study takes some comfort that most of Chinese debt takes place between Chinese domestic state-owned banks and state-owned companies or local government financing vehicles. Foreign investors have limited involvement, thus reducing potential direct contagion outside of China in the event of a financial event. Still, the potential for contagion internationally via global sentiment and/or the economic fallout is high. The other bad news is that, while regulators in the advanced economies have managed to improve the ability of financial institutions to weather shocks, potential risks to the financial system have increased in number and in probability of occurrence. The Global Risk Institute (GRI) recently published a detailed comparison of potential shocks today relative to 2007.7 The report sees twice the number of risks versus 2007 that are identified as “current” (i.e. could occur at any time) and of “high impact”. The most pressing risks today include extreme weather events, asset bubbles, sovereign debt crises, large-scale involuntary migration, water crises and cyber & data attacks. Any of these could trigger a broad financial crisis if the shock is sufficiently intense, despite improved regulation. The GRI study also eventuates how the risks will evolve over the next 11 years. Readers should see the study for details, but it is interesting that the experts foresee cyber dependency rising to the top of the risk pile by 2030. The increase is driven by the importance of data ownership, the increasing role of algorithms and control systems, and the $1.2 trillion projected cost of cyber, data and infrastructure attacks. Our computer systems are not prepared for the advances of technology, such as quantum computing. Climate change moves to the number two risk spot in its base-case outlook. Space limitations precluded a discussion of the rise of populism in this report, but the GRI sees the political tensions related to income inequality as the number three threat to the global financial system by 2030. Bottom Line: Regulators have managed to substantially reduce the amount of hidden risk and the potential for contagion between financial institutions and across countries since 2007. Banks have a larger buffer against stocks. Unfortunately, the number and probability of potential shocks to the financial system appear to have increased since 2007. (3) Implications Of The Global Debt Overhang The End of the Debt Supercycle is a key BCA theme influencing our macro view of the economic and market outlook for the coming years. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness of monetary policy. During times of economic and/or financial stress, it was relatively easy for the Federal Reserve and other central banks to improve the situation by engineering a new credit up-cycle. However, since the 2007-09 meltdown, even zero (or negative) policy rates have been unable to trigger a strong revival in private credit growth in the major developed economies, except in a few cases. The end of the Debt Supercycle has severely impaired the key transmission channel between changes in monetary policy and economic activity. The combination of high debt burdens and economic uncertainty has curbed borrowers’ appetite for credit while increased regulatory pressures and those same uncertainties have made lenders less willing to extend loans. This has severely eroded the effectiveness of lower interest in boosting credit demand and supply, forcing central banks to rely increasingly on manipulating asset prices and exchange rates. On a positive note, the plunge in interest rates has lowered debt servicing costs to historically low levels. Yet, it is the level, rather than the cost, of debt that seems to have been an impediment to the credit cycle, contributing to a lethargic economic expansion. The Bank for International Settlements (BIS) publishes an excellent dataset of credit trends across a broad swath of developing and emerging economies. Some broad conclusions come from an examination of the data (Charts II-10 and II-11):8 Chart II-10Advanced Economies: Some Deleveraging Advanced Economies: Some Deleveraging Advanced Economies: Some Deleveraging Chart II-11EM: Deleveraging Has Not Even Started EM: Deleveraging Has Not Even Started EM: Deleveraging Has Not Even Started Private debt growth has only recently accelerated for the advanced economies as a whole. There are only a handful of developed economies where private debt-to-GDP ratios have moved up meaningfully in the past few years. These are countries that avoided a real estate/banking bust and where property prices have continued to rise (e.g. Canada and Australia). The high level of real estate prices and household debt currently is a major source of concern to the authorities in those few countries. Even where some significant consumer deleveraging has occurred (e.g. the U.S., Spain and Ireland), debt-to-income ratios remain very high by historical standards. In many cases, a stabilization or decline in private debt burdens has been offset by a continued rise in public debt, keeping overall leverage close to peak levels. This is a key legacy of the financial crisis; many governments were forced to offset the loss of demand from private sector deleveraging by running larger and persistent budget deficits. Weak private demand accounts for close to 50% of the rise in public debt on average according to the IMF. Global debt of all types (public and private) has soared from 207% of GDP in 2007 to 246% today. The Debt Supercycle did not end everywhere at the same time. It peaked in Japan more than 20 years ago and has not yet reached a decisive bottom. The 2007-09 meltdown marked the turning point for the U.S. and Europe, but it has not even started in the emerging world. The financial crisis accelerated the accumulation of debt in the latter as investors shifted capital away from the struggling advanced economies to (seemingly less risky) emerging markets. Both EM private- and public-sector debt ratios have continued to move up at an alarming pace. The lesson from Japan is that deleveraging cycles following the bursting of a major credit bubble can last a very long time indeed. One key area where there has been significant deleveraging is the U.S. household sector (Chart II-12). The ratio of household debt to income has fallen below its long-term trend, suggesting that the deleveraging process is well advanced. However, one could argue that the ratio will undershoot the trend for an extended period in a mirror image of the previous overshoot. Or, it may be that the trend has changed; it could now be flat or even down. Chart II-12U.S. Household Deleveraging... U.S. Household Deleveraging... U.S. Household Deleveraging... What is clear is that U.S. attitudes toward saving and spending have changed dramatically since the Great Financial Crisis (GFC) (Chart II-13). Like the Great Depression of the 1930s that turned more than one generation off of debt, the 2008/09 crisis appears to have been a watershed event that marked a structural shift in U.S. consumer attitudes toward credit-financed spending. The Debt Supercycle is over for this sector. Chart II-13...As Attitudes To Debt Change ...As Attitudes To Debt Change ...As Attitudes To Debt Change Developing Countries: Debt And Economic Fundamentals BCA’s long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Trade wars and a tightening Fed are negative for EM assets, but the main headwinds facing this asset class are structural. Excessive debt is a ticking time bomb for many of these countries. EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart II-14). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart II-14, bottom panel). Chart II-14EM: High Debt And Slow Growth... EM: High Debt And Slow Growth... EM: High Debt And Slow Growth... The 2019 Key Views9 report from our Emerging Markets Strategy team highlights that excessive capital inflows over the past decade have contributed to over-investment and mal-investment. Much of the borrowing was used to fund unprofitable projects, as highlighted by the plunge in productivity growth, profit margins and return on assets in the EM space relative to pre-Lehman levels (Chart II-15) Decelerating global growth in 2018 has exposed these poor fundamentals. Chart II-15...Along With Deteriorating Profitability ...Along With Deteriorating Profitability ...Along With Deteriorating Profitability As we highlighted in the BCA Outlook 2019, emerging financial markets may enjoy a rally in the second half of 2019 on the back of Chinese policy stimulus. However, this will only represent a ‘sugar high’. The debt overhang in emerging market economies is unlikely to end benignly because a painful period of corporate restructuring, bank recapitalization and structural reforms are required in order to boost productivity and thereby improve these countries’ ability to service their debt mountains. China’s Debt Problem Space limitations preclude a full discussion of the complex debt situation in China and the risks it poses for the global financial system. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart II-16). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart II-17). Chinese banks are currently being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. Chart II-16China's Overinvestment... China's Overinvestment... China's Overinvestment... Chart II-17Has Undermined The Return On Assets Has Undermined The Return On Assets Has Undermined The Return On Assets The previous section highlighted that much of the debt has been created in the opaque shadow banking system, where vast amounts of hidden risk have likely accumulated. Whether or not the central government is willing and/or able to cover a wave of defaults and recapitalize the banking system in the event of a negative shock is hotly debated, both within and outside of BCA. But even if a financial crisis can be avoided, bringing an end to the unsustainable credit boom will undoubtedly have significant consequences for the Chinese economy and the emerging economies that trade with it. Interest Costs To Rise Globally, many are concerned about rising interest costs as interest rates normalize over the coming years. In Appendix Charts II-19 to II-21, we provide interest-cost simulations for selected government, corporate and household sectors under three interest-rate scenarios. The good news is that the starting point for interest rates is still low, and that it takes years for the stock of outstanding debt to adjust to higher market rates. Even if rates rise by another 100 basis points, interest burdens will increase but will generally remain low by historical standards. It would take a surge of 300 basis points across the yield curve to really ‘move the needle’ in terms of interest expense. This does not imply that the global debt situation is sustainable or that a financial crisis can be easily avoided. The next economic downturn will probably not be the direct result of rising interest costs. Nonetheless, elevated government, household and/or corporate leverage has several important long-term negative implications: Limits To Counter-Cyclical Fiscal Policy: Government indebtedness will limit the use of counter-cyclical fiscal policy during the next economic downturn. Chart II-18 highlights that structural budget deficits and government debt levels are higher today compared to previous years that preceded recessions. The risk is especially high for emerging economies and some advanced economies (such as Italy) where investors will be unwilling to lend at a reasonable rate due to default fears. Even in countries where the market still appears willing to lend to the government at a low interest rate, political constraints may limit the room to maneuver as voters and fiscally-conservative politicians revolt against a surge in budget deficits. This will almost certainly be the case in the U.S., where the 2018 tax cuts mean that the federal budget deficit is likely to be around 6% of GDP in the coming years even in the absence of recession. A recession would push it close to a whopping 10%. Even in countries where fiscal stimulus is possible, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend and take on more debt. Chart II-18 Growth Headwinds: The debt situation condemns the global economy to a slower pace of trend growth in part because of weaker capital spending. From one perspective this is a good thing, because spending financed by the excessive use of credit is unsustainable. Still, deleveraging has much further to go at the global level, which means that spending will have to be constrained relative to income growth. The IMF estimates that deleveraging in the private sector for the advanced economies is only a third of historical precedents at this point in the cycle. The IMF also found that debt overhangs have historically been associated with lower GDP growth even in the absence of a financial crisis. Sooner or later, overleveraged sectors have to retrench. Vulnerability To Negative Shocks: If adjustment is postponed, debt reaches levels that make the economy highly vulnerable to negative shocks as defaults rise and lenders demand a higher return or withdraw funding altogether. IMF work shows that economic downturns are more costly in terms of lost GDP when it is driven or accompanied by a financial crisis. This is particularly the case for emerging markets. Bottom Line: Although credit growth has been subdued in most major advanced economies, there has been little deleveraging overall and debt-to-GDP is still rising at the global level. Elevated debt levels are far from benign, even if it appears to be easily financed at the moment. It acts as dead weight on economic activity and makes the world economy vulnerable to negative shocks. It steals growth from the future and, in the event of such a shock, the lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide fiscal relief. The end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. Mark McClellan Senior Vice President The Bank Credit Analyst APPENDIX Chart II-19Corporate Interest Cost Scenarios Corporate Interest Interest Cost Scenarios Corporate Interest Interest Cost Scenarios   Chart II-20Government Interest Cost Scenarios Government Interest Cost Scenarios Government Interest Cost Scenarios   Chart II-21U.S. Household Sector Interest Cost Scenarios U.S. Household Sector Interest Cost Scenarios U.S. Household Sector Interest Cost Scenarios   III. Indicators And Reference Charts Our tactical upgrade of equities to overweight this month goes against most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicators for the U.S., Japan and Europe are all heading lower. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors are clearly moving funds away from the equity market at the moment. Our Revealed Preference Indicator (RPI) for stocks continues to issue a ‘sell’ signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, supporting the view that caution is still warranted. The U.S. net earnings revisions ratio has dropped into negative territory. The earnings surprises index has also declined, although it remains above 60%. Finally, our Composite Technical Equity Indicator has broken below the zero line and its 9-month exponential moving average, sending a negative technical signal. On the positive side, our Monetary Indicator has hooked up, although it is still in negative territory for equities. From a contrary perspective, the fact that equity sentiment has turned bearish is positive for stocks. In fact, this is the main reason why we upgraded stocks this month. While it is late in the U.S. economic expansion and the Fed is tightening, sentiment regarding U.S. and global growth has become overly pessimistic. Thus, we are playing a late-cycle bounce in stocks. For bonds, the term premium moved further into negative territory in December, which is unsustainable from a long-term perspective. Long-term inflation expectations are also too low to be consistent with the Fed meeting its 2% target over the medium term. These facts suggest that bond yields have not peaked for the cycle, although at the moment they have not yet worked off oversold conditions according to our technical indicator. The U.S. dollar is overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators   Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   1      For more details, please see BCA Geopolitical Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at gps.bcaresearch.com 2      Please see BCA U.S. Investment Strategy Special Report "The Bane Of Investors’ Existence: Why Is Correlation High And When Will It Fall?" dated January 4, 2012, available at usis.bcaresearch.com. Also see BCA Global ETF Strategy Special Report "The Passive Menace," dated September 13, 2017, available at etf.bcaresearch.com 3       We use only below average returns in the calculation of volatility (downside volatility) because we are more concerned with the risk of equity market declines for the purposes of this model. 4       The LCR requires a large bank to hold enough high-quality liquid assets to cover the net cash outflows the bank would expect to occur over a 30-day stress scenario. The NSFR complements the LCR by requiring an amount of stable funding that is tailored to the liquidity risk of a bank’s assets and liabilities, based on a one-year time horizon. 5       Structural Changes in Banking After the Crisis. CGFS Papers No.60. Bank for International Settlements, January 2018. 6       Shadow Banking and Capital Markets Risks and Opportunities. Group of Thirty. Washington, D.C., November 2016. 7       Back to the Future: 2007 to 2030. Are New Financial Risks Foreshadowing a Systemic Risk Event? Global Risk Institute. 8       For more details on public and private debt trends, please see BCA Special Report "The End Of The Debt Supercycle: An Update," dated May 11, 2016, available at bca.bcaresearch.com 9       Please see BCA Emerging Markets Strategy Weekly Report "2019 Key Views: Will The EM Lost Decade End With A Bang Or A Whimper?" dated December 6, 2018, available at ems.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: