Grains

Highlights Exogenous risks will remain more of a threat to grain prices than out-of-whack fundamentals, which are closer to balance than not, as the USDA’s World Agricultural Supply and Demand Estimates (WASDE) indicate. COVID-19-induced public-health risks leading to renewed lockdowns – particularly in the US, where infection rates are rampaging ahead of its trading partners’ – remain at the forefront of these exogenous risks (Chart of the Week). Headline-grabbing grain purchases notwithstanding, fraying Sino-US trade, diplomatic and military relations again threaten these markets, particularly soybeans. China promises to retaliate against actions taken by US President Donald Trump in response to a new security law Beijing foisted on Hong Kong at the end of June, which sharply curtails freedom and autonomy. Sino-US military tensions in the South China Sea remain elevated. Countering these risks, a weaker USD – in line with our House view – would boost demand for grains as EM income growth picks up. Still, global economic policy uncertainty will remain a formidable headwind to a weaker USD. Feature Grains generally are closer to balance than not globally, which suggests the next market-moving developments – outside weather – will be caused by news exogenous to fundamentals (Chart 2). Chart of the WeekCOVID-19 Infection Surge In US Could Lead To Renewed Lockdowns Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge The four key markets tracked by the UN’s Agricultural Market Information System (AMIS) – corn, wheat, rice and soybeans – are in “a generally comfortable global supply situation. However, in many parts of the world, local markets brace for the looming impacts of COVID-19, amid uncertainties related to demand, logistics and even access to food.”1 Chart 2Grain Markets Close To Balanced Grain Markets Close To Balanced Grain Markets Close To Balanced The USDA sees corn markets tightening in the coming 2020-21 crop year beginning in September, with US production down 995mm bushels on the back of lower plantings and harvests.2 Output ex-US is expected to be largely unchanged, while Chinese corn demand will pick up in response to higher soybean feed usage. Stocks in China, Argentina, the EU, Canada, and Mexico, are expected to be lower leading to a net decline in global inventories. US soybean stocks are expected to increase, but this will be offset by declines in Brazil and China, reducing global bean inventories by some 1.3mm tons to 95.1mm, based on USDA estimates. The USDA’s soybean export commitments to China (i.e., outstanding sales plus accumulated exports) are 1.8mm tons higher than last year at 16.2mm tons, but still are well below historic levels (Chart 3). The US slack has been picked up by Brazilian exports, which have been aided by a weak BRL and record bean crops. A weaker USD and a resumption of Sino-US bean trade would reverse this. Wheat and rice stocks are expected to increase globally. Wheat inventories are expected to hit record highs globally, with China accounting for a little more than half of these stocks, and India accounting for 10%. Rice supplies are expected to increase more than demand globally, lifting ending stocks for the 2020-21 crop year to a record 186mm tons; China and India account for 63% and 21% of these inventories, respectively, in the USDA’s estimates. Chart 3Sino-US Trade Tensions Reduce Soybean Exports Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Chart 4Rising US COVID-19 Infections Are A Risk, But Won’t Derail Global Recovery Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Sources Of Market-Moving News The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly. With markets largely in line with fundamentals, the three most likely sources of market-moving “new news” affecting grain markets – outside weather – will come from public-health developments, particularly in the US; political developments affecting global trade, particularly the escalating Sino-US diplomatic tensions; and FX-market developments, which will continue to process these developments in real time. The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly (Chart 4). While we do not except a repeat of the massive lockdowns earlier this year, rising infection rates do place increasing strains on public-health resources, which could force officials to reimpose lockdowns locally. The global recovery from the pandemic remains uneven, with China’s recovery apparently ahead of most other states in terms of returning its economy to normal. China was first to be hit by the virus and first to largely recover, due to its more extensive lockdowns. Rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. For grain markets, China remains an attractive destination for exporters, given the premium grains and soybeans trade at relative to other destinations (Chart 5). This should keep China’s imports of grains robust in the near future, particularly for corn (Chart 6). Chart 5China Grains Prices Are Attractive To Exporters China Grains Prices Are Attractive To Exporters China Grains Prices Are Attractive To Exporters While economics favor movement of grains – and other commodities – to China, rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. Chart 6China Should Remain Well Bid For Corn Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge A new security law foisted on Hong Kong by Beijing at the end of June limiting freedom and autonomy drew sharp responses from the US and EU. President Trump this week signed an order ending Hong Kong’s preferential status as a US trading partner in the wake of the new law, and threatened direct sanctions against Chinese officials involved in enforcing the law.3 The European Union issued a statement on July 1, which decried the passage of the law by the Standing Committee of China’s National People’s Congress, expressing “grave concerns about this law which was adopted without any meaningful prior consultation of Hong Kong’s Legislative Council and civil society.”4 In addition to this political turmoil, the US and China are engaged in a war of words over China’s territorial claims on the South China Sea, which is contested by states surrounding the sea and branded as illegal by the US.5 The US and China carried out simultaneous large-scale naval exercises earlier this month, raising concerns of an unintended military confrontation.6 Weaker USD Will Buoy Grain Markets We are aligned with our House view expecting a weakening of the USD, driven by the massive fiscal and monetary stimulus from the US; lower real rates in the US, and America’s apparent inability to successfully contain the COVID-19 pandemic to the degree other states (e.g., China) have (Chart 7). This implies the US is at a greater risk of a marked slowdown in its ongoing economic recovery. These factors will support flows to markets ex-US, pressuring the USD lower. For grain markets this will be bullish for demand. A weaker USD lifts EM GDP growth, which boosts industrial activity (Chart 8). Higher income boosts demand for protein, which drives demand for corn and soybeans used as animal feed, and grain consumption (wheat and rice).7 Chart 7USD Weakness Expected As Real Rates Fall, Deficits Rise USD Weakness Expected As Real Rates Fall, Deficits Rise USD Weakness Expected As Real Rates Fall, Deficits Rise Chart 8Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand   On the supply side, a higher (lower) US dollar decreases (raises) the local costs of production for ag exporting countries with a certain lag. A persistently high (low) dollar will incentivize (disincentivize) crop planting in these countries – allowing producers to increase local currency profits from USD-denominated ag exports. This pushes up (down) global supply at the margin. Hence, over relatively long periods, ag prices and the US dollar tend to trend in opposite directions. We cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress. Longer term, disparities in monetary and fiscal policies, interest rates, and economic activity between the US and other DM economies will dominate the evolution of the dollar. In our simulations for the USD’s trajectory between now and the end of the year, a 5% depreciation of the USD would lift the CCI grains and oilseed index 13%, while a 5% strengthening of the dollar would push the index down by -8% by December 2020 (Chart 9).8 Should this weakening in the USD materialize, we can expect US grains’ stocks-to-use ratios to fall, which would reinforce price strength in grains (Chart 10). Chart 9USD Weakness Will Buoy Grains USD Weakness Will Buoy Grains USD Weakness Will Buoy Grains While the weaker-dollar scenarios are our favored evolution, we cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress (Chart 11). Chart 10Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Chart 11USD's Safe-Haven Status Could Keep Dollar Well Bid USD's Safe-Haven Status Could Keep Dollar Well Bid USD's Safe-Haven Status Could Keep Dollar Well Bid Bottom Line: Global grain markets are closer to balance than not, leaving exogenous risks – i.e., a COVID-19 second wave, renewed Sino-US trade and military tensions, and a stronger USD – as the key threats to grain prices. The impact of these exogenous risks will be filtered through to grain markets – and commodities generally – via FX markets. While we expect a weaker USD to prevail, in line with our House view, we cannot gainsay the dollar’s safe-haven role and its attraction during times of tension and crisis.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight As we go to press, Brent prices are steady at ~ $43/bbl as market participants await OPEC 2.0's Joint Ministerial Monitoring Committee decision on next month's output levels. The group is reportedly set to ease production curtailment to 7.7mm b/d starting next month from 9.7mm b/d in July. This would add to the growing concerns about the impact on oil demand of mounting COVID-19 cases in the US and in EM economies. Still, Saudi Arabia’s Energy Minister reiterated the effective cuts would be deeper as countries that overproduced in May/Jun will have to compensate with extra cuts over the coming months. Our global oil balances point to a supply deficit in 2H20. Thus, prices will recover if a correction were to occur. Base Metals: Neutral Copper prices surged by 5% since last week and have now completely recovered from the damaging COVID-19 shock – up 4% ytd. Fears of strike over wages at Antofagasta’s Zaldivar mine in Chile – following unionized workers rejection of a pay offer – and of virus-related mine disruptions in Latin America, combined with strong imports numbers out of China for the month of June supported the recent rally.9 In USD terms, Chinese imports growth recovered to 2.7% from -16.7% in May as stimulus programs start impacting the real economy (Chart 12). Precious Metals: Neutral Gold and silver prices are up 19% and 9% ytd. Silver rose to $19.5/oz as of Tuesday’s close, pushing the gold-to-silver ratio down to 93 after several weeks at ~ 100. Silver prices are supported by both safe-haven and industrial demand at the moment, which is pushing its equilibrium value higher, based on our silver price model (Chart 13). Our long Dec/20 silver futures trade is up 6.4% since inception on July 2, 2020. Ags/Softs:  Underweight On Tuesday the corn market shrugged off the biggest Chinese single-day purchase of U.S. corn and the USDA’s report of a 2% decline in corn crop conditions rated good to excellent. Despite this arguable bullish news, corn prices were still down on prospects of large carryovers both this season and the next marketing year, which begins in September. Going forward, the USDA cattle on feed inventory figure as well as ethanol demand will be key to assessing the evolution of corn carryovers. Feed and residual use of corn went down in the latest WASDE report, with year-to-date cattle on feed inventory lower than 2019, due to consumer stockpiling during the pandemic. With the beginning of grilling season well on its way re-stocking will be a challenging task. Chart 12Chinese Stimulus Will Lift Import Growth Chinese Stimulus Will Lift Import Growth Chinese Stimulus Will Lift Import Growth Chart 13Higher Equilibrium Value of Silver Higher Equilibrium Value of Silver Higher Equilibrium Value of Silver     Footnotes 1     Please see the UN’s AMIS Market Monitor for July 2020. 2     Please see World Agricultural Supply and Demand Estimates (WASDE) published by the USDA July 10, 2020. 3    Reuters reports that per the executive order signed by Trump this week, “U.S. property would be blocked of any person determined to be responsible for or complicit in ‘actions or policies that undermine democratic processes or institutions in Hong Kong.’”  In addition, the order requires US officials to “revoke license exceptions for exports to Hong Kong.”  Hong Kong passport holders no longer will be accorded special treatment under the order as well.  Please see China vows retaliation after Trump ends preferential status for Hong Kong published by reuters.com July 14, 2020. 4    Please see Declaration of the High Representative on behalf of the European Union on the adoption by China’s National People’s Congress of a National Security Legislation on Hong Kong. This was issued by the EU July 1, 2020. 5    Please see South China Sea dispute: China's pursuit of resources 'unlawful', says US published by bbc.com July 14, 2020.  See also China Pushes Back Against U.S. Statement on South China Sea Claims, ASEAN Stays Silent published by news.usni.org July 14, 2020. 6    Please see U.S. Carriers Send a Message to Beijing Over South China Sea published by foreignpolicy.com July 9, 2020. 7     In our modeling, we find that ag prices are generally less responsive to short-term changes in the US dollar compared to oil or base metals, but that they follow a common trend with the dollar over the long term. 8    These percent changes scale linearly in percentage terms, so a 10% weakening of the USD would lift the index 26%. 9    Please see Workers at Antofagasta's Zaldivar copper mine in Chile vote to strike: union published by reuters.com on July 10, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Exogenous Risks Keep Grains, Beans On Edge Exogenous Risks Keep Grains, Beans On Edge

Highlights Global shortages of medical equipment – including medicines – are frontloaded until emergency production kicks in. As the crisis abates, political recriminations between the US and China will surge. The US will seek to minimize medical supply exposure to China going forward, a boon for India and Mexico. China has escaped the COVID-19 crisis with minimal impact on food supply. Pork prices are surging due to African Swine Flu, but meat is a luxury. Still, the “Misery Index” is spiking and this will increase social instability. Food insecurity, inflation, and large current account deficits suggest that emerging market currencies will remain under pressure. Turkey and South Africa stand to suffer while we remain overweight Malaysia. Feature Chart 1Collapse In Economic Activity Collapse In Economic Activity Collapse In Economic Activity With a third of the world population under some form of lockdown, general activity in the world’s manufacturing powerhouses has collapsed (Chart 1). The breakdown is a double whammy on market fundamentals. On the supply side, government-mandated containment efforts force workers in non-essential services to stay home while, on the demand side, households confined to their homes are unable to spend. Acute demand for medical supplies is causing shortages, while supply disruptions threaten states that lack food security. While global monetary and fiscal stimulus will soften the blow (Chart 2), the economic shock is estimated to be a 2% contraction in real GDP for every month of strict isolation. If measures are extended beyond April, markets will sell and new stimulus will be applied. Already the US Congress is negotiating the $1-$2 trillion infrastructure package that we discussed in our March 4 report, and cash handouts will be ongoing. When the dust settles the political fallout will be massive. Authoritarian states like China and especially Iran will face greater challenges maintaining domestic stability. Democracies like Italy and the US, which lead the COVID-19 case count, are the most likely to experience a change in leadership (Chart 3). Initially the ruling parties of the democracies are receiving a bump in opinion polling, but this will fade as households will be worse off and will likely vent their grievances at the ballot box. Chart 2 Chart 3 Until a vaccine or treatment is discovered, medical equipment and social distancing are the only weapons against the pandemic. National production is (rightly) being redirected from clothing and cars to masks and ventilators to meet the spike in demand. Will the supply shock cause shortages in food and medicine – essential goods for humankind? In this report we address the impact of COVID-19 on global supply security and assess the market implications. Medical Equipment Shortages Will Spur Protectionism Chart Policymakers are fighting today’s crisis with the tools of the 2008 crisis, but a lasting rebound in financial markets will depend on surmounting the pandemic, which is prerequisite to economic recovery (Table 1). As the US faces the peak of its COVID-19 outbreak, public health officials and doctors are raising the alarm on the shortage of medical supplies. A recent US Conference of Mayors survey reveals that out of the 38% of mayors who say they have received supplies from their state, 84.6% say they are inadequate (Chart 4). Italy serves as a warning: A reported 8% of the COVID-19 cases there are doctors and health professionals, often treating patients without gloves or with compromised protective gear. These workers are irreplaceable and when they succumb the virus cannot be contained. In the US, doctors and nurses are re-using masks and sometimes treating patients behind a mere curtain, highlighting the supply shortage. While the shortages are mainly driven by a surge in demand from both medical institutions and households, they also come from the supply side, particularly China. Factory closures and transportation disruptions in China earlier this year, coupled with Beijing’s government-mandated export curbs, reduced Chinese exports, a major source of US and global supplies (Chart 5). Chart 4 Chart 5 Other countries have imposed restrictions on exports of products used in combating the spread of COVID-19. Following export restrictions by the French, German, and Czech governments in early March, the European Commission intervened on March 15 to ensure intra-EU trade. It also restricted exports of protective medical gear outside of the EU. At least 54 nations have imposed new export restrictions on medical supplies since the beginning of the year.1 Both European and Chinese measures will reduce supplies in the US, the top destination for most of these halted exports (Chart 6). Chart 6 Thus it is no wonder that the Trump administration has rushed to cut import duties and boost domestic production. The administration has released strategic stockpiles and cut tariffs on Chinese medical equipment used to treat COVID-19. With the whole nation mobilized, supply kinks should improve greatly in April. After a debacle in rolling out test kits (Chart 7), the US is rapidly increasing its testing capabilities to manage the crisis, with over a million tests completed as of the end of March (Chart 8). Meanwhile a coalition of companies is taking shape to make face masks. The president has invoked the defense production act to force companies to make ventilators. Chart 7 Chart 8 However, with the pandemic peaking in the US, the hardest-hit regions will continue experiencing shortages in the near term. Shortages are prompting public outcry against the US government for its failure to anticipate and redress supply chain vulnerabilities that were well known and warned against. A report in The New York Times tells how Mike Bowen, owner of Texas-based mask-maker Prestige Ameritech, has advised the past three presidents about the danger in the fact that the US imports 95% of its surgical masks. “Aside from sitting in front of the White House and lighting myself on fire, I feel like I’ve done everything I can,” he said. He is currently inundated with emergency orders from US hospitals. The same report tells of a company called Strong Manufacturers in North Carolina that had to cut production of masks because it depends on raw materials from Wuhan, China, where the virus originated.2 The Trump administration will suffer the initial public uproar, but the US government will also seek to reduce import dependency going forward, and it will likely deflect some of the blame by focusing on the supply risks posed by China. Beijing, for its part, is launching a propaganda campaign against the US to distract from its own failures at home (some officials have even blamed the US for the virus). Meanwhile it is cranking up production and shipping medical supplies to crisis hit areas like Italy to try to repair its global image after having given rise to the virus. In addition, the city of Shenzhen is sending 1.2 million N95 masks to the US on the New England Patriots’ team plane. Even Russia is sending small donations. But these moves work to propagandistic efforts in these countries and will ultimately shame the Americans into taking measures to improve self-sufficiency. Bottom Line: The most important supply shortage amid the global pandemic is that of medical equipment. While these shortages will abate sooner rather than later, the supply chain vulnerabilities they have exposed will trigger new policies of supply redundancy and import substitution. The US in particular will seek to reduce dependency on China. That COVID-19 is aggravating rather than reducing tensions between these states, despite China’s role as a key supplier in a time of need, highlights the secular nature of their rising tensions. The US-China Drug War Shortages of pharmaceuticals are also occurring, despite the fact that the primary pandemic response is necessarily “non-pharmaceutical” (e.g. social distancing). The US Food and Drug Administration (FDA) announced the first COVID-19 related drug shortage in the US on February 27. While the specific drug was not disclosed, the announcement notes that “the shortage is due to an issue with manufacturing of an active pharmaceutical ingredient used in the drug.”3 The FDA is monitoring 20 other (non-critical) drugs potentially at risk of shortages because the sole source is China. The global spread of the pandemic will increase these shortages. On March 3 India announced export restrictions on 26 drugs, including paracetamol and several antibiotics, due to supply disruptions caused by the Chinese shutdown. While Chinese economic activity has since picked up, India is now among the string of countries under a nationwide lockdown. Similar measures enforced across Europe will also hamper the production and transportation of these goods. The implication is that even if Chinese drugs return to market, supplies further down the chain and from alternative suppliers will take a hit. The risk that this will evolve into a drug shortage depends on the intensity of the outbreak. Drug companies generally hold 3-6 months’ worth of inventories. Consequently, while inventories are likely to draw as supplies are disrupted, consumers may not experience an outright shortage immediately. In the US, as with equipment and protective gear, the government’s strategic stockpile will buffer against shortfalls in supplies of critical drugs. COVID-19 is aggravating rather than reducing US-China tensions. Nevertheless the supply chain is getting caught up in the larger US-China strategic conflict. Even before the pandemic, the US-China trade war brought attention to the US’s vulnerabilities to China’s drug exports. This dispute is not limited to illicit drugs, as with China’s production of the opioid fentanyl, but also extends to mainstream medicines, as highlighted in the selection of public statements shown in Table 2. Chart Chart 9 How much does the US rely on China for medicine? According to FDA data, just over half of manufacturing facilities producing regulated drugs in finished dosage form for the US market are located abroad, with China’s share at 7% (Chart 9).4 The figures are higher for manufacturing facilities producing active pharmaceutical ingredients, though still not alarming – 72% of the facilities are located abroad, with 13% in China. Of course, high-level data understate China’s influence. The complex nature of global drug supply chains means that the source of finished dosage forms masks dependencies and dominance higher up the supply chain (Figure 1). Chart For instance, active pharmaceutical ingredients produced in Chinese facilities are used as intermediate goods by finished dosage facilities in India as well as China. The FDA reports that Indian finished dosage facilities rely on China for three-quarters of the active ingredients in their generic drug formulations, which are then exported to the US and the rest of the world. Any supply disruption in China – or any other major drug producer – will lead to shortages further down the supply chain. Chart 10 Chinese influence becomes more apparent when the sample is restricted to generic prescription drugs. These are especially relevant because nearly 70% of Americans are on at least one prescription drug, of which more than 90% are dispensed in the generic form. In this case, 87% of ingredient manufacturers and 60% of finished dosage manufacturers are located outside the US, with 17% of ingredient facilities and 8% of dosage facilities in China (Chart 10). Of all the facilities that manufacture active ingredients that are listed on the World Health Organization’s Essential Medicines List – a compilation of drugs that are considered critical to the health system – 71% are located aboard with 15% located in China (Chart 11). Moreover, manufacturers are relatively inflexible when adapting to market conditions and shortages. Drug manufacturing facilities generally operate at above 80% of their capacity and are thus left with little immediate capacity to ramp up production in reaction to shortages elsewhere. In addition, manufacturers face challenges in changing ingredient suppliers – there is no centralized source of information on them, and additional FDA approvals are required. The US will look to reduce its dependency on China for its drug supplies regardless of 2020 election outcome. China also has overwhelming dominance in specific categories. The Council on Foreign Relations reports that China makes up 97% of the US antibiotics market.5 Other common drugs that are highly dependent on China for supplies include ibuprofen, acetaminophen, hydrocortisone, penicillin, and heparin (Chart 12). Chart 11 Chart 12 Taking it all together, US vulnerability can be overstated. Consider the following: Of the 370 drugs on the Essential Medicines List that are marketed in the US, only three are produced solely in China. None of these three are used to treat top ten causes of death in the United States. Import substitution is uneconomical. Foreign companies, especially Chinese companies, are attractive due to their lower costs and lax regulations. While China’s influence extends higher up the supply chain, this is true for US markets as well as other consumer markets. While China can cut off the US from the finished dosages it supplies, it cannot do the same for the ingredients that are used by facilities in other countries and eventually make their way to the US in finished dosage form. Americans are demanding that drug prices be reduced and an obvious solution is looser controls on imports. The recent activation of the Defense Production Act shows that the US can take action to boost domestic production in emergencies. Nevertheless, China is growing conspicuous to the American public due to general trade tensions and COVID-19. As it moves up the value chain, it also threatens increasing competition for the US and its allies. Hence the US government will have a strategic reason to cap China’s influence that is also supported by corporate interests and popular opinion. This will lead to tense trade negotiations with China and meanwhile the US will seek alternative suppliers. China will not want to lose market share or leverage over the United States, so it may offer trade concessions at some point to keep the US engaged. Ultimately, however, strategic tensions will catalyze US policy moves to reduce the cost differential with China and promote its rivals. Pressure on China over its currency, regulatory standards, and scientific-technological acquisition will continue regardless of which party wins the White House in 2020. The Democrats would increase focus on China’s transparency and adherence to international standards, including labor and environmental standards. Both Republicans and Democrats will try to boost trade with allies. The key beneficiaries will be India, Southeast Asia, and the Americas. Taiwan’s importance will grow as a middle-man, but so will its vulnerability to strategic tensions. Bottom Line: The US and the rest of the world are suffering shortfalls of equipment necessary to combat COVID-19. There is also a risk of drug shortages stemming from supply disruptions and emergency protectionist policies. These shortages look to be manageable, but they have exposed national vulnerabilities that will be reduced in future via interventionist trade policies. While the US and Europe will ultimately manage the outbreak, the political fallout will be immense. The US will look to reduce its dependency on China. This will increase investment in non-China producers of active pharmaceutical ingredients, such as India and Mexico. The US tactics against China will vary according to the election result, but the strategic direction of diversifying away from China is clear and will have popular impetus in the wake of COVID-19. Food Security In addition to the challenges posed by COVID-19 on medical supplies, food – another essential good – also faces risk of shortages. China is a case in point. Food prices there were on the rise well before the COVID-19 outbreak, averaging 17.3% in the final quarter of 2019. However inflation was limited to pork and its substitutes – beef, lamb and poultry – and reflected a reduction in pork supplies on the back of the African Swine Flu outbreak. While year-on-year increases in the prices of pork and beef averaged 102.8% and 21.0%, respectively, grain, fresh vegetable, and fresh fruit prices averaged 0.6%, 1.5%, and -5.0% in Q42019 (Chart 13). Chart 13Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chinese Inflation Has (Thus far) Been Contained To Pork Chart 14China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability China's Misery Index Is Spiking - A Political Liability However China’s COVID-19 containment measures had a more broad-based impact on food supplies, threatening to push up China’s Misery Index (Chart 14). Travel restrictions, roadblocks, quarantined farm laborers, and risk-averse truck drivers introduced challenges not only in ensuring supplies were delivered to consumers, but also to daily farm activity and planting. The absence of farm inputs needed for planting such as seeds and fertilizer, and animal feed for livestock, was especially damaging in regions hardest hit by the pandemic. Livestock farmers already struggling with swine flu-related reductions in herd sizes were forced to prematurely cull starving animals, cutting the stock of chicken and hogs. Now as the country transitions out of its COVID-19 containment phase and moves toward normalizing activity (Chart 15), food security is top of the mind. Authorities are emphasizing the need to ensure sufficient food supplies and adopt policies to encourage production.6 This is especially important for crops due to be planted in the spring. Delayed or reduced plantings would weight on the quality and quantity of the crops, pushing prices up. Chart 15 With food estimated to account for 19.9% of China’s CPI basket – 12.8% of which goes towards pork (Chart 16) – a prolonged food shortage, or a full-blown food crisis, would be extremely damaging to Chinese families and their pocketbooks. Chart 16 However, apart from soybeans and to a lesser extent livestock, China’s inventories are well stocked (Chart 17) and are significantly higher than levels amid the 2006-2008 and 2010-2012 food crises. Inventories have been built up specifically to provide ammunition precisely in times of crisis. Corn and rice stocks are capable of covering consumption for nearly three quarters of a year, and wheat stocks exceeding a year’s worth of consumption. Thus, while not completely immune, China today is better able to weather a supply shock. Moreover, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 18). Chart 17   Chart 18 As the COVID-19 epicenter shifts to the US and Europe, farmers there are beginning to face the same challenges. Reports of delays in the arrival of shipments of inputs such as fertilizer and seeds have prompted American farmers to prepare for the worst and order these goods ahead of time. Chart 19 While these proactive measures will help reduce risks to supply, farmers in Europe and parts of the US who typically rely on migrant laborers will need to search for alternative laborers as the planting season nears. Just last week France’s agriculture minister asked hairdressers, waiters, florists, and others that find themselves unemployed to take up work in farms to ensure food security. As countries become increasingly aware of the risks to food supplies, some have already introduced protectionist measures, especially in the former Soviet Union: The Russian agriculture ministry proposed setting up a quota for Russian grain exports and has already announced that it is suspending exports of processed grains from March 20 for 10 days. Kazakhstan suspended exports of several agricultural goods including wheat flour and sugar until at least April 15. On March 27, Ukraine’s economy ministry announced that it was monitoring wheat export and would take measures necessary to ensure domestic supplies are adequate. Vietnam temporarily suspended rice contracts until March 28 as it checked if it had sufficient domestic supplies. The challenge is that, unlike China, inventories in the rest of the world are not any higher than during the previous food crisis and do not provide much of a buffer against supply shortfalls (Chart 19). Higher food prices would be especially painful to lower income countries where food makes up a larger share of household spending (Chart 20). In addition to using their strategic food stockpiles, governments will attempt to mitigate the impact of higher food prices by implementing a slew of policies: Chart 20 Trade policies: Producing countries will want to protect domestic supplies by restricting exports – either through complete bans or export quotas. Importing countries will attempt to reduce the burden of higher prices on consumers by cutting tariffs on the affected goods. Consumer-oriented policies: Importing countries will provide direct support to consumers in the form of food subsidies, social safety nets, tax reductions, and price controls. Producer-oriented policies: Governments will provide support to farmers to encourage greater production using measures such as input subsidies, producer price support, or tax exemptions on goods used in production. While these policies will help alleviate the pressure on consumers, they also result in greater government expenditures and lower revenues. Thus, subsidizing the import bill of a food price shock can weigh on public finances, debt levels, and FX reserves. Currencies already facing pressure due to the recessionary environment, such as Turkey, South Africa and Chile will come under even greater downward pressure. Food inventories ex-China are insufficient to protect against supply shortages. Bottom Line: COVID-19’s logistical disruptions are challenging farm output. This is especially true when transporting goods and individuals across borders rather than within countries. This will be especially challenging for food importing countries, as some producers have already started erecting protectionist measures and this will result in an added burden on government budgets that are already extended in efforts to contain the economic repercussions of the pandemic. Investment Implications Chart 21Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD Ag Prices Inversely Correlated With USD China will continue trying to maximize its market share and move up the value chain in drug production. At the same time, the US is likely to diversify away from China and try to cap China’s market share. This will result in tense trade negotiations regardless of the outcome of the US election. The COVID-19 experience with medical shortages and newfound public awareness of potential medical supply chain vulnerabilities means that another round of the trade war is likely. Stay long USD-CNY. Regarding agriculture, demand for agricultural commodities is relatively inelastic. This inelasticity should prevent a complete collapse in prices even amid a weak demand environment. Thus given the risk on supplies, prices face upward pressure. However, not all crops are facing these same market dynamics. While wheat and rice prices have started to move in line with the dynamics described above, soybeans and to a greater extent corn prices have not reacted as such (Chart 21). In the case of soybeans, we expect demand to be relatively muted. China accounts for a third of the world’s soybean consumption. 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry. However, the 21% y/y decline in pork output in 2019 on the back of the African Swine Flu outbreak will weigh on demand and mute upward pressures on supplies. Demand for corn will also likely come in weak. The COVID-19 containment measures and the resulting halt in economic activity reduce demand for gasoline and, as a consequence, reduce demand for corn-based ethanol, which is blended with gasoline. In addition to the above fundamentals, ag prices have been weighed down by a strong USD which makes ex-US exporters relatively better off, incentivizing them to raise exports and increase global supplies. A weaker USD – which we do not see in the near term – would help support ag prices. It is worth noting that if there is broad enforcement of protectionist measures, then producers will not be able to benefit from a stronger dollar. In that case we may witness a breakdown in the relationship between ag prices and the dollar. In light of these supply/demand dynamics, we expect rice and wheat prices to be well supported going forward and to outperform corn and soybeans.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 See "Tackling COVID-19 Together: The Trade Policy Dimension," Global Trade Alert, University of St. Gallen, Switzerland, March 23, 2020. 2 See Rachel Abrams et al, "Governments and Companies Race to Make Masks Vital to Virus Fight," The New York Times, March 21, 2020. 3 The announcement also notes that there are other alternatives that can be used by patients. See "Coronavirus (COVID-19) Supply Chain Update," US FDA, February 27, 2020. 4 All regulated drugs include prescription (brand and generic), over the counter, and compounded drugs. 5 Please see Huang, Yanzhong, "The Coronavirus Outbreak Could Disrupt The US Drug Supply," Council on Foreign Relations, March 5, 2020. 6 The central government ordered local authorities to allow animal feed to pass through checkpoints amid the lockdowns. In addition, Beijing has relaxed import restrictions by lifting a ban on US poultry products and announcing that importers could apply for waivers on goods tariffed during the trade war such as pork and soybeans. The lifting of these restrictions also serves to help China meet its phase one trade deal commitments. Please see "Coronavirus hits China’s farms and food supply chain, with further spike in meat prices ahead," South China Morning Post, dated February 21, 2020.

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

Highlights Given that rising crop yields have been the main vehicle through which global supply of agricultural commodities grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. The impact of climate change will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The implications of climate change on agriculture producers are non-uniform. Low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. Expect greater volatility in agriculture prices as the frequency of weather events will raise uncertainty. Feature The steady expansion of global population and rising per-capita calorie consumption has directly translated to growing demand for agricultural products of all types. However, these demand-side pressures increasingly will be met with disruptions to global supply of agricultural commodities, as the impact of climate change raises uncertainty. In any given year, the aggregate decisions of farmers all over the world – i.e., the choice of which crops to plant and how much acreage to dedicate to each crop – determine the supply and market prices of ags. In this competitive market, each farmer attempts to maximize his or her welfare by planting the crops that are expected to yield the greatest profit. Chart 12010/11 Shock Highlights Ag Vulnerability To Weather 2010/11 Shock Highlights Ag Vulnerability To Weather 2010/11 Shock Highlights Ag Vulnerability To Weather The collective action of these producers in reaction to perceived demand generally leads to stable prices, especially for staple commodities such as grains and oilseeds, which differ from industrial commodities in that they are not highly correlated with global business cycles. Demand trends are long-term and slow moving, and typically do not result in abrupt price pressures, as farmers have time to adjust and adapt to changing consumer preferences. Unforeseen, weather-induced supply-side shocks, therefore, are the main source of sudden price changes in ag markets. Such a shock was dramatically on display during the drought-induced crop failures in major grain and cereal producing regions in the most recent global food crisis of 2010/11. While this massive supply shock was not the first of its kind (Chart 1, on page 1), it highlighted the vulnerability of ag markets to weather risks and specifically the evolving environment under climate change. A 2019 study quantifies the impact of shifting weather patterns on the agricultural market, finding that year-to-year changes in climate factors during the growing season explain 20%-49% of change in corn, rice, soybean, and wheat yields, with climate extremes accounting for 18%-43% of this variation.1 In theory, the impact can manifest in several ways, sometimes contradictory: Extreme weather events: An increase in the frequency and intensity of droughts or floods which threaten to wipe out crops or reduce yields, creating unpredictable supply shocks. The gradual rise in temperature: Each crop has cardinal temperatures – defined by the minimum, maximum and optimum – that determine its boundaries for growth. Increases in temperatures induced by global warming may push the boundary, reducing yields in some regions. Changes in precipitation patterns: In many areas precipitation is projected to increase – both in short bursts and over longer periods. This will lead to greater soil erosion resulting in deterioration in the quality of soil. In other regions, precipitation will decrease, and drought is expected to become more frequent.2 Moreover, the interaction of these factors – along with other region-specific variables – will amplify the impact on crops: Rising temperatures and greater precipitation will result in greater amounts of water in the atmosphere, producing increased water vapor and greater cloud cover. This will reduce solar radiation, and will harm crop productivity. Elevated atmospheric carbon dioxide and CO2 fertilization: Greater CO2 concentrations brought on by continued growth in air pollution are positive for crops as they stimulate photosynthesis and plant growth. However, the impact differs across crops with plants such as soybeans, rice and wheat set to benefit relatively more than plants such as corn.3 Moreover, elevated atmospheric CO2 levels can help crops respond to environmental stresses and reduce yield losses due to ozone and crop water loss through partial stomatal closure and a reduction in ozone penetration into leaves. Temperature changes and the magnitude and intensity of precipitation impact soil moisture and surface runoff. Indirect effects of climate change – weeds, pests and pathogens – also present challenges as they require changes to management practices and may raise farming costs required. The impact of climate change on agriculture markets is already evident in increasing intensity and frequency of extreme weather events. The confluence of these factors, and the region- and crop-specific nature of these variables, makes it impossible to estimate the impact of evolving climate conditions on ag products with great accuracy. Nevertheless, our research suggests that the impact of climate change on ag markets will create opportunities in this evolving and highly uncertain market. Abrupt Shocks Amid Gradual Warming: The Long And Short View The impact of climate change on agriculture markets is already evident in the increasing intensity and frequency of extreme-weather events such as heatwaves, floods, and droughts. Charts 2A, 2B, and 2C, illustrate the impact of major weather events in crop-producing regions of the U.S. on yields, production and acreage for the crop year in which the events took place. Chart 2AExtreme Weather Events Reduce U.S. Corn Supplies … Extreme Weather Events Reduce U.S. Corn Supplies Extreme Weather Events Reduce U.S. Corn Supplies Chart 2B… Soybean Supplies … Extreme Weather Events Reduce U.S. Soybean Supplies Extreme Weather Events Reduce U.S. Soybean Supplies Chart 2C… And Wheat Supplies In A Big Way Extreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Extreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Chart 3Climate-Induced U.S. Supply Shocks Associated With Price Spikes Climate-Induced U.S. Supply Shocks Associated With Price Spikes Climate-Induced U.S. Supply Shocks Associated With Price Spikes   While the individual losses are a function of the magnitude of the event, the events highlighted translate to a 16%, 10%, and 7% decline in corn, soybean, and wheat yields, respectively. These supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. Given that the U.S. is a major global supplier of these crops, extreme weather events and the subsequent supply reductions lead to non-negligible price pressures (Chart 3). While crop conditions thus far have failed to deteriorate in trend (Chart 4), greater frequency and intensity of weather events raise the probability of a decline in overall crop and could lower supply.   Chart 4Crop Conditions Have Generally Held Up Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Expanding the analysis to other major crop-producing regions of the world, we find that once again, extreme-weather events are associated with a decline in yields and production in the corresponding crop year (Chart 5). This exercise also indicates that the impact of droughts is significantly more pronounced than the impact of floods.4 While the weather-induced supply shocks described above are unpredictable, abrupt, and have an immediate impact on output and prices, the gradual warming of temperatures is a slow-moving process. Consequently, the impact will manifest in the form of gradual changes that are difficult to capture and quantify, especially given the mitigating effect of CO2 fertilization – i.e., higher yields resulting from higher CO2 in the atmosphere. Nonetheless, rising temperatures will become a serious risk in crop-planting regions both in the U.S. and globally (Chart 6). While rising temperatures are expected to bring about increasingly more wide-ranging supply disruptions (Chart 7), the net impact over the coming decade is not a clear negative. Chart 5Weather Events, Especially Droughts, Hurt Global Supplies Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Chart 6Rising Global Temperatures Will Pose A Serious Risk … Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Chart 7… Especially Above The 2°C Mark Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction One study expects the positive impact of CO2 fertilization on yields to overwhelm the negative effect of rising temperatures over the coming decade (Table 1). Elsewhere, studies forecast different responses, with some predicting incremental yield gains over the coming decade before temperatures rise to levels that overwhelm the benefits of greater CO2. Similarly, according to the FAO’s assessment, the net negative impact of climate change on global crop yields will only become apparent with a high degree of certainty post-2030.5 Table 1Estimates For The Response Of Global Average Crop Yields To Warming And CO2 Changes Over The Next Decades Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Bottom Line: Given that rising crop yields have been the main vehicle through which global ag supply grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. Supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. The impact will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The Winners … And Losers Rising temperatures are expected to result in a negligible impact on ag markets over the coming decade; yet this finding is not uniform across all regions. The FAO study cited above finds that by 2030, the projected impact on crop yields will be slightly net negative in developing countries. However, in developed countries, the effect will be net positive. In terms of global supply, the impact of climate change over the coming decade is expected to remain relatively contained, affecting certain regions at various times without causing major global disruptions. That said, as global warming and extreme weather persist, the ramifications will begin to extend beyond individual regions, and will cause supply shocks on a global scale. In part, this can be explained by a greater potential for net reductions in crop yields in warmer, low-latitude areas and semi-arid regions of the world.6 This non-uniform impact will create relative winners and losers. Producers located in temperate regions – where climate change does not yet pose as serious a threat – are set to profit from their increased role in global supply. Conversely, tropical regions are much more vulnerable to climate change. This is especially true for those whose economies are highly dependent on agriculture (Chart 8). Chart 8Agricultural Economies In Tropical Regions Are Most Vulnerable Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction On net, the overall economies of DM countries – which generally are not economically dependent on agriculture and are located in northern regions – will be relatively more insulated from the impact of climate change on the agriculture sector. Aside from the impact on producers, the implications on consumers are also region-dependent. Clearly the direct impact of climate change on global agriculture will be higher food prices, which directly impacts the food component of inflation generally. As a result, consumers who spend a large share of their income to food – generally consumers in lower income countries – will be hardest hit (Chart 9). Chart 9Higher Food Prices Disproportionately Hurt Consumers In Lower Income Countries Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction In theory, a food supply shock is transitory, and given that food is usually excluded from core inflation gauges targeted by central banks, monetary policy should not react to these price spikes. All the same, aside from this direct impact on inflation, food inflation can also pass-through into other components of the CPI basket, for example through wage pressures or inflation expectations. This would lead to a more persistent impact on core inflation, forcing policy makers to react to these transitory forces, complicating the monetary policy response function for these countries. Given that inflation expectations are less well-anchored in lower income economies and that food makes up a larger share of consumption expenditures in these economies, they are most vulnerable to weather-induced food shocks. Chart 10Subsidies Partially Insulate Against International Shocks Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction In countries where food prices are highly subsidized, the impact of higher global food prices will not immediately translate to higher domestic prices. This explains why there is no one-to-one relationship between global food prices and domestic food prices (Chart 10). Instead, the higher prices are absorbed by the governments, resulting in an expansion in government expenditures. This distorts the local food market, as it prevents demand from adjusting to the higher prices, and could potentially result in an undershoot in inventories that makes global markets even more vulnerable to further supply shocks. Bottom Line: The implications of climate change on ag producers are non-uniform. While higher-latitude regions are set to benefit, at least in the short-run, low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. On the consumer side, individuals who spend a large share of their income on food are set to suffer most. While consumers in countries that subsidize the crops will be protected from the immediate inflation risk, they may feel a delayed impact due to an increase in budget expenditures needed to cover the larger import bill. Mitigation Efforts While the potential impact of climate change on the agriculture sector can be large, it will be at least partially managed through adoption of mitigation policies (Diagram 1). Diagram 1Adaptation Reduces Vulnerability Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction A key question in determining the extent of this behavior is whether warming temperatures and the increased occurrence and intensity of extreme events will be sufficient to justify a major acceleration of investment in agriculture. These efforts would range from simple management changes on the part of farmers to technological advances that raise the productivity of farming or reduce the vulnerability of farmers to climate change. For example, farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates (Chart 11). The earlier planting has also been accompanied by a longer growing season with the average number of days in the season increasing. Farmers are also adapting by altering their decisions on which crops to plant. For example, since soybean and corn are planted in many of the same regions of the U.S., farmers often plant more soybeans than corn when experiencing weather shocks. Chart 11Weather Events, Especially Droughts, Hurt Global Supplies Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction The agriculture sector is also using more efficient machinery that can plant and harvest crops much faster as well as developing heartier seeds and more potent fertilizers. In turn, farmers will alter their decision making by selecting crop varieties or species that are more resistant to heat and drought. Or they will change fertilizer rates, amounts and timing of irrigation, along with other water-management techniques. Farmers also are making wider use of integrated pest and pathogen management techniques, in order to raise the effectiveness of pest, disease, and weed control. Given that the number of firms in the agriculture sector are fewer in developed markets than in the rest of the world, management decisions can be more easily implemented in the former. Farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates. On the other hand, emerging market countries where ag output is driven by numerous individual farmers will have a more difficult time implementing policies. Individual farms may not have the means to support themselves, which raises the potential impact of climate change. What is more, climate-change mitigation efforts may require projects, programs, or funds set aside by the government to support these efforts. This is more likely to occur in wealthier developed countries. Bottom Line: Adaptation and mitigation measures on the part of farmers have the potential to reduce the impact of climate change. That said, farmers in richer countries with the funds and institutions in place to support the ag sector likely will fare better. Investment Implications Over the coming decade, the ramifications of climate change are likely to be contained to a regional level. Although global supply will be vulnerable to regional disruptions, the impact will, in part, be mitigated by inventories, which have been rising for years. These stocks will create a buffer against unpredictable supply shocks (Chart 12). Chart 12Higher Inventories Needed To Buffer Against Unpredictable Shocks Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction However, given that the global soybean market resembles an oligopoly with Brazil, the U.S., and Argentina accounting for 81% of global supply, global soybean prices will be more vulnerable to supply events in these regions than other crops (Chart 13). Chart 13Soybeans Most Vulnerable To Shocks Affecting Major Producers Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction At the other end of the spectrum, global wheat markets will be relatively more insulated from isolated weather events impacting any one major producer as each of these regions contributes a relatively small share to global wheat output. This analysis also finds that yields and supply generally recover in the crop year following an extreme climate event. This implies that while the extent of damage from these events can be severe, they are not persistent unless the increasing frequency of extreme events leads to a secular change. Aside from the price impact, the weather and temperature changes will manifest in the form of greater volatility in supply, translating to greater price volatility. Options-implied volatilities for corn, wheat and soybeans have been on a general downtrend since the two major global food scares in 2007/08 and 2010/11 (Chart 14). We expect the trend to reverse going forward as the frequency of weather events will create greater price uncertainty. We summarize the findings of this report in Table 3 (Appendix, on page 16). Chart 14Volatility Will Go Up Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Roukaya Ibrahim Editor/Strategist RoukayaI@bcaresearch.com Jeremie Peloso Research Analyst JeremieP@bcaresearch.com Amr Hanafy Research Associate AmrH@bcaresearch.com Hugo Bélanger Senior Analyst HugoB@bcaresearch.com Isabelle Dimyadi Research Associate Isabelled@bcaresearch.com Appendix Table 2Extreme Weather Events In The U.S. Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Table 3Summary Table Climate Change Special Series: An Introduction Climate Change Special Series: An Introduction Footnotes 1 Please see Vogel et al, The effects of climate extremes on global agricultural yields, Environ. Res. Lett 14 054010, 2019. 2 As a consequence of greenhouse gas emissions precipitation is expected to increase in high altitude regions such as much of the U.S. and decrease in subtropical regions such as the southwest U.S., Central America, southern Africa, and the Mediterranean basin. 3 Plants can be broken down into either C3 or C4 based on the way they assimilate atmospheric CO2 into different physiological components. While rising CO2 causes C3 plants to raise the rate of photosynthesis and reduce the respiration rate, C4 plants do not experience a rise in photosynthesis since  photosynthesis is already saturated. For example, studies show that soybean yields increased 12%-15% under 550 ppm vs. 370 ppm CO2 concentrations while corn experienced negligible yield increases. 4 Please see Lesk C., P. Rowhani, and N. Ramankutty, Influence of extreme weather disasters on global crop production, Nature, 529(7584), 84-87, 2016. 5 Please see The State Of Food And Agriculture: Climate Change, Agriculture, And Food Security, Food and Agriculture Organization of the United Nations, 2016. 6 Please see Stevanovic et al., The impact of high-end climate change on agricultural welfare, Sci-Adv 2(8), 2016.

The steady expansion of global population and rising per-capita calorie consumption has directly translated to growing demand for agricultural products of all types. However, these demand-side pressures increasingly will be met with disruptions to global supply of agricultural commodities, as the impact of climate change raises uncertainty. In any given year, the aggregate decisions of farmers all over the world – i.e., the choice of which crops to plant and how much acreage to dedicate to each crop – determine the supply and market prices of ags. In this competitive market, each farmer attempts to maximize his or her welfare by planting the crops that are expected to yield the greatest profit. The collective action of these producers in reaction to perceived demand generally leads to stable prices, especially for staple commodities such as grains and oilseeds, which differ from industrial commodities in that they are not highly correlated with global business cycles. Demand trends are long-term and slow moving, and typically do not result in abrupt price pressures, as farmers have time to adjust and adapt to changing consumer preferences. Unforeseen, weather-induced supply-side shocks, therefore, are the main source of sudden price changes in ag markets. Such a shock was dramatically on display during the drought-induced crop failures in major grain and cereal producing regions in the most recent global food crisis of 2010/11. While this massive supply shock was not the first of its kind (Chart 1), it highlighted the vulnerability of ag markets to weather risks and specifically the evolving environment under climate change. A 2019 study quantifies the impact of shifting weather patterns on the agricultural market, finding that year-to-year changes in climate factors during the growing season explain 20%-49% of change in corn, rice, soybean, and wheat yields, with climate extremes accounting for 18%-43% of this variation.1 In theory, the impact can manifest in several ways, sometimes contradictory: Chart 12010/11 Shock Highlights Ag Vulnerability To Weather 2010/11 Shock Highlights Ag Vulnerability To Weather 2010/11 Shock Highlights Ag Vulnerability To Weather Extreme weather events: An increase in the frequency and intensity of droughts or floods which threaten to wipe out crops or reduce yields, creating unpredictable supply shocks. The gradual rise in temperature: Each crop has cardinal temperatures – defined by the minimum, maximum and optimum – that determine its boundaries for growth. Increases in temperatures induced by global warming may push the boundary, reducing yields in some regions. Changes in precipitation patterns: In many areas precipitation is projected to increase – both in short bursts and over longer periods. This will lead to greater soil erosion resulting in deterioration in the quality of soil. In other regions, precipitation will decrease, and drought is expected to become more frequent.2 Moreover, the interaction of these factors – along with other region-specific variables – will amplify the impact on crops: Rising temperatures and greater precipitation will result in greater amounts of water in the atmosphere, producing increased water vapor and greater cloud cover. This will reduce solar radiation, and will harm crop productivity. Elevated atmospheric carbon dioxide and CO2 fertilization: Greater CO2 concentrations brought on by continued growth in air pollution are positive for crops as they stimulate photosynthesis and plant growth. However, the impact differs across crops with plants such as soybeans, rice and wheat set to benefit relatively more than plants such as corn.3 Moreover, elevated atmospheric CO2 levels can help crops respond to environmental stresses and reduce yield losses due to ozone and crop water loss through partial stomatal closure and a reduction in ozone penetration into leaves. Temperature changes and the magnitude and intensity of precipitation impact soil moisture and surface runoff. Indirect effects of climate change – weeds, pests and pathogens – also present challenges as they require changes to management practices and may raise farming costs required. The confluence of these factors, and the region- and crop-specific nature of these variables, makes it impossible to estimate the impact of evolving climate conditions on ag products with great accuracy. Nevertheless, our research suggests that the impact of climate change on ag markets will create opportunities in this evolving and highly uncertain market. Abrupt Shocks Amid Gradual Warming: The Long And Short View The impact of climate change on agriculture markets is already evident in increasing intensity and frequency of extreme-weather events. The impact of climate change on agriculture markets is already evident in the increasing intensity and frequency of extreme-weather events such as heatwaves, floods, and droughts. Charts 2A, 2B, and 2C, illustrate the impact of major weather events in crop-producing regions of the U.S. on yields, production and acreage for the crop year in which the events took place. While the individual losses are a function of the magnitude of the event, the events highlighted translate to a 16%, 10%, and 7% decline in corn, soybean, and wheat yields, respectively. These supply disruptions generally do not extend beyond the event year, as the new crop year offers farmers a clean slate to raise output and maximize profits. Chart 2AExtreme Weather Events Reduce U.S. Corn Supplies Extreme Weather Events Reduce U.S. Corn Supplies Extreme Weather Events Reduce U.S. Corn Supplies Chart 2BExtreme Weather Events Reduce U.S. Soybean Supplies Extreme Weather Events Reduce U.S. Soybean Supplies Extreme Weather Events Reduce U.S. Soybean Supplies Chart 2CExtreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Extreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Extreme Weather Events Reduce U.S. Wheat Supplies In A Big Way Chart 3Climate-Induced U.S. Supply Shocks Associated With Price Spikes Climate-Induced U.S. Supply Shocks Associated With Price Spikes Climate-Induced U.S. Supply Shocks Associated With Price Spikes Given that the U.S. is a major global supplier of these crops, extreme weather events and the subsequent supply reductions lead to non-negligible price pressures (Chart 3). While crop conditions thus far have failed to deteriorate in trend (Chart 4), greater frequency and intensity of weather events raise the probability of a decline in overall crop and could lower supply. Chart 4Crop Conditions Have Generally Held Up Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change Expanding the analysis to other major crop-producing regions of the world, we find that once again, extreme-weather events are associated with a decline in yields and production in the corresponding crop year (Chart 5). This exercise also indicates that the impact of droughts is significantly more pronounced than the impact of floods.4 The net impact of rising temperatures over the coming decade is not a clear negative. While the weather-induced supply shocks described above are unpredictable, abrupt, and have an immediate impact on output and prices, the gradual warming of temperatures is a slow-moving process. Consequently, the impact will manifest in the form of gradual changes that are difficult to capture and quantify, especially given the mitigating effect of CO2 fertilization – i.e., higher yields resulting from higher CO2 in the atmosphere. Nonetheless, rising temperatures will become a serious risk in crop-planting regions both in the U.S. and globally (Chart 6). While rising temperatures are expected to bring about increasingly more wide-ranging supply disruptions (Chart 7), the net impact over the coming decade is not a clear negative. Chart 5Weather Events, Especially Droughts, Hurt Global Supplies Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change Chart 6Rising Global Temperatures Will Pose A Serious Risk … Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change   One study expects the positive impact of CO2 fertilization on yields to overwhelm the negative effect of rising temperatures over the coming decade (Table 1). Elsewhere, studies forecast different responses, with some predicting incremental yield gains over the coming decade before temperatures rise to levels that overwhelm the benefits of greater CO2. Similarly, according to the FAO’s assessment, the net negative impact of climate change on global crop yields will only become apparent with a high degree of certainty post-2030.5 Chart 7… Especially Above The 2 ℃ Mark Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change Table 1Estimates For The Response Of Global Average Crop Yields To Warming And CO2 Changes Over The Next Decades Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change Bottom Line: Given that rising crop yields have been the main vehicle through which global ag supply grew to meet expanding demand, the risks posed to yields due to climate change are non-trivial. The impact will manifest itself in the form of two simultaneous trends: the gradual rise in temperatures alongside more frequent and severe weather events. While the latter will threaten immediate supply, the former is a slower moving process, and its net negative impact is unlikely to manifest before 2030. The Winners … And Losers Rising temperatures are expected to result in a negligible impact on ag markets over the coming decade; yet this finding is not uniform across all regions. The FAO study cited above finds that by 2030, the projected impact on crop yields will be slightly net negative in developing countries. However, in developed countries, the effect will be net positive. In terms of global supply, the impact of climate change over the coming decade is expected to remain relatively contained, affecting certain regions at various times without causing major global disruptions. That said, as global warming and extreme weather persist, the ramifications will begin to extend beyond individual regions, and will cause supply shocks on a global scale. In part, this can be explained by a greater potential for net reductions in crop yields in warmer, low-latitude areas and semi-arid regions of the world.6 This non-uniform impact will create relative winners and losers. Producers located in temperate regions – where climate change does not yet pose as serious a threat – are set to profit from their increased role in global supply. Conversely, tropical regions are much more vulnerable to climate change. This is especially true for those whose economies are highly dependent on agriculture (Chart 8). Chart 8Agricultural Economies In Tropical Regions Are Most Vulnerable Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change On net, the overall economies of DM countries – which generally are not economically dependent on agriculture and are located in northern regions – will be relatively more insulated from the impact of climate change on the agriculture sector. Aside from the impact on producers, the implications on consumers are also region-dependent. Clearly the direct impact of climate change on global agriculture will be higher food prices, which directly impacts the food component of inflation generally. As a result, consumers who spend a large share of their income to food – generally consumers in lower income countries – will be hardest hit (Chart 9). Chart 9Higher Food Prices Disproportionately Hurt Consumers In Lower Income Countries Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change In theory, a food supply shock is transitory, and given that food is usually excluded from core inflation gauges targeted by central banks, monetary policy should not react to these price spikes. All the same, aside from this direct impact on inflation, food inflation can also pass-through into other components of the CPI basket, for example through wage pressures or inflation expectations. This would lead to a more persistent impact on core inflation, forcing policy makers to react to these transitory forces, complicating the monetary policy response function for these countries. Given that inflation expectations are less well-anchored in lower income economies and that food makes up a larger share of consumption expenditures in these economies, they are most vulnerable to weather-induced food shocks. Individuals who spend a large share of their income on food are set to suffer most. In countries where food prices are highly subsidized, the impact of higher global food prices will not immediately translate to higher domestic prices. This explains why there is no one-to-one relationship between global food prices and domestic food prices (Chart 10). Instead, the higher prices are absorbed by the governments, resulting in an expansion in government expenditures. This distorts the local food market, as it prevents demand from adjusting to the higher prices, and could potentially result in an undershoot in inventories that makes global markets even more vulnerable to further supply shocks Chart 10Subsidies Partially Insulate Against International Shocks Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change Bottom Line: The implications of climate change on ag producers are non-uniform. While higher-latitude regions are set to benefit, at least in the short-run, low-latitude countries with economies that are highly dependent on the agriculture sector will suffer most. On the consumer side, individuals who spend a large share of their income on food are set to suffer most. While consumers in countries that subsidize the crops will be protected from the immediate inflation risk, they may feel a delayed impact due to an increase in budget expenditures needed to cover the larger import bill. Mitigation Efforts While the potential impact of climate change on the agriculture sector can be large, it will be at least partially managed through adoption of mitigation policies (Diagram 1). Diagram 1Adaptation Reduces Vulnerability Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change A key question in determining the extent of this behavior is whether warming temperatures and the increased occurrence and intensity of extreme events will be sufficient to justify a major acceleration of investment in agriculture. These efforts would range from simple management changes on the part of farmers to technological advances that raise the productivity of farming or reduce the vulnerability of farmers to climate change. For example, farmers across the U.S. have been planting corn and soybeans earlier in the spring, resulting in an advancement in planting dates (Chart 11). The earlier planting has also been accompanied by a longer growing season with the average number of days in the season increasing. Farmers are also adapting by altering their decisions on which crops to plant. For example, since soybean and corn are planted in many of the same regions of the U.S., farmers often plant more soybeans than corn when experiencing weather shocks. Chart 11Farmers Are Planting Earlier In The Season Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change The agriculture sector is also using more efficient machinery that can plant and harvest crops much faster as well as developing heartier seeds and more potent fertilizers. In turn, farmers will alter their decision making by selecting crop varieties or species that are more resistant to heat and drought. Or they will change fertilizer rates, amounts and timing of irrigation, along with other water-management techniques. Farmers also are making wider use of integrated pest and pathogen management techniques, in order to raise the effectiveness of pest, disease, and weed control. Given that the number of firms in the agriculture sector are fewer in developed markets than in the rest of the world, management decisions can be more easily implemented in the former. On the other hand, emerging market countries where ag output is driven by numerous individual farmers will have a more difficult time implementing policies. Individual farms may not have the means to support themselves, which raises the potential impact of climate change. What is more, climate-change mitigation efforts may require projects, programs, or funds set aside by the government to support these efforts. This is more likely to occur in wealthier developed countries. Bottom Line: Adaptation and mitigation measures on the part of farmers have the potential to reduce the impact of climate change. That said, farmers in richer countries with the funds and institutions in place to support the ag sector likely will fare better. Investment Implications Over the coming decade, the ramifications of climate change are likely to be contained to a regional level. Although global supply will be vulnerable to regional disruptions, the impact will, in part, be mitigated by inventories, which have been rising for years. These stocks will create a buffer against unpredictable supply shocks (Chart 12). Chart 12Higher Inventories Needed To Buffer Against Unpredictable Shocks Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change However, given that the global soybean market resembles an oligopoly with Brazil, the U.S., and Argentina accounting for 81% of global supply, global soybean prices will be more vulnerable to supply events in these regions than other crops (Chart 13). At the other end of the spectrum, global wheat markets will be relatively more insulated from isolated weather events impacting any one major producer as each of these regions contributes a relatively small share to global wheat output. This analysis also finds that yields and supply generally recover in the crop year following an extreme climate event. This implies that while the extent of damage from these events can be severe, they are not persistent unless the increasing frequency of extreme events leads to a secular change. Aside from the price impact, the weather and temperature changes will manifest in the form of greater volatility in supply, translating to greater price volatility. Options-implied volatilities for corn, wheat and soybeans have been on a general downtrend since the two major global food scares in 2007/08 and 2010/11 (Chart 14). We expect the trend to reverse going forward as the frequency of weather events will create greater price uncertainty. Chart 13Soybeans Most Vulnerable To Shocks Affecting Major Producers Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change   Chart 14Volatility Will Go Up Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Jeremie Peloso, Research Analyst U.S. Bond Strategy JeremieP@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Amr Hanafy, Research Associate Global Asset Allocation AmrH@bcaresearch.com Isabelle Dimyadi, Research Associate Isabelled@bcaresearch.com     Appendix Table 2Extreme Weather Events In The U.S. Agriculture In The Age Of Climate Change Agriculture In The Age Of Climate Change   Footnotes 1      Please see Vogel et al, The effects of climate extremes on global agricultural yields, Environ. Res. Lett 14 054010, 2019. 2      As a consequence of greenhouse gas emissions precipitation is expected to increase in high altitude regions such as much of the U.S. and decrease in subtropical regions such as the southwest U.S., Central America, southern Africa, and the Mediterranean basin. 3           Plants can be broken down into either C3 or C4 based on the way they assimilate atmospheric CO2 into different physiological components. While rising CO2 causes C3 plants to raise the rate of photosynthesis and reduce the respiration rate, C4 plants do not experience a rise in photosynthesis since photosynthesis is already saturated. For example, studies show that soybean yields increased 12%-15% under 550 ppm vs. 370 ppm CO2 concentrations while corn experienced negligible yield increases. 4      Please see Lesk C., P. Rowhani, and N. Ramankutty, Influence of extreme weather disasters on global crop production, Nature, 529(7584), 84-87, 2016. 5      Please see The State Of Food And Agriculture: Climate Change, Agriculture, And Food Security, Food and Agriculture Organization of the United Nations, 2016. 6      Please see Stevanovic et al., The impact of high-end climate change on agricultural welfare, Sci-Adv 2(8), 2016.

President Trump’s announcement this week of a new deployment of aid to U.S. farmers, to offset China’s retaliation to steeper tariffs, highlights that agriculture has been the sacrificial lamb in the U.S.’s hawkish trade policy. The $15 billion announcement follows last year’s $12 billion disbursement, and suggests that the path to a trade agreement with China remains fraught. Although China and the U.S. continue to negotiate, and President Trump has indicated that “maybe something will happen” within a “three or four week” timeframe, last week’s events indicate that a resolution is far from guaranteed. Both positive and negative trade war news will dominate the near term evolution of ag prices – stay on the sidelines as negotiations will sway markets. Highlights Energy: Overweight. Crude oil prices are up ~2% since the beginning of the week on escalating tensions in the Middle East, as expected. Two Saudi oil-pumping stations were targeted in a drone attack on Tuesday. This follows attacks on four oil tankers – including two Saudi ships – off the coast of the United Arab Emirates. These events highlight the increased risk of supply outages since the U.S. decision not to extend waivers on Iran sanctions.1 Base Metals: Neutral. The recent escalation in Sino-U.S. trade tensions pushed LMEX prices down 2% since the beginning of last week. Nevertheless, we believe that in the medium term Chinese authorities will manage to offset the negative economic impact on metals by ramping up fiscal-and-credit stimulus.2 Precious Metals: Gold’s geopolitical risk premium is rising amid escalating trade tensions. Gold rallied ~2% since May 3, amid declining global equities. Our gold trade is up 5.3% since inception. Ags/Softs: Underweight. Sino-U.S. trade tensions are weighing heavily on agriculture commodities. The grains and oilseed index is down 9% since the beginning of the year. Continued trade war uncertainty will keep risks elevated in the ags space (see below). Feature Several factors – including dollar strength and bearish fundamentals – have come together to drive down ag prices so far this year. However, the latest plunge highlights that trade risks remain a real threat to ag markets. This is in line with the sharp cutback in Chinese imports of U.S. ags, which make up a large share of Chinese imports from the U.S. and have been hit hard by tariffs (Chart of the Week). Soybeans in particular have become the poster child of the dispute. Uncertainty has taken their prices down to 10 year lows. In 2017, they accounted for $12.4 worth, or 9.3%, of U.S. exports to China. However, since the onset of the dispute, American soybean farmers have been struggling to market their crops. U.S. exports to China are down more than 80% y/y since 2H18 (Chart 2), and while there have been efforts to find other markets, they have yet to offset the impact of lower trade with China (Chart 3). Chart 1 Chart 2Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Soybeans Are The Poster Child Of The Conflict Chart 3 A long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. In fact, the Chinese tariffs add to ongoing trade disputes between the U.S. and some of its other major ag markets (Charts 4A & 4B). Canada, Mexico, and the EU have placed tariffs on a range of U.S. agricultural goods in response to the Section 232 tariffs on steel and aluminum. Chart 4 Chart 4 As such, American farmers are suffering the brunt of the trade war’s burden. Chinese retaliation comes at a time when U.S. ag stockpiles are already elevated (Chart 5). Inflation-adjusted farm income had been deteriorating prior to the trade dispute, falling to about half its 2013 level (Chart 6). The trade dispute has only reinforced this trend. In its most recent Ag Credit Survey, the Kansas City Fed found the pace of decline in farm loan repayment rates increased, while carry-over debt increased for many borrowers, ultimately causing a deterioration in ag credit conditions. Given that exports account for 20% of U.S. farm income, according to USDA estimates, a long-term solution is necessary to support the agriculture industry and prices of grains and oilseeds. Otherwise, tariffs will simply be another constraint on U.S. ag exports, which have been losing global market share since the mid-1990s (Chart 7). Chart 5U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated U.S. Stocks Are Relatively Elevated Chart 6Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Farmers Suffering The Brunt Of The Burden Chart 7U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share U.S. Agriculture Losing Global Market Share Even though China briefly resumed some purchases of U.S. ags this year as a goodwill gesture during negotiations, these purchases stand significantly below those of previous years. They resulted from one-time purchases by Chinese state-owned enterprises, and barriers to trade remain in place. Such ad hoc attempts at reconciliation will not be sufficient to support a distrustful market going forward. The trade war is just one facet of a broader strategic U.S.-China conflict. This means a reso­lution would be only a cyclical improvement in an ongoing structural deterioration in relations. A number of potential outcomes can result from the ongoing negotiations: Most bearish: China raises the tariff rate on U.S. ag exports even further. A situation in which a fallout in the negotiations leads to strategic tensions – a scenario to which BCA’s geopolitical strategists attribute a 50% chance – could result in further ratcheting up of tariffs by China. Given that Chinese imports of U.S. ags are approaching zero, there is limited significant further downside even in this most pessimistic scenario. However, unless the U.S. is able to smoothly market its crops in other regions, upside will also be limited for some time. Since trade tariffs have already been initiated with many of the U.S.’s major ag consumers, securing reliable alternative markets may prove a challenge. Especially since Trump’s hawkish foreign policy raises risks and uncertainties for America’s trade partners. Bearish: Tariffs remain at current levels. Similar to the most bearish scenario, given that the U.S. is already having a difficult time marketing its crops abroad, significant further downside from current levels is also limited. However, any premium priced on the expectation of a resolution of the trade conflict will be eliminated. Again, as in the most bearish scenario, the loss of the Chinese market may be mitigated by an expansion of alternative markets, but challenges will remain. Bullish: Tariffs are cut back to pre-trade war levels. In this scenario, the tariffs imposed since the onset of the trade war will be unwound. This would once again raise the competitiveness of American crops in Chinese markets, and would entail higher ag prices as demand channels are re-established. Most Bullish: Tariffs fall to equalized levels. One of Trump’s key complaints is that U.S. and Chinese tariffs are not “reciprocal in nature and value” (Chart 8). Given that Chinese tariffs are above those of the U.S., this would entail a reduction in Chinese tariffs to below trade war levels (Table 1). Chart 8 Table 1... And They Have Gone Up American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship A lasting trade deal will likely include measures to close the bilateral trade deficit, which in 2018 stood at $379 billion. Last year Trump called on Beijing to reduce this deficit by $200 billion over two years. If we make the overly simplistic assumption that the share of imports remains unchanged, such a reduction would lead to an additional $19 billion in soybeans, $0.54 billion in wheat, and $0.23 billion in corn imports. This back of the envelope calculation implies a doubling of these U.S. exports to China, relative to 2017 levels. As we highlighted in our March ags update, investors had become overly optimistic with their expectation of a swift resolution of the trade war.3 In fact, according to BCA’s geopolitical strategists, the trade war is just one facet of a broader strategic U.S.-China conflict. This means a resolution would be only a cyclical improvement in an ongoing structural deterioration in relations. They assign only 40% odds that a deal will be finalized by year-end, with 30% odds that the frictions will escalate into strategic tensions. In the meantime, Trump’s palliatives – which include a “trade relief” program, an EU promise to purchase more U.S. soybeans, and last week’s suggestion of government purchases for humanitarian aid – are unlikely to lift ag prices. Bottom Line: The U.S.-China trade war has weighed on American ag exports. The impact on farmers – in terms of lower incomes, and higher stockpiles – has been significant. Granting that odds of a resolution this year are no greater than 40%, we recommend a cautious stance on ag markets. However, a trade deal that entails Chinese promises to import U.S. ags – either through more favorable tariff rates or commitments to purchase large volumes – would provide a buying opportunity. In any case, we suspect that prices are near the bottom, but will require a significant catalyst – in the form of a trade deal – to begin to climb materially. No Relief From Fundamentals, Either With spring planting underway, the recent escalation in trade tensions comes at a busy time of year for U.S. farmers. According to the USDA’s annual Prospective Planting Report, released at the end of March, the planted area of corn will likely increase by 4% in 2019, while soybean and wheat will fall 5% y/y and 4% y/y, respectively. If realized, the planting area that farmers intend to dedicate to wheat will be the lowest on record – that is, since 1919 (Chart 9). However, farms in the Midwest were hit by a “bomb cyclone” in March, which has damaged crops and delayed planting. Inundated fields mean farmers are forced to push back their schedule. The latest Weekly Crop Progress Report from the USDA, indicates that farmers have fallen behind relative to typical progress at this time of year (Table 2). Although farmers’ current lack of headway is cause for concern, they may still be able to catch up and attain their targeted acreage. Chart 9Record Low Wheat Acreage Record Low Wheat Acreage Record Low Wheat Acreage Table 2Flooding Has Delayed Spring Planting American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship American Farmers Caught In The Crosshairs Of Sino-U.S. Brinkmanship Given that stockpiles are full, due to years of surplus, the impact of the flooding is unlikely to move international ag prices. Nevertheless, planting delays raise the possibility that corn farmers will switch to soybeans, which can be planted later in the season. In the May update of the World Supply And Demand Estimates – which includes the first estimates for the 2019/20 crop year — the USDA projected a decline in U.S. soybean ending stocks on the back of lower production and a pickup in exports. The switch in planting intentions towards soybeans at the expense of corn may at least partially reverse this expectation, raising global soybean inventories which are expected to remain unchanged (Chart 10). In addition to trade war, the African swine fever has hit pig herds in China – the main consumers of soybeans. According to China’s official statistics, more than a million pigs have been culled, and Chinese pork production is expected to be slashed by between a quarter and a half this year. This will depress demand for soybeans, further weighing on prices. So far this year the greenback has been a source of bearishness toward ags. Since the epidemic has spread to other Asian neighbors including Hong Kong and Vietnam, soybean demand from Asia will be reduced, regardless of the outcome of the trade war. This will also weigh on other major producers such as Brazil and Argentina, which have so far benefited from China’s shunning of the American crop. South American producers are also at risk if a positive outcome emerges from the negotiations. Chart 10No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year No Change In Soybean Inventories Expected In The Coming Crop Year Chart 11Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories Preliminary Projections Of Uptick In 2019/20 Wheat Inventories On the other hand, according to the latest USDA estimates, both global and U.S. year-end wheat inventories are expected to pick up in the 2019/2020 crop year (Chart 11). Greater European production will add to already elevated supplies. While global corn inventories are projected to come down, U.S. inventories will likely rise amid greater production and weaker exports. However, these acres are at risk given the flood delays (Chart 12). In addition to these supply-demand fundamentals, U.S. financial conditions – especially the U.S. dollar – will remain a key driver of ag prices. So far this year the greenback has been a source of bearishness toward ags. Ag prices have an inverse relationship with the U.S. trade-weighted dollar (Chart 13). While in our earlier report we had expected the dollar to peak by mid-year, the May 5 escalation in the trade war poses a risk to this view by threatening the global trade and growth outlook and spurring risk-off sentiment. Chart 12Another Deficit Expected ##br##For Corn Another Deficit Expected For Corn Another Deficit Expected For Corn Bottom Line: Farmers in the U.S. Midwest facing inundated fields are behind schedule in their spring planting. This poses a risk that a greater number of soybeans will be planted at the expense of corn – weighing down on an already depressed soybean market and potentially requiring the USDA to revise down its U.S. bean ending stocks in its next WASDE report. Chart 13U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags U.S. Financial Conditions Continue To Weigh On Ags What is more, the African swine fever, which is spreading across East Asia, is reducing demand for animal feed there. Unless the trade conflict is resolved, we expect corn and wheat to outperform the soybean market.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com   Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Special Report titled “U.S.-Iran: This Means War?” dated May 3, 2019, available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Expanded Sino-U.S. Trade War Could Be Bullish For Base Metals,” dated May 9, 2019, available at ces.bcaresearch.com. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Financial Conditions, Trade War Continue To Dominate Ag Market,” dated March 28, 2019, available at ces.bcaresearh.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Closed Trades Image

Highlights Just when it looked like the agricultural complex was starting to perk up, it was slapped down again. After crawling its way back from a mid-2018 crash – retracing more than half of its decline – the CCI Grains and Oilseeds index plummeted in February, declining by nearly 9% (Chart Of The Week). The decline was broad-based, but was led by wheat, which was dragged down by muted demand and accounted for most of the index’s decline. Looking forward, we expect U.S. financial conditions and developments on the trade-war front to remain the main forces driving ag prices. Ample inventories will provide the cushion necessary to moderate the impact of potential supply-side shocks. Highlights Energy: Overweight. Venezuela suffered another power outage earlier this week, indicating the deterioration of its infrastructure is accelerating. While officials claim to have restored power, we expect more such outages going forward, which will severely reduce the country’s production and export capacity. Separately, Aramco announced it will buy 70% of Sabic, a Saudi state-owned petchem producer, for $69 billion, according to the Wall Street Journal. Base Metals: Neutral. China’s MMG Ltd was set to declare force majeure following protests at its Las Bambas mine in Peru earlier this week. The mine produces ~ 385k MT p.a., most of which goes to China. Precious Metals: Neutral. The inversion of the U.S. yield curve put a bid into the gold market this week, as investors sought a safe-haven refuge. Continued weakness in bond yields, and accommodative central banks responding to low inflation expectations globally will continue to support gold. Agriculture: Underweight. A more patient Fed will be supportive of ag prices in 2H19, as we discuss below. Feature Chart of the WeekWheat Had A Rough Start To 2019 Wheat Had A Rough Start To 2019 Wheat Had A Rough Start To 2019 A Patient Fed Will Support Ags In 2H19 While differences across ag markets will arise due to idiosyncratic supply shocks and targeted trade policies, a common determinant of ag price movements more generally is U.S. financial conditions. Since our last assessment of global ag markets, Fed policymakers have adopted a much more patient approach to monetary policy.1 In line with the pause in the Fed’s rates-normalization policy, financial conditions have eased considerably (Chart 2). We believe this will, ceteris paribus, bring relief to commodity markets in general, ags in particular, in the second half of this year. Chart 2Easier Financial Conditions Bode Well For Ags Easier Financial Conditions Bode Well For Ags Easier Financial Conditions Bode Well For Ags The bulk of this relief will be transmitted through the impact of a weaker dollar. Since the dollar is a countercyclical currency, its weakness implies an improvement in global growth. This more solid economic backdrop is associated with greater aggregate demand, particularly in EM economies, as well as demand for agricultural products. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. Furthermore, when the USD weakens against the currencies of ag exporting countries, farmers there are incentivized to hoard or cut exports – thus reducing supply – awaiting periods when a stronger greenback will raise their profits. At the same time, ags priced in USD become relatively more affordable for importing nations, incentivizing them to raise consumption. The net impact of this contraction in supply amid greater demand will pull up prices – illustrated by the relatively tight inverse relationship between ag prices and the dollar (Chart 3). Chart 3A Weaker USD Will Be A Tailwind In 2H19 A Weaker USD Will Be A Tailwind In 2H19 A Weaker USD Will Be A Tailwind In 2H19 Going into mid-2019, we expect global economic indicators to continue to be uninspiring. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. However, as these factors fade and give way to an improvement in global economic conditions and easier financial conditions, we expect the dollar to peak around mid-year. As such, a resurgence in global growth in the second half of the year will be reflected in an improvement in the value of the currencies of major ag exporters ex-U.S. (Chart 4). Ceteris paribus, this also benefits ag prices. Chart 4Weak Local Currencies Supporting Farm Profits, Incentivizing Production Weak Local Currencies Supporting Farm Profits, Incentivizing Production Weak Local Currencies Supporting Farm Profits, Incentivizing Production China’s Economy Remains Central Our outlook hinges on developments in the Chinese economy. Peter Berezin – our Chief Global Investment Strategist – expects Chinese authorities to not only stabilize credit growth, but also increase it, creating room for improvement in the world’s second largest economy.2 This combination of supportive global growth and a softer dollar bodes well for ag prices in 2H19. The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. Apart from the currency impact, easy financial conditions are supportive of global growth. A rise in income levels of emerging economies will support demand for goods and services generally, and agricultural commodities specifically.3 The market now expects 36 and 51 basis points of rate cuts over the coming 12 and 24 months, respectively. Similarly, following last week’s FOMC meeting, the median Fed dot indicates no rate hikes this year from the U.S. central bank, and only one in 2020. While our Global Investment Strategists would not be surprised to see a hike this year, the noticeably less hawkish tone in the Fed’s forward guidance and dot plots are positive for ag markets.4 Looking beyond that into late-2020 or early 2021, a potential pick-up in inflation will force the Fed to take a more hawkish stance, and once again support the U.S. dollar. This will weigh down on ag prices over the strategic time horizon. Bottom Line: The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. However, this is unlikely to occur before mid-year. In the meantime, a stronger dollar on the back of the lagged effects of growth dampening events in 2018, will remain a headwind. Ample Inventories Will Cushion Against Supply Shocks Putting aside the more or less uniform impact of U.S. financial conditions, individual supply-demand fundamentals will manifest as idiosyncratic risks and opportunities. The USDA has been revising its projections for ending stocks higher in its monthly World Agricultural Supply and Demand Estimates (WASDE) across the board since it released the first projections for the 2018/2019 crop year last May. However, we find that solely on the back of fundamentals, soybeans are more likely to resist upward pressure from easier U.S. financial conditions in 2H19 vs. wheat and corn. The USDA’s latest projections for the current crop year indicate that global bean markets are well supplied. Expectations of a global surplus this crop year – for the seventh consecutive year – will add to the growing cushion (Chart 5). Chart 5Beans Surplus Will Add To the Glut Beans Surplus Will Add To the Glut Beans Surplus Will Add To the Glut Since May, global ending bean stocks have been revised higher by a total of 20.47mm MT. The change in projections comes on the back of upward revisions to production and beginning stocks, compounded by downward revisions to consumption. The latter will likely contract further if the U.S. and China do not reach an agreement on the trade front (see below). Consequently, unless a weather disruption weakens supply, we expect soybean inventories to stand at record highs relative to consumption at the end of the current crop year. In the case of wheat, the impact on prices will likely be marginal. The global balance is expected to shift to a deficit in the current marketing year, following five years of surplus (Chart 6). While this is a positive for wheat prices, given that global inventory levels are relatively elevated – capable of supporting 37% of consumption – and the current deficit is relatively small, we do not expect the deficit to pressure prices in the near term. Chart 6Elevated Wheat Inventories Will Cushion Against Minor Deficit Elevated Wheat Inventories Will Cushion Against Minor Deficit Elevated Wheat Inventories Will Cushion Against Minor Deficit Despite continued downward revisions to the USDA’s wheat production projections, expectations of ending stocks have actually risen on the back of downward revisions to consumption. Similarly, corn fundamentals are also unlikely to sway prices much. The grain is expected to remain in deficit for the second consecutive year, which will pull inventories down off their 2016/17 peak to be capable of covering ~27% of global consumption (Chart 7). Despite this contraction in availability, global supplies remain relatively elevated, especially compared to the 2003 to 2012 period. Thus unless there is a significant supply shock, we don’t expect much support from fundamentals. Chart 7A Global Corn Deficit ... A Global Corn Deficit ... A Global Corn Deficit ... Unlike wheat demand, which has been downgraded, the USDA has revised corn consumption up relative to the first projections for the crop year released last May. Nevertheless, stronger expectations of consumption have been overwhelmed by upward revisions to production and beginning inventory levels. Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Since the mid-1990s, U.S. farmers had been planting more corn and wheat at the expense of soybean acreage (Chart 8). On a global level, while wheat remains more popular in terms of acreage, it is generally trending downwards, while corn and soybean plantings are trending up. However, over the longer term, U.S. farmers are expected to dedicate more land to corn relative to soybeans. Chart 8... Will Be Met By Rising U.S. Acreage ... Will Be Met By Rising U.S. Acreage ... Will Be Met By Rising U.S. Acreage Bottom Line: Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Similarly, a global glut in soybean supplies will only add to swelling inventories. The Trade War And Soybeans: It Ain’t Over Till It’s Over Aside from U.S. financial conditions and supply-demand balances, U.S. trade policy has also been roiling ag markets since China slapped U.S. soybeans with 25% tariffs in mid-2018. In fact, since the escalation of the trade dispute, soybean prices have been moving largely in response to developments on the trade front (Chart 9). As developments since the G20 Summit in Buenos Aires last December have been more favorable, soybean markets are on the path to recovery. Chart 9Markets Optimistic Of A Trade War Resolution Markets Optimistic Of A Trade War Resolution Markets Optimistic Of A Trade War Resolution So far, even though U.S. soybean exports to China picked up over the past two months, total U.S. exports still lag levels typical for this time of year (Chart 10). This comes despite U.S. efforts to raise shipments to other trading partners. Furthermore, U.S. exports will now be in direct competition with the Brazilian crop, which usually dominates trade flows at this time of year (Chart 11). Chart 10 While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. Chart 11 While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. The Trump-Xi meeting that was expected to occur in late-March was postponed; the next most likely date for a meeting is at the G20 summit in end-June. This leaves another 3 months of trade uncertainty. Nevertheless, our models indicate that soybeans are now priced at fair value, based on U.S. financial variables – absent a trade war (Chart 12). Chart 12 Furthermore, the premium priced into Brazilian beans above those traded on the CBOT has returned to its historical average (Chart 13). Thus, we do not expect a further reduction in the premium in the event Sino-U.S. trade negotiations are successful. Chart 13Premium For Brazilian Beans Has Normalized Premium For Brazilian Beans Has Normalized Premium For Brazilian Beans Has Normalized Rather, markets will be disappointed if the U.S. and China are unable to conclude a deal. This would put CBOT prices at risk and support the premium on those traded in Brazil. Given that our geopolitical strategists assign a non-negligible 30% probability that the trade war escalates further, we believe markets are overly optimistic that a deal will be concluded.5 If the trade war drags on and turns into a multi-year conflict, soybean markets will likely take a more meaningful hit. According to the USDA’s latest long-term projections released earlier this month, China’s soybean imports were projected to rise 32.1mm MT during the 2018-28 period – a massive downward revision from the 46mm MT expected for the 2017-2027 period contained in the previous long-run projections. Furthermore, outbreaks of African swine fever in China may put demand there at risk. Over 100 cases have so far been reported in China, with several cases already reported in Vietnam as well. This threatens to depress China’s need for soybean as animal feed, regardless of what happens on the trade front. Bottom Line: A positive outcome from the U.S.-China trade negotiations is not a given. Nevertheless, soybean markets are treating it as such. Our geopolitical strategists assign 30% odds that a final deal falls through. This non-negligible probability threatens to cause soybean prices to relapse anew, should Sino-U.S. trade negotiations break down.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published by BCA Research’s Commodity & Energy Strategy December 13, 2018.  It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Global Investment Strategy Weekly Report titled “What’s Next For The Dollar,” dated March 15, 2019, available at gis.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Global Financial Conditions Will Drive Grain Prices In 2018,” dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see BCA Research’s Global Investment Strategy Weekly Report titled “Questions From The Road,” dated March 22, 2019, available at gis.bcaresearch.com. 5 Please see BCA Research’s Geopolitical Strategy Special Report titled “China-U.S. Trade: A Structural Deal?,” dated March 6, 2019, available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Image