Iraq

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Our Commodity & Energy Strategy (CES) desk is using a new ensemble forecast, which takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl, and WTI to $70/bbl from $72/bbl. For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and WTI goes to $67/bbl from $72/bbl. CES expects higher volatility, as well. Feature Following the roll-out of our oil-price ensemble model last week, we are publishing a Special Report written by our colleague Marko Papic, who runs BCA's Geopolitical Strategy (GPS) service. This report explores the more nuanced aspects of the U.S. - Iran sanctions conflict, and why the contest for Iraq is important for investors. We also summarize our latest forecast. We trust you will find this analysis informative, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Chart 2BCA's Updated Ensemble Forecast:##BR##Brent Averages /bbl in 2H18 BCA's Updated Ensemble Forecast: Brent Averages $76/bbl in 2H18 BCA's Updated Ensemble Forecast: Brent Averages $76/bbl in 2H18 Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 CES's updated ensemble forecast takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl previously, and its WTI forecast to $70/bbl from $72/bbl (Chart 2). For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and its WTI expectation goes to $67/bbl from $72/bbl. CES expects higher volatility, as well, as markets continue to process sometimes-conflicting news flows. This means spike to and through $80/bbl for Brent are more likely than markets currently anticipate. Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.4 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).5 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.6 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."7 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).8 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.9 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Chart 4Geopolitical Crises And Global Peak Supply Losses Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). Map 3The Collapse Of A Would-Be Caliphate Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.10 Chart 5Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.11 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. Chart 6Great Power Competition Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission. In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix on page 24). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Diagram 1South China Sea As Traffic Roundabout Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.14 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.15 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Chart 8Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. Box 1: Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1a Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.16 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##BR##Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##BR##Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). Chart 11Primary OPEC 2.0 Members Are Producing##BR##1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary##BR##OPEC 2.0 Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Chart 13Venezuela Is##BR##A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk 2H18, 2019 Oil Forecasts BCA's Commodity & Energy Strategy updated its forecast last week, after the leaders of OPEC 2.0 indicated member states would be considering putting as much as 1mm b/d back on the market, following the price run-up accurately called from the beginning of this year. KSA and Russian are not being explicit about what they intend to do. In the background are the U.S.'s renewed Iran sanctions discussed above, which could remove ~ 500k b/d from the export markets by the end of 1H19, and the increasingly likely collapse of Venezuela's exports, which could remove ~ 1mm b/d. Against this, we have production in the U.S. shales increasing this year and next by ~ 1.3 - 1.4mm b/d to offset these potential losses, but even there we're seeing problems getting the shale oil out of the U.S.17 That's why CES went to an ensemble forecast, and will keep it in place as the market continues to process these conflicting signals (Chart 14). While some production will be restored to the market this year, it will be a drawn-out process, given CES's view OPEC 2.0 does not want to undo the hard work it took to drain OECD oil inventories (Chart 15). CES's Brent forecast was lowered $2/bbl in 2H18 and $7/bbl in 2019 to $76/bbl and to $73/bbl, respectively. CES's WTI forecast for 2H18 also was lowered $2/bbl to $70/bbl, while our 2019 forecast is now at $67/bbl, down $5/bbl vs. our previous forecast. Chart 14Factors In BCA's Ensemble Forecast Factors In BCA's Ensemble Forecast Factors In BCA's Ensemble Forecast Chart 15Balances Will Loosen If Supply Increases Balances Will Loosen If Supply Increases Balances Will Loosen If Supply Increases CES continues to expect continued strength on the demand side, with global oil consumption growing 1.7mm b/d. This will be driven by steady income growth in EM economies. One of the principal gauges CES uses to assess EM demand - import volumes - continues to move higher on a year-on-year basis, signaling incomes continue to expand (Chart 16). EM growth accounts for 1.3 of the 1.7mm b/d of growth we're expecting in 2018 and 2019. In forthcoming research, CES will be looking more deeply into the evolution of demand and the threat - if any - higher prices pose for EM growth. As was noted in last week's CES publication,17 consumers in many states no longer are shielded from high oil prices, as they were in the past: Governments around the world used the collapse in prices beginning in 2014 to remove/reduce fuel subsidies. This changes the dynamics of EM oil demand considerably, even if governments feel compelled to step into markets and order suppliers to not pass through the entire price increase. OPEC 2.0's leaders - KSA and Russia - appear united in their view of what is required to keep oil markets balanced over the long haul, so as not to disincentivize consumers from purchasing cars and trucks and the motor fuel required to run them. But over the short term, their goals differ. KSA is looking to IPO Saudi Aramco - next year, according to the latest reports - and this sale would most definitely benefit from higher prices. Indeed, KSA's oil minister Khalid al-Falih appeared to be comfortable with prices pushing toward $80/bbl recently. Russia's energy minister, Alexander Novak, has said in the past he favors an oil price somewhere between $50 and $60/bbl. CES continues to believe the dominant price risks remain on the upside - at 28.31% and 12.12%, markets continue to underestimate the probability Brent prices will trade above $80 and $90/bbl this year and next (Chart 17). Chart 16Strong EM Commodity Demand Expected,##BR##As Incomes And Imports Continue To Grow Strong EM Commodity Demand Expected, As Incomes And Imports Continue To Grow Strong EM Commodity Demand Expected, As Incomes And Imports Continue To Grow Chart 17Oil Markets Continue To Underestimate##BR##Upside Price Risks In 2H18 And 2019 Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bottom Line: A renewal of U.S. - Iran tensions throws up real risks that are not being fully priced by the oil markets at present. They raise the probability global oil supplies out of the Middle East will be directly threatened, and that tensions in Iran and Iraq will flare into proxy wars. Such an outcome would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Lastly, rising tensions could exacerbate sectarian conflict in the Middle East as a whole, particularly along the Sunni - Shia divide, which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 5 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 6 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 7 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 8 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 9 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 10 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 11 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 12 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 13 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 14 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 17 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again," published May 31, 2018.It is available at ces.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Trades Closed in 2018 Summary of Trades Closed in 2017 Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Average Brent and WTI oil prices should rise to $80/bbl and $72/bbl in 2019 even without adding the full range of events that will drive up the geopolitical risk premium. Risks lie to the upside. Feature Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 To put some numbers on the difference between our view and the market's view, we rely on the implied option volatilities for crude oil futures.4 As Chart 2 illustrates, the oil markets are currently pricing in just under 30% probability that oil prices will exceed $80/bbl by year-end, and merely 14% that they will touch $90/bbl in the same timeframe. We believe these odds are too low and will take the other side of that bet. Chart 2The Market Continues To Underestimate High Oil Prices Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.5 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).6 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.7 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."8 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).9 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.10 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 4Geopolitical Crises And Global Peak Supply Losses Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.11 Map 3The Collapse Of A Would-Be Caliphate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 5Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.12 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission.14 In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Chart 6Great Power Competition Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Diagram 1South China Sea As Traffic Roundabout Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.15 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.16 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 8Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. BOX 1 Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1 Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.17 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##br## Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##br## Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Chart 11Primary OPEC 2.0 Members Are Producing##br## 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary OPEC 2.0 "Contributors" ##br##Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). BCA's Commodity & Energy Strategy therefore projects that the combination of stable global demand, steady declines in Venezuela's crude oil output, and the loss of Iranian exports to U.S. sanctions in 2019 will lift the average Brent and WTI prices to $80 and $72/bbl respectively (Chart 14).18 This forecast, however, represents our baseline based on fundamentals of global oil supply and demand (Chart 15) and does not include our potential scenarios outlined in Diagram 2, which would obviously add additional geopolitical risk premium. Chart 13Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 14Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Chart 15Balances Tighter As Supply Falls Balances Tighter As Supply Falls Balances Tighter As Supply Falls For investors looking for equity-market exposure in this scenario, BCA's Energy Sector Strategy recommends overweighing U.S. shale producers and shale-focused service companies for investors looking for equity-market exposure to oil prices. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has broken down this recommendation into specific equity calls, which we encourage our clients to peruse.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 We use Brent implied volatility - of at-the-money options of the selected futures contract - as an input to construct the cumulative normal density of future prices. Thus, the probability obtained is one where the terminal futures price, at the selected months, exceeds the strike price quoted. In order to derive this probability, we need the current market price of the selected future contract, the number of days to expiration, the strike price, and a measure of the volatility of this contract. 5 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 6 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 7 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 8 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 9 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 10 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 11 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 12 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 13 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 14 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 15 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 18 Please see BCA Commodity & Energy Strategy Weekly Report, "Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019," dated May 24, 2018, available at ces.bcaresearch.com. 19 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize

Highlights U.S. Treasury yields should continue to rise as investors price-out doomsday risk; Tensions surrounding North Korea will continue, but there are signs that negotiations have started and that China is playing ball on sanctions; Meanwhile, our view that tax cuts are coming is finally coming to fruition; Fade renewed European risks regarding Brexit and Catalan independence; But the independence push by Kurds in Iraq could have market impact. Feature Early in the second quarter, BCA's Geopolitical Strategy made two predictions. First, we said that summer would be a time to stay invested in U.S. equities and largely ignore domestic politics.1 Second, that North Korea would become an investment-relevant risk and buoy safe-haven plays but would not lead to a full-scale war (and hence not cause a global correction).2 The summer proved lucrative for both risk-on and risk-off trades, best emblemized by solid returns for both the S&P 500 and 10-year U.S. Treasury (Chart 1 A & B). Chart 1ARisk Assets Have Rallied... Risk Assets Have Rallied... Risk Assets Have Rallied... Chart 1B...At The Same Time As Safe Havens ...At The Same Time As Safe Havens ...At The Same Time As Safe Havens Can this continue? We do not think so. Geopolitics can influence the 10-year Treasury yield via two mechanisms: safe-haven flows and fiscal policy. On both fronts, we see movements that should support a pickup in yields over the rest of the year, a view corroborated by our colleagues on the fixed-income team. First, investors finally have progress on tax legislation that we have been forecasting since President Trump's election. Given the markets' collective pessimism on corporate tax reform (Chart 2), we expect any good news to change the current narrative. While it is still difficult to envision tax legislation that massively stimulates the economy, it is also difficult to imagine tax legislation that is revenue-neutral. As such, fiscal policy in the U.S. should be at least mildly stimulative in 2018, supporting higher yields. Second, we remain concerned that North Korea could escalate the ongoing tensions in East Asia.3 However, Pyongyang is constrained by its military capacity, which limits what it can realistically do to threaten its neighbors. As we discuss below, there are emerging signs of both diplomatic negotiations and Chinese pressure, key signposts that we have passed the peak on our "Arc of Diplomacy." As such, investors should prepare for the bond rally to reverse and the broader risk-on phase to extend through the end of the year. We expect the "Trump reflation trade" - USD appreciation, yield-curve steepening, and small-cap outperformance (Chart 3) - to restart if our views on the U.S. legislative agenda and North Korean tensions hold. Chart 2Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Investors Remain Pessimistic On Tax Reform... Chart 3...And On Trump's Policy In General ...And On Trump's Policy In General ...And On Trump's Policy In General U.S. Treasuries: Fade The Doomsday Trade Our colleagues at BCA's fixed-income desk have shown that flows into safe havens over the summer have widened the disconnect between global yields and economic fundamentals (Chart 4).4 Chief Fixed-Income Strategist Rob Robis points out that BCA's own valuation model for the 10-year U.S. Treasury yield indicates that "fair value" sits at 2.67%, nearly 55bps higher than current market levels (Chart 5).5 This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Rob believes that the summer bond rally is about safe-haven demand, depressed investor sentiment, and underwhelming inflation, in that order. It is certainly not about growth expectations, which remain buoyant (Chart 6). Chart 4Falling Yields Reflect Save Haven Demand,##br## Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Falling Yields Reflect Save Haven Demand, Not Slower Growth Chart 5U.S. Treasuries ##br##Are Overvalued U.S. Treasuries Are Overvalued U.S. Treasuries Are Overvalued Chart 6Global Growth##br## Remains Buoyant Global Growth Remains Buoyant Global Growth Remains Buoyant To prove that underwhelming inflation has not spurred the latest rally in Treasuries, Rob decomposes developed market bond yield changes since the July 7 peak in U.S. yields. The benchmark 10-year U.S. Treasury yield has risen 20bps off those September lows as investors have priced out doomsday risk. Table 1 shows that yields declined everywhere but Canada (where the central bank has been hiking interest rates). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations, which have actually stabilized over the summer. This has also occurred via a bull-flattening move in government bond yield curves, which suggests it is risk-aversion that has driven yields lower. Table 1Changes In DM Bond Yields Over The Summer (From July 7th Peak In U.S. Treasury Yields) Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? The conclusion of our fixed-income team is that there is now considerable upside risk in global yields. We agree. While North Korea could retaliate against the just-imposed UN sanctions in various ways, it is difficult to see the market reacting with the same vigor as it did in July and August. Investors are becoming desensitized to North Korean provocations, especially as the latter remain confined to "expected and accepted" forms of belligerence, even in the current context of heightened tensions. Future North Korean safe-haven rallies will be of shorter amplitude and duration. The September 15 missile launch over Japan (the fourth time this has happened) has shown this to be the case. Chart 7Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Bottom Line: BCA's bond team remains short duration, a position that our political analysis supports. We will keep our 2-year/30-year Treasury curve-steepener trade open, despite it being in the red by 34.3bps. In addition, we are closing our short Fed Funds January 2018 futures position (for a gain of 0.51bps) and opening a new short Fed Funds December 2018 position. Any sign of emerging bipartisanship should also favor higher fiscal spending, as policymakers almost always come together to spend money rather than cut spending. In addition, we are recommending that our clients put on a U.S. Treasury-German Bund spread widening trade.6 Rob has pointed out that this is a way to profit directly from higher fiscal spending in the U.S., particularly since there is no sign that Germany will change its government spending following its unremarkable election campaign. The data also supports a tactical widening of the Treasury-Bund spread, which is correlated with the relative data surprises (Chart 7). U.S. Politics: From Impeachable To Ingenious The crucial moment for the Trump presidency was the White House purge of the "Breitbart clique" following the social unrest in Charlottesville, Virginia on August 11-12.7 That move has made headway for upcoming tax legislation and resolution of the debt ceiling imbroglio. While some investors saw the racially motivated rioting in Virginia as a harbinger of a major risk-off episode, we saw it essentially as a "Peak Stupid" moment in U.S. politics. We may not know precisely what goes on in President Trump's mind, but we know that he likes polls. And his polling with Republican voters suffered appreciably following the Charlottesville fiasco (Chart 8). Strong Republican support for President Trump is the main source of his political capital. He can use it to cajole and influence Republicans in Congress via the upcoming Republican primary process ahead of the midterm elections. If he loses that support, his political capital will erode and he could become the earliest "lame duck" president in recent U.S. history. Worse, if support among Republicans were to fall below 70%, Trump could embark upon a Nixonian trajectory that could indeed lead to impeachment (Chart 9). Chart 8Trump's Support With GOP Voters Suffered... Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 9... But Remains Well Above Nixonian Levels Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Many clients have asked us about the debt ceiling deal that President Trump made with Democrats and whether it signals a radical shift towards bipartisanship. We do not think so. In fact, we think the deal is mostly irrelevant. As we argued throughout the summer, the idea that there would be another debt ceiling crisis this year was always a figment of the media's imagination. There was never any evidence that a sufficient number of members of the House of Representatives wanted to play brinkmanship with the debt ceiling. First, Democrats in both houses of Congress have been clear throughout the year that they would not play politics with the debt ceiling. Second, investors and the media continuously overestimate the strength of the Freedom Caucus, the fiscally conservative grouping of Tea Party-linked representatives. There are 41 members of the Freedom Caucus, whereas 55 Republicans in the House sit in districts that are at least theoretically vulnerable to a Democratic challenge (Table 2).8 The danger for House Speaker Paul Ryan is not that the Freedom Caucus abandons the establishment line, but that the 55 Republicans listed in Table 2 abandon the Republican line. This, in fact, happened throughout the Obama presidency, with centrist Republicans voting with Democrats in the House on a number of key legislative bills (Chart 10). Table 2Plenty Of Vulnerable Republican Representatives Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Chart 10The Obama Years: A Governing 'Grand Coalition' Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? This is why Speaker Paul Ryan largely ignored the Freedom Caucus and proposed an eighteen-month extension of the debt ceiling. He was never going to allow the Freedom Caucus to play brinkmanship. That President Trump picked the shorter Democrat version is significant only in so far as it signaled that he was willing to work with Democrats. In other words, the move was a "shot across the bow" of Republicans, a message that they had better get started on tax legislation, or else ... What should investors watch now? There are three main issues to follow: Tax legislation outline: House Speaker Paul Ryan has set the week of September 25 as the deadline for Republicans to outline their tax policy plan. The good news for investors is that the outline will supposedly include an already agreed-upon framework by both the House Ways and Means Committee - Chaired by Representative Kevin Brady (R, TX) - and the Senate Finance Committee - Chaired by Senator Orin Hatch (R-UT). Brady and Hatch are serious players and their comments on tax policy should be followed closely. Both favor legislation that would be retroactively applied to FY 2017, even if the bill is actually passed in 2018. They are also part of the Republican "Big Six" group on tax policy, along with Speaker Ryan, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin, and National Economic Council Director Gary Cohn. Reconciliation instructions: The House Budget Committee passed a FY 2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. These instructions allow Republicans to use the reconciliation procedure - a process that allows the Senate to pass legislation without needing 60 votes.9 However, the House version of the budget resolution also included over $200 billion of spending cuts, which is unlikely to pass in the Senate. As such, investors have to carefully watch for the House and Senate Republicans to pass a final budget resolution in order to kick off the reconciliation process. This process will likely happen in October, after the tax legislation package is presented by the Big Six. At that point, the Freedom Caucus will have the ability to extract concessions from establishment Republicans as their votes are needed to pass the budget resolution. We suspect that no Democrats will support the budget resolution given that they have not been involved in the tax policy process thus far. Trump's involvement: President Ronald Reagan's personal support and lobbying for the 1986 tax reform proved critical in getting the bill through Congress.10 President Trump's focus and energy will have to be on par with that of Reagan's if he plans to accomplish the same. A headwind for Trump is the lack of legislative experience in his White House (Chart 11). However, since the appointment of Chief of Staff General John F. Kelly, there has been a clear shift of focus on the legislative process. Chart 11Trump Administration Is On The Low End Of Congressional Experience Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Bottom Line: We expect investors to start gleaning the outlines of tax policy by late September, with the budget resolution containing reconciliation instructions being passed by both houses of Congress by the end of November. It may be too much to ask Congress to have an actual bill ready to pass by the end of the year, as we originally expected,11 particularly as there is now a potential immigration deal to negotiate with Democrats and last-minute effort to repeal and replace Obamacare. As such, we still think that it will take until the end of Q1 2018 for tax legislation to pass Congress (Q2 in the worst-case scenario for Republicans). Investors, however, will begin to price in a higher probability of tax policy as soon as the outline of the bill emerges in October. As such, we are reiterating our recommendation that investors go long U.S. small caps relative to large caps. Tax policy should overwhelmingly benefit small caps, which actually pay the 35% corporate tax rate. In addition, we would expect the USD to arrest its decline and rally by the end of the year. North Korea: At The Apogee Of "The Arc Of Diplomacy" To illustrate the current North Korean predicament to readers, we have referred to an "arc of diplomacy" (Chart 12), which we illustrate by referencing the rise and fall of U.S. tensions with Iran from 2010-15. The pattern is for the U.S. to increase tensions deliberately in order to convince its enemy that the military option is "on the table." Only once a "credible threat" of war has been established can the negotiations begin in earnest. Chart 12A Lesson From Iran: Tensions Ramp Up As Nuclear Negotiations Begin Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? We are at or near the peak of this process. First: what is the worst-case scenario for markets if the North causes a crisis short of a devastating war? Using our short list of geopolitical crises (Table 3),12 our colleague Anastasios Avgeriou, chief strategist of BCA's U.S. Equity Strategy, notes that while the average peak-to-trough drop of a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis. To illustrate the trend, Anastasios has constructed an S&P 500 profile of the average geopolitical crisis, and the picture is encouraging (Chart 13). It shows that the market is likely to grind higher even if North Korea does something truly out of the box. Table 3Geopolitical Crises And SPX Returns Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? Nor is a geopolitical incident (again, short of total war) likely to cause a U.S. or global recession. Aside from direct shocks to oil, such as in 1973 and 1990, only the U.S. Civil War (that is, a war waged on U.S. turf) caused a recession at the outset. Other major wars (WWI, WWII, the Korean War) caused recessions when they concluded because of the sharp drop in federal spending as a result of reduced military spending. What makes us think we are at or near the peak of North Korea's belligerent threats? China appears to be enforcing sanctions: at least according to China's official statistics (Chart 14). There is no doubt there are discrepancies and black market activity, but it makes sense for China to dial up the pressure (while never imposing crippling sanctions) and that appears to be occurring. China and Russia agreed to reduce fuel supplies. Both sides agreed to new UN sanctions on September 11 that would partially cut off North Korean fuel. This is a significant step, given that Chart 14 indicates China is already moving in this direction. The U.S. and North Korea have begun diplomatic talks. According to Japan's NHK press on September 14, former U.S. diplomat Evans Revere met with Choe Kang-Il, the deputy director general of the North American bureau of North Korea's foreign ministry in Switzerland over the past week. The U.S. State Department spokeswoman Heather Nauert all but confirmed that some kind of communication is underway, and Secretary of State Rex Tillerson has described his diplomatic initiative as highly active. The last efforts at negotiations, via the longstanding New York channel, were discontinued in June after the death of a U.S. prisoner in North Korea. Those were focused on retrieving U.S. citizens, whereas the new talks allegedly centered on the latest UN sanctions, i.e. a crux of the relationship. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. South Korea is offering aid. South Korea's new government is looking to give the North humanitarian aid, as expected, and will decide on September 21 about a special package for pregnant women and infants. It is suggesting that such aid has no conditionality on the North's behavior. At the same time, the U.S. administration is talking down Trump's recent threat to discontinue the U.S.-South Korean free trade agreement - meaning that the U.S. may even condone the South Korean administration's more diplomatic approach to the North. Chart 13Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Who Is Afraid Of Geopolitical Crises? Chart 14Is China Finally Playing Ball? Is China Finally Playing Ball? Is China Finally Playing Ball? At the same time, North Korea is running out of options for provocations that it can commit without provoking a costly response from the U.S. and its allies. The September 15 missile test over Japan was essentially the fourth of its kind, and the market shrugged it off. Here are some options, drawn from our list of scenarios and probabilities (Table 4): Table 4North Korean Scenarios Over The Next Year Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? More of the same: Nuclear and missile tests could continue, or be conducted at higher frequencies or simultaneously. While technical advances may become apparent, they will not change the game. U.S. Territory: The North could create a bigger risk-off move than we saw in July-August if it shot ICBMs toward Guam, or other U.S. territories, as it has suggested it might do. This is especially risky because the U.S. Secretary of Defense James Mattis has repeated Trump's warning to North Korea to not even threaten the United States. However, as long as no such missile actually strikes U.S. territory, the U.S. is unlikely to respond with an attack, and thus such a scare seems likely to fade like the others. Attacking South Koreans: The North has a history of state-backed terrorist actions and military actions. An attack limited to South Korea will cause a shock, in the current context, but the military consequences are still likely to be contained given the extensive history of such attacks. If it is an attack against South Korean civilians in a non-disputed territory, it will leave a bigger mark than it otherwise would, but the South is still likely either to retaliate in strict proportionality, or to refrain from action and use the event as a way of galvanizing international sanctions. Attacking Americans or U.S. allies: The true danger in the current climate is an attack that kills U.S. citizens, or U.S. allies who are not as, shall we say, understanding as the South Koreans (such as the Japanese). This could cause the U.S. or Japan or another ally to take a retaliatory action. Even if limited, this could cause a deep correction in the market. The U.S. response would likely still be limited and proportional. Then the question would be whether the North Koreans can afford to escalate. They can't. The military asymmetry is excessive. This is not the case of the Japanese in 1941, who believed they had the potential of defeating the U.S. if they acted quickly enough and the U.S. was distracted in Europe (Diagram 1). Diagram 1North Korea Crisis: A Decision Tree Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? As the foregoing demonstrates, there could still be big ups and downs between now and the resumption of formal international negotiations, let alone a satisfactory diplomatic accord. The tensions could yet reach another peak. Nevertheless, our sense is that the pieces are falling into place for the North to moderate its behavior, sending the signal that it is ready to engage in real negotiations. Since the U.S. has consistently shown its readiness to talk directly with the North - coming from both Trump and Tillerson - we think we could see shuttle diplomacy taking place as early as this winter. Here are some dates and events to watch: Military exercises: Will the U.S., South Korea, and Japan stop or slow down the pace of military exercises? This could open space for North Korea to offer an olive branch in return. October 10 - anniversary of the Worker's Party of Korea: The North may take an extraordinary action, no action, or familiar actions like missile tests. October 11-25 - China's party congress: The North could fall silent ahead of the big event, or could attempt to disrupt it. China, in turn, could take action around this time (particularly afterwards) to send a signal to the North to tone down the belligerence. In previous periods of tension, China has reputedly drawn a harder line on North Korea in the month of December, when end-of-year quotas made certain trade measures more convenient. Late October - Japanese snap election? Rumor has it that Shinzo Abe is thinking of calling a snap election as early as this month. We normally dismiss such rumors but this time there is a certain logic: two North Korean missiles have flown over Hokkaido in as many months, while the Japanese opposition is in total disarray. If Abe calls early polls, it suggests that he thinks Korean fears are peaking. If he delays, and exploits these fears by pushing constitutional revisions through the Diet (our base case), then he may provoke a North Korean response, given that the revisions pave the way for Japan to "re-militarize." November 1 - APEC and Trump's visit to China: Trump is supposed to head to Vietnam for the APEC summit and to China to visit President Xi Jinping. Xi has recently shown his sensitivity to such summits by concluding the Doklam dispute with India just days ahead of the BRICS summit in Xiamen, China in order to ensure that Indian President Narendra Modi would attend. Xi may have also wanted to advertise his ability to negotiate solutions to international showdowns for the world (and U.S.) to see. Thus, progress on North Korea before or after Trump's arrival could improve Xi's authority both with Trump and the rest of the world. November 23 - U.S. Thanksgiving: North Korea likes to be "cute," so we cannot rule out attempts to unsettle the Americans on Thanksgiving or Christmas Day, as with the July 4 ICBM launch. Trump's visit is very consequential and it is more likely under the circumstances that China will receive him warmly, like Nixon, rather than coldly, like Obama last year. Trump is holding serious trade negotiations (via Commerce Secretary Wilbur Ross) and at the same time threatening to sanction Chinese companies and imports (via Treasury Secretary Steve Mnuchin). There are many reasons for Beijing to cooperate on North Korea in order to get advantageous treatment on the economic front. Bottom Line: The market is already discounting North Korea. We may be wrong temporarily if the North ups the ante yet again, but we are very near the peak of the latest round of tensions. The North is running out of options short of instigating a fight it would lose, while China is enforcing sanctions more seriously (including fuel), and Washington has apparently opened direct talks with Pyongyang. We will maintain our portfolio hedge of Swiss bonds and gold, for now. We are also re-opening our long CBOE China ETF volatility index to account for potential rising political uncertainty surrounding the coming October Party Congress and possibly for further North Korea related risks. However, we are closing our short KRW / THB trade for a gain of 5.33%. Europe: More Red Herrings Brexit is no longer market-relevant. Its economic effect was fully priced in when Prime Minister Theresa May announced on January 17 that the U.K. would not seek membership in the Common Market. Since then, the pound has effectively bottomed against both the dollar and the euro, as we argued it would (Chart 15).13 This does not mean that investors should necessarily go long the pound. Rather, we are pointing out that the moves in the U.K. currency have ceased to be Brexit-related since we called its bottom in January. Going forward, investors should make bets on the pound based on macroeconomic fundamentals, not on the U.K.-EU negotiations. The one political risk to the pound going forward is the potential for the Labour Party, headed by opposition leader Jeremy Corbyn, to come to power in the U.K. in the near term. Corbyn is the most left-of-center leader of a developed world economy since French president François Mitterrand in 1981. And he symbolizes a leftward shift on economic policy by the median voter. Nevertheless, the risks to PM May are overstated, for now. A key test for the Prime Minister, the EU (Withdrawal) Bill, passed its first parliamentary hurdle in Westminster on September 12. No Conservatives rebelled, with seven Labour politicians defying Corbyn's instructions to vote against the bill. The bill still faces several days of amendments, but it largely gives May a free hand to negotiate with Europe going forward. Bremain-leaning Tory backbenchers could have posed problems for May had they decided to obstruct the bill. That they did not tells us that nobody wants to challenge May and that she will likely remain the prime minister until the eventual deal with the EU is reached. Our clients often balk at our dismissal of Brexit as an investment-relevant geopolitical event. However, the crucial question post-Brexit was whether any other EU member states would follow the U.K. out of the bloc. We answered this question in the negative, with high conviction, the day of the U.K. referendum.14 Not only did no country follow U.K.'s lead, but the effect of Brexit was in fact the exact opposite of the conventional wisdom, with a slew of defeats for populists around Europe following the referendum. For the U.K. economy and assets, the key two Brexit-related questions were whether the economy's service sector would have unfettered access to the European market via membership in the Common Market (Chart 16); and whether the labor market would have access to the European labor pool (Chart 17). Both questions were answered by May during her January 17 speech in the negative, which is why we continue to cite that moment as the date when U.K. assets fully priced in Brexit. Chart 15Is Brexit##br## Still Relevant? Is Brexit Still Relevant? Is Brexit Still Relevant? Chart 16U.K. Needs A Free Services Agreement##br## With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! U.K. Needs A Free Services Agreement With The EU, Not An FTA! Chart 17Intra-EU Migration Boosts ##br##Labor Force Growth Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? What could change our forecast? We would need to see the negotiations with Europe become a lot more acrimonious. Disputes over the amount of the "exit bill" or the status of the Irish border simply do not count as acrimony. We need to see the threat of a "Brexit cliff" - where the EU-U.K. trade relationship reverts to "WTO rules" - emerge due to a conflict between the two powers. However, this is unlikely to happen as the EU greatly values its trade relationship with the U.K. And London's demand for an FTA actually plays to the EU's strengths, since FTAs normally privilege trade in goods (where Europe is competitive) relative to trade in services (where the U.K. has an advantage). Bear in mind, as well, that the U.K. and EU are negotiating an FTA from a starting point of a high degree of economic integration: this is not the equivalent of two separate economies pursuing an FTA for the first time. Similarly overstated as a risk is the upcoming Catalan independence referendum. As we argued this February, the referendum is a non-event.15 Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 18). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.16 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.17 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). Chart 18Catalans Do Not Want Independence Catalans Do Not Want Independence Catalans Do Not Want Independence We expect the turnout of the upcoming referendum to be low. Given that Madrid will not recognize it, the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. What does that mean precisely? The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to be willing to take up arms in order for its referendum to be relevant to the markets. Without recognition from Spain, and with no support for independence from fellow EU and NATO peers, Catalonia cannot win independence at the ballot box. Bottom Line: Fade Brexit and Catalonia risks. Iraq: An Emergent Risk In 2014, we wrote the following about the future of Iraq:18 "Furthermore, the recent Kurdish occupation of Kirkuk - nominally to secure it from ISIS, in reality to (re)claim it for the Kurdish Regional Government (KRG) - will not be acceptable to Baghdad. In our conversations with clients, too much optimism exists over the stability of Kurdistan and its expected oil output. While we are broadly positive on the KRG, there are many challenges. First, three-quarters of Iraqi production is, in fact, located in the Southern part of the country, far from Iraqi Kurdistan. Second, Kirkuk and its associated geography has the potential to boost production, but the Kurds (and their ally Turkey) will eventually have to face-off against Baghdad (and its ally Iran) for control over this territory. Just because the KRG secured Kirkuk today does not mean that it will stay in their control in the future. We are fairly certain that once ISIS is defeated, Baghdad will ask for Kirkuk back." In 2016, we followed up again on the situation in Iraq by pointing out that a series of defeats for the Islamic State were raising the probability that a reckoning was coming between Baghdad and Iraqi Kurds.19 Now that the Islamic State threat is in the rear-view mirror, our forecast is coming to fruition. On September 25, Kurds in Iraq will hold an independence referendum. Opposition to the referendum is uniform across the region, with the U.S. - Kurds' strongest ally - requesting that it not take place. Why should investors care? First, there is the issue of oil production. There are no reliable figures regarding KRG production, but it is thought to be around 550,000 bpd, although KRG officials have themselves downplayed their production. This figure includes production from the Kurdish-controlled Bai Hassan and Avana fields in the Kirkuk province, which is not formally part of the KRG territory but which Kurds nominally control due to their 2014 anti-ISIS intervention. A conflict over Kurdish independence could impact this production, particularly if war breaks out over Kirkuk. However, the bigger risk to global oil supply is what it would do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production. Second, there are problematic regional dynamics. There are about six million Kurds in Iraq, about 20% of the total population. The Kurdish Regional Government controls the northeast corner of Iraq, but fighting against the Islamic State has allowed the Kurds to extend their control further south and almost double their territory (Map 1). Turkey has largely supported the KRG over the years, as the ruling party in the autonomous province is relatively hostile to the Kurdistan Workers' Party (PKK), which Turkey considers a terrorist organization. However, Turkey is opposed to the independence of the KRG due to fears that it would start the ball rolling on the independence of Kurds in Syria and potentially one day in Turkey as well. Also opposed to KRG secession are Iran (Baghdad's closest ally) and Syria (which is dealing with its own Kurdish question). Map 1Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Can Equities And Bonds Continue To Rally? Can Equities And Bonds Continue To Rally? On the other hand, the KRG does have international support. Russia just recently concluded a major oil deal with KRG, promising to buy Kurdish oil and refine it in Germany. Moscow will also invest US $3 billion in KRG territory. Russia also supplied the KRG Peshmerga - armed forces - with weapons during their fight against the Islamic State. From Russia's perspective, any conflict in the Middle East is a boon. It stalls investment in the region, curbs its oil production, and potentially adds a risk premium to oil prices. In addition, a close alliance with the KRG would allow Russia to gain another ally in the region. Bottom Line: While it is difficult to see how the independence referendum will play out in the short term, we have had a high-conviction view that Iraq's stability will not improve with the fall of the Islamic State. For investors, rising tensions in Iraq are significant because they could curb investment in the long term and potentially even impact production in the short term. Unlike the Islamic State, which never threatened oil production in the Middle East in any significant way, Iraq and the KRG are both oil producers. In fact, their main conflict is over an oil-producing region centered on Kirkuk. Tensions in the region support BCA Commodity & Energy Strategy's bullish view on oil prices.20 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017; "North Korea: No Longer A Red Herring" in BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017; and "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 5 BCA Global Fixed Income Strategy 10-year Treasury yield model only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Duration 'Hot Potato' Shifts Back To The U.S.," dated August 8, 2017, available at gfis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Is The 'Trump Put' Over?" dated August 23, 2017, available at gps.bcaresearch.com. 8 We use the Cook Political Report for their assessment of how U.S. electoral districts lean. Charlie Cook is Washington's foremost election handicapper with a long record of accomplishment. Anyone interested in closely following the U.S. midterm elections should consider his research, which is found on http://www.cookpolitical.com/ 9 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 10 Please see Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see footnote 3 above. 13 The GBP/USD bottomed then and there. The GBP/EUR has recently hit a new low, for reasons other than Brexit. This bottom is only slightly below its previous lows in October 2016, when May confirmed that her government would seek to leave the EU in accordance with the referendum result, and in January 2017, when May admitted what the GBP/EUR had already reflected, that this meant leaving the Common Market. Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World," dated January 25, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, and Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 16 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 17 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat 18 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 20 Please see BCA Commodity & Energy Strategy Weekly Report, "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," dated September 14, 2017, available at ces.bcaresearch.com.

Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege G19 G19 The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq G19 G19 The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria G19 G19 Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey G19 G19 Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.

Highlights With crude-oil inventory transfers from OPEC to western refining centers slowing, OPEC 2.0's production cuts will begin to show up in high-frequency OECD inventory data in the form of lower stock levels. The coalition has been bedeviled by higher production from Libya and Nigeria, and a push from Iraq asserting its right - in line with its huge reserves - to increase production. U.S. imports from Iraq are growing this year, even as other OPEC members slow shipments. In addition, Iraqi crude oil inventories also were increasing while other OPEC states were running their stocks down, which suggests Iraq may be preparing to lift production and exports in the near future. Energy: Overweight. Crude oil rallied sharply over the past week, despite reports of higher Libyan production. We remain long via Dec/17 $50/bbl vs. $55/bbl call spreads in Brent and WTI. Base Metals: Neutral. The U.S. reportedly is using a national security review of the U.S. steel industry, to determine whether it will impose tariffs on steel imports at this week's G20 meeting in Germany. Precious Metals: Neutral. Gold recovered after selling off last week on the back of more aggressive guidance from central bankers. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. The USDA's acreage reports for grains were less bearish than expected, rallying markets into this week. We remain bearish, but also recommend investors continue to avoid shorting these markets. Feature Chart of the WeekCrude Oil Prices Rally,##BR##Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Crude Oil Prices Rally, Despite Reports Of Higher Production Oil rallied 9.6% over the past week from recent lows, despite news reports of Libya pushing crude oil production toward 1mm b/d by the end of this month, and further indications Iraq is gearing up to increase production and exports (Chart of the Week). We expect prices to continue to be well supported in 2H17, as the production cuts engineered by OPEC 2.0 - the OPEC and non-OPEC producers' coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, respectively - finally begin showing up in the high-frequency storage data for the U.S. and the OECD. This is because, we believe, the massive crude-oil inventory transfers between OPEC and OECD refining centers is winding down. OPEC Inventory Transfer Winding Down Crude oil inventories in major oil importers with significant refining capabilities - in particular, the U.S. and the Amsterdam-Rotterdam-Antwerp (ARA) refining center in the Netherlands and Belgium - grew by a bit more than 35mm barrels (bbl) year-on-year (yoy) on average over the January - April period, based on data from the Joint Organisations Data Initiative (JODI), a transnational group made up of producing and consuming interests headquartered in Riyadh, Saudi Arabia. The January - April period marked the first four months of the OPEC 2.0 production-cutting Agreement, in which OPEC pledged to reduce output by 1.2mm b/d, and non-OPEC obliged itself to cut an additional 600k b/d of production. The yoy builds in the U.S. and ARA inventories were a mirror-image of the average yoy inventory withdrawals occurring in OPEC states that reported their stock levels to JODI in the first four months of this year (Chart 2). The JODI inventory data indicates that even as OPEC 2.0 was cutting production in the first four months of the year - by some estimates by more than 100% of the pledged 1.8mm b/d of reductions - these states were draining stocks from inventories during this period to maintain sales to key clients. The declining trend in high-frequency U.S. inventory data from the EIA for the U.S. East coast (PADD 1), the Midwest (PADD 2), and the U.S. Gulf (PADD 3), and declining weekly import estimates support our contention that OPEC inventories will continue to decline, and that the production surge by OPEC in 4Q16 will finally be worked off (Chart 3). Given the downtrend in the weekly high-frequency crude oil import data for the U.S., we expect crude-oil shipments from OPEC to continue to slow as production cuts no longer are masked by inventory draws (Chart 4). Among the top 10 crude oil exporters to the U.S., KSA shipments are down an average 55k b/d in yoy 2Q17 vs. an increase of slightly more than 150k b/d in 1Q17. KSA shipped 1.09mm b/d to the U.S. in 2Q17 vs. 1.23mm b/d in 1Q17. The rates at which Iraq and Nigeria were shipping oil to the U.S. also slowed, but are still above year-ago levels, as is to be expected given the civil strife from which both are recovering - Iraq's 2Q17 exports to the U.S. were up 279k b/d vs. 316k in 1Q17 yoy at 663k and 592k b/d, while Nigeria's exports to the U.S. were up 67k b/d yoy in 2Q17 and 69k b/d in 1Q17, at 286k b/d and 270k b/d, respectively. Chart 2OPEC Inventory Transfer##BR##Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 OPEC Inventory Transfer Winds Down In 2017 Chart 3Surge In 2H16 OPEC Production##BR##Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Surge In 2H16 OPEC Production Is Being Worked Off Continued high levels of U.S. refining runs and exports of crude and products also will accelerate draws in the U.S., even though refining runs are not growing at rates seen last year when the overall level of refining was lower (Chart 5). Chart 4OPEC Exports To##BR##The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing OPEC Exports To The U.S. Are Slowing Chart 5U.S. Refinery Runs And Exports##BR##Remain High U.S. Refinery Runs And Exports Remain High U.S. Refinery Runs And Exports Remain High Watch Iraq Chart 6Libya, Nigeria Increase Production,##BR##But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq Libya, Nigeria Increase Production, But The Big Story Will Be Iraq The OPEC 2.0 agreement has been bedeviled by higher-than-expected production from Libya, where officials claim they will be producing at 1.0mm b/d by the end of July, and Nigeria.1 In our balances, we have Libyan production up some 100k b/d from last month at ~ 800k b/d. Nigeria currently is producing ~ 1.5mm b/d, after falling to as low as 1.2mm b/d due to sabotage of its export facilities. But, without doubt, the OPEC state with the greatest potential for production growth is Iraq, which currently is producing ~ 4.5mm b/d (Chart 6). Iraqi local inventories were up 43% yoy in April at just over 11mm bbl. Iraqi exports to the U.S. were up more than 50% yoy to just over 640k b/d in June. Ordinarily, this would not warrant much attention, given the harmony that so far has characterized OPEC 2.0's performance since year-end 2016. However, Iraqi officials have begun advocating for higher production levels, which, in their protestations, would be consistent with their high reserve levels. Just this week, the country's oil minister, Jabar al-Luaibi, asked rhetorically, "Why should Iraq be deprived from increasing its production? Not to disturb or disrupt OPEC at all, or the prices, but it is our right to have our production that corresponds to our reserves."2 He observed, "We have gas, we have oil. We have the right to do well. As simple as that." Iraq certainly has the reserves necessary to increase production significantly, but would require significant time and capital to grow production materially above the record levels reached in Q4 2016, which were about 200,000-300,000 b/d above current levels. "Whatever It Takes" May Require KSA To Cut Again If Libya can hold to its higher production level, and even reach 1mm b/d, and Iraq decides to exercise its "right" to produce more, OPEC 2.0 will have to cut additional barrels from the coalition's production to accommodate the higher output. Given Russia's apparent reluctance to do so, this could mark the first significant test of the durability of the agreement that created OPEC 2.0. The stakes are high if these production cuts are not addressed. As Russians go to the polls in March 2018, and, later in the year, KSA seeks to IPO Aramco, multiple problems will present themselves: Another production free-for-all that collapses prices would trigger another round of high consumer-level inflation in Russia, as the rouble falls once again, and KSA's IPO would value Aramco far below the $2 trillion Saudi officials are hoping for. Our bullish price view - we're expecting Brent to trade to $60/bbl by year-end - will be deep-sixed if production cannot be controlled. As it stands, we have total OPEC crude production just over 32mm b/d in 2017, and slightly over 32.5mm b/d in 2018. Given the stout demand growth we expect this year and next, we expect close to 900k b/d more demand growth over supply growth, based on our modelling. Next year, we expect supply growth of 2.25mm b/d, and demand growth of 1.62mm b/d, so supply growth exceeds demand growth in 2018 by 630k b/d, moving oil markets from undersupplied to balanced/slightly over-supplied. Obviously, higher production would change these balances. The big questions for the market going forward: Will OPEC states that have drained inventories supporting sales to key clients maintain production discipline, allowing inventories in the U.S. and ARA to drain? Will OPEC 2.0 unravel under pressure from Russia and KSA assessments of the need for additional cuts? Can Libya and Nigeria maintain higher output? Libya is a failed state, and warring tribes almost surely will seek to take control over as much of the revenue-generating capacity of the oil-export facilities in the East and West of the country as possible. Nigeria, although not a failed state, faces similar difficulties containing the sabotage that has disabled export capacity on and off for the past few years. Whither Iraq? A price collapse would definitely reduce U.S. shale output, as the 2015 - 1H2016 experience demonstrated. If domestic U.S. prices stayed lower for longer, we would expect rig counts to decline, reducing the rate of growth in U.S., supply. Right now, we expect U.S. shale output to grow 340k b/d this year and by ~ 1mm b/d next year based on earlier, higher price levels. Our research has shown the very high correlation between U.S. shale output and WTI prices along the forward curve out to 3 years forward, and a low price definitely will lead to lower rig counts. Bottom Line: OPEC 2.0 still is holding together. Going into its ministerial meeting at the end of this month, it must provide clear guidance to the market over how it will handle a sustained increase in Libyan production. In addition, Iraq's intentions must be clear - otherwise, the market will assume the worst. We remain bullish, and continue to recommend low-risk long positions - we are long Dec/17 $50 vs. $55/bbl call spreads in Brent and WTI. Once markets are given greater clarity, we will look for higher-risk alternatives for putting new length on. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Libya's Oil Production Nears 4 Year High," in oilprice.com's June 29, 2017, online edition. 2 The minister's remarks were reported in the July 5, 2017, issue of, Iraq Daily Journal's online edition. Please see "Iraq Has Right To Achieve Oil Output In Line With Reserves - Minister." Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 OPEC's Oil Inventory Shift Winding Down OPEC's Oil Inventory Shift Winding Down Summary of Trades Closed in 2016

Highlights This week, Commodity & Energy Strategy is publishing a joint report with our colleagues at BCA's Energy Sector Strategy. Driven by the leadership of the Kingdom of Saudi Arabia (KSA) and Russia, OPEC 2.0 formalized the well-telegraphed decision to extend its production cuts for another nine months, carrying the cuts through the seasonally weak demand period of Q1 2018. The extension is will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating) setting in later this year. Energy: Overweight. We are getting long Dec/17 WTI vs. short Dec/18 WTI at tonight's close, given our expectation OPEC 2.0's extension of production cuts, and lower exports by KSA to the U.S., will cause the U.S. crude-oil benchmark to backwardate. Base Metals: Neutral. Despite "catastrophic flooding" in March, 1Q17 copper output in Peru grew almost 10% yoy to close to 564k MT, according to Metal Bulletin. This occurred despite strikes at Freeport-McMoRan's Cerro Verde mine, where production was down 20.5% yoy in March. Precious Metals: Neutral. Our strategic gold portfolio hedge is up 2.61% since it was initiated on May 4, 2017. Ags/Softs: Underweight. The USDA's Crop Progress report indicates plantings are close to five-year averages, despite harsh weather in some regions. We remain bearish. Feature Chart 1Real OPEC Cuts Of ~1.0 MMb/d##BR##For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days OPEC 2.0's drive to normalize inventories by early 2018 will be accomplished with last week's agreement to extend current production cuts through March 2018. In total, OPEC has agreed to remove over 1 MMb/d of producible OPEC oil from the market for over 400 days (Chart 1), supplemented by an additional 200,000-300,000 b/d of voluntary restrictions of non-OPEC oil through Q3 2017 at least, perhaps longer if Russia can resist the temptation to cheat after oil prices start to respond. Many of the participants in the cut, from both OPEC and non-OPEC, are not actually reducing output voluntarily, but have had quotas set for them that merely reflect the natural decline of their productive capacity, limitations that will be even more pronounced in H2 2017 than in H1 2017. With production restricted by the OPEC 2.0 cuts, global demand growth will outpace supply expansion by another wide margin in 2017, just as it did last year (Chart 2). As shown in Chart 3, steady demand expansion and the slowdown in supply growth allowed oil markets to move from oversupplied in 2015 to balanced during 2016; demand growth will increasingly outpace production growth in 2017, creating sharp inventory draws (Chart 4) that bring stocks down to normalized levels by the end of 2017 (Chart 5). Chart 2 Chart 3Production Cuts And Demand##BR##Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Chart 4Higher Global Inventory##BR##Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Chart 5OECD Inventories To Be##BR##Reduced To Normal OECD Inventories To Be Reduced To Normal OECD Inventories To Be Reduced To Normal The extension of the cut through Q1 2018 will help prevent a premature refilling of inventories during the seasonally weak first quarter next year. The return of OPEC 2.0's production to full capacity in Q2 2018 will drive total production growth above total demand growth for 2018, returning oil markets from deliberately undersupplied during 2017 to roughly balanced markets in 2018, with stable inventory levels that are below the rolling five-year average. 2018 inventory levels will still be 5-10% above the average from 2010-2014, in line with the ~7% demand growth between 2014 and 2018. Compliance Assessment: Only A Few Players Matter In OPEC 2.0 OPEC's compliance with the cuts announced in November 2016 has been quite good, with KSA anchoring the cuts by surpassing its 468,000 b/d cut commitment. In addition to KSA, OPEC is getting strong voluntary compliance from the other Middle Eastern producers (except Iraq), while producers outside the Middle East lack the ability to meaningfully exceed their quotas in any case. OPEC's Core Four Remain Solid. The core of the OPEC 2.0 agreement has delivered strong compliance with their announced cuts. Within OPEC, the core Middle East countries Kingdom of Saudi Arabia, Kuwait, Qatar, and UAE have delivered over 100% compliance of their 800,000 b/d agreed-to cuts. We expect these countries to continue to show strong solidarity with the voluntary cuts through March 2018 (Chart 6). Iraq And Iran Make Small/No Sacrifices. Iraq and Iran were not officially excluded from cuts, but they were not asked to make significant sacrifices either. We estimate Iran has little-to-no capability to materially raise production in 2017 anyhow, and KSA is leaning on Iraq to better comply with its small cuts. Chart 7 shows our projections for Iran and Iraq production levels through 2018. Chart 6KSA, Kuwait, Qatar & UAE Carrying##BR##The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts Chart 7Iran And Iraq Production##BR##Near Full Capacity Iran And Iraq Production Near Full Capacity Iran And Iraq Production Near Full Capacity Iraq surged its production above 4.6 MMb/d for two months between OPEC's September 2016 indication that a cut would be coming and the late-November formalization of the cut. Iraq's quota of 4.35 MMb/d is nominally a 210,000 b/d cut from its surged November reference level, but is essentially equal to the country's production for the first nine months of 2016, implying not much of a real cut. Despite the low level of required sacrifice, Iraq has produced about 100,000 b/d above its quota so far in 2017 at a level we estimate is near/at its capacity anyway. KSA and others in OPEC are not pleased with Iraq's overproduction and have pressured it to comply with the agreement. We forecast Iraq will continue producing at 4.45 MMb/d. Iran's quota represented an allowed increase in production, reflecting the country's continued recovery from years of economic sanctions. We project Iran will continue to slowly expand production, but since the country is almost back up to pre-sanction levels, there is little remaining easily-achievable recovery potential. South American & African OPEC Capacity Eroding On Its Own. Chart 8 clearly shows how production levels in Venezuela, Angola and Algeria started to deteriorate well before OPEC formalized its production cuts, with productive capacity eroded by lack of reinvestment rather than voluntary restrictions. The quotas for these three countries (as well as for small producers Ecuador and Gabon) are counted as ~258,000 b/d of "cuts" in OPEC's agreement, but they merely represent the declines in production that should be expected anyway. With capacity deteriorating and no ability to ramp up anyway, these OPEC nations will deliver improving "compliance" (i.e. under-producing their quotas) in H2 2017, and are happy to have the higher oil prices created by the extension of production cuts by the core producers within OPEC 2.0. Libya and Nigeria Exclusions Unlikely To Result In Big Production Gains. Both Libyan and Nigerian production levels have been constrained by above-ground interference. Libyan production has been held below 1.0 MMb/d since 2013 principally by chronic factional fighting for control of export terminals, while Nigerian production--on a steady natural decline since 2010--has been further limited by militants sabotaging pipelines in 2016-2017. While each country has ebbs and flows to the amount of oil they are able to produce, we view both countries' problems as persistent risks that will continue to keep production below full potential (Chart 9). Chart 8 Chart 9Libya And Nigeria Production Could Go Higher##BR##Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances For Nigeria, we estimate the country's crude productive capacity has eroded to about 1.8 MMb/d from 2.0 MMb/d five years ago due to aging fields and a substantial reduction in drilling (offshore drilling is down ~70% since 2013). Within another year or two, this capacity will dwindle to 1.7 MMb/d or below. On top of this natural decline, we have projected continued sabotage / militant obstruction will limit actual crude output to an average of 1.55 MMb/d for the foreseeable future. Libyan production averaged just 420,000 b/d for 2014-2016, a far cry from the 1.65 MMb/d produced prior to the 2011 Libyan Revolution that ousted strongman Muammar Gaddafi. Since Gaddafi was deposed and executed, factional strife and conflict has persisted. Each faction wants control over oil export revenues and, just as importantly, wants to deny the opposition those revenues, resulting in a chronic state of conflict that has limited production and exports. If a détente were reached, we expect Libyan oil production could quickly rise to about 1.0 MMb/d of production within six months; however, we put the odds of a sustainable détente at less than 30%. As such, we forecast Libyan crude production will continue to struggle, averaging about 600,000 b/d in 2017-2018. Non-OPEC Cuts Hang On Russia In November, ten non-OPEC countries nominally agreed to restrict production by a total of 558,000 b/d, but Russia--with 300,000 b/d of pledged cuts--is the big fish that KSA and OPEC are relying on. Mexico's (and several others') agreements are window dressing, reframing natural production declines as voluntary action to rebalance markets. Through H1 2017, Russia has delivered on about 60-70% of its cut agreement, with compliance growing in Q2 (near 100%) versus Q1 (under 50%). From the start, Russia indicated it would require some time to work through the physical technicalities of lowering production to its committed levels, implying that now that production has been lowered, Russia could deliver greater compliance over H2 2017 than it delivered in H1 2017. We are a little more skeptical, expecting some weakening in Russia's compliance by Q4, especially if the extended cuts deliver the expected results of bringing down OECD inventories and lifting prices. Russia surprised us with stronger-than-expected production during 2016. Some of the outperformance was clearly due to a lower currency and improved shale-like drilling results in Western Siberia, but it is unclear whether producers also pulled too hard on their fields to compensate for lower prices, and are using the OPEC 2.0 cut as a way to rest their fields a bit. We have estimated Russian production returning to 11.3 MMb/d by Q4 2017 (50,000 b/d higher than 2016 average production) and holding there through 2018 (Chart 10), but actual volumes could deviate from this level by as much as 100,000-200,000 b/d. Mexico, the second largest non-OPEC "cutter," is in a position similar to Angola, Algeria, and Venezuela. Mexican production has been falling for years (Chart 11), and the nation's pledge to produce 100,000 b/d less in H1 2017 than in Q4 2016 is merely a reflection of this involuntary decline. As it has happened, Mexican production has declined by only ~60,000 b/d below its official reference level, but continues to deteriorate, promising higher "compliance" with their production pledge in H2 2017. Chart 10Russia Expected##BR##To Cheat By Q4 Russia Expected To Cheat By Q4 Russia Expected To Cheat By Q4 Chart 11Mexican Production Deterioration##BR##Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Kazakhstan and Azerbaijan are not complying with any cuts, and we don't expect them to. Despite modest pledges of 55,000 b/d cuts combined, the two countries have produced ~80,000 b/d more during H1 2017 than they did in November 2016. We don't expect any voluntary contributions from these nations in the cut extension, but Azerbaijan's production is expected to wane naturally (Chart 12). While contributing only a small cut of 45,000 b/d, Oman has diligently adhered to its promised cuts, supporting its OPEC and Gulf Cooperation Council (GCC) neighbors. We expect Oman's excellent compliance will be faithfully continued through the nine-month extension (Chart 13). Chart 12Kazakhstan And Azerbaijan Not Expected##BR##To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Chart 13Oman Has Faithfully Complied##BR##With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date OPEC Extension Will Continue To Support Increased Shale Drilling Energy Sector Strategy believed OPEC's original cut announced in November 2016 was a strategic mistake for the cartel, as it would accelerate the production recovery from U.S. shales in return for "only" six months of modestly-higher OPEC revenue. As we cautioned at the time, the promise of an OPEC-supported price floor was foolish for them to make; instead, OPEC should have let the risk of low prices continue to restrain shale and non-Persian Gulf investment, allowing oil markets to rebalance more naturally. However, despite our unfavorable opinion of the strategic value of the original cut, since the cut has not delivered the type of OECD inventory reductions expected (seemingly due to a larger-than-expected transfer of non-OECD inventories into OECD storage), we view the extension of the cut as a necessary, and logical, next step. OPEC 2.0's November 2016 cut agreement signaled to the world that OPEC (and Russia) would abandon KSA's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers (and supporting capital markets) to pour money into vastly increased drilling programs. Now that the shale investment genie has already been let out of the bottle, extending the cuts is unlikely to have nearly the same stimulative impact on shale spending as the original paradigm-changing cut created. The shale drilling and production response has been even greater than we estimated six months ago, and surely greater than OPEC's expectations. The current horizontal (& directional) oil rig count of 657 rigs is nearly twice the 2016 average of 356 rigs, is 60% higher than the level of November 2016 (immediately before the cut announcement), and is still rising at a rate of 25-30 rigs per month (Chart 14). The momentum of these expenditures will carry U.S. production higher through YE 2017 even if oil prices were allowed to crash today. Immediately following OPEC's cut, we estimated 2017 U.S. onshore production could increase by 100,000 - 200,000 b/d over levels estimated prior to the cut, back-end weighted to H2 2017, with a greater 300,000-400,000 b/d uplift to 2018 production levels. Drilling activity has roared back so much faster than we had expected, indicative of the flooding of the industry with external capital, that we have raised our 2017 production estimate by 500,000 b/d over our December estimate, and raised our 2018 production growth estimate to 1.0 MMb/d (Chart 15). Chart 14Rig Count Recovery Dominated##BR##By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Chart 15Onshore U.S. Production##BR##Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Other Guys' Decline Requires Greater Growth From OPEC, Shales, And Russia We've written before about "the Other Guys' in the oil market, defined as all producers outside of the expanding triumvirate of 1) U.S. shales, 2) Russia, and 3) Middle East OPEC. While the growers receive the vast majority of investors' focus, the Other Guys comprise nearly half of global production and have struggled to keep production flat over the past several years (Chart 16). Chart 17 shows the largest offshore basins in the world, which should suffer accelerated declines in 2019-2020 (and likely beyond) as the cumulative effects of spending constraints during 2015-2018 (and likely beyond) result in an insufficient level of projects coming online. This outlook requires increasing growth from OPEC, Russia and/or the shales to offset the shrinkage of the Other Guys and simultaneously meet continued demand growth. Chart 16The Other Guys' Production##BR##Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat Chart 17 Risks To Rebalancing Our expectation global oil inventories will draw, and that prices will, as a result, migrate toward $60/bbl by year-end is premised on the continued observance of production discipline by OPEC 2.0. GCC OPEC - KSA, Kuwait, Qatar, and the UAE - Russia and Oman are expected to observe their pledged output reduction, but we are modeling some compliance "fatigue" all the same. Even so, this will not prevent visible OECD oil inventories from falling to their five-year average levels by year-end or early next year. Obviously, none of this can be taken for granted. We have consistently highlighted the upside and downside risks to our longer term central tendency of $55/bbl for Brent crude, with an expected trading range of $45 to $65/bbl out to 2020. Below, we reprise these concerns and our thoughts concerning OPEC 2.0's future. Major Upside Risks Chief among the upside risks remains a sudden loss of supply from a critical producer and exporter like Venezuela or Nigeria, which, respectively, we expect will account for 1.9 and 1.5 MMb/d of production over the 2017-18 period. Losing either of these exporters would sharply rally prices above $65/bbl as markets adjusted and brought new supply on line. Other states - notably Algeria and Iraq - highlight the risk of sustained production losses due to a combination of internal strife and lack of FDI due to civil unrest. Algeria already appears to have entered into a declining production phase, while Iraq - despite its enormous potential - remains dogged by persistent internal conflict. We are modeling a sustained, slow decline in Algeria's output this year and next, which takes its output from 1.1 MMb/d in 2015 down to slightly more than 1 MMb/d on average this year and next. For Iraq, where we expect a flattening of production at ~ 4.4 MMb/d this year and a slight uptick to ~ 4.45 MMb/d in 2018, continued violence arising from dispersed terrorism in that country in the wake of a defeat of ISIS as an organized force, will remain an ongoing threat to production. Longer term - i.e., beyond 2018 - we remain concerned the massive $1-trillion-plus cutbacks in capex for projects that would have come online between 2015 and 2020 brought on by the oil-price collapse in 2015-16 will force prices higher to encourage the development of new supplies. The practical implication of this is some 7 MMb/d of oil-equivalent production the market will need, as this decade winds down, will have to be supplied by U.S. shales, Gulf OPEC and Russia, as noted above. Big, long-lead-time deep-water projects requiring years to develop cannot be brought on fast enough to make up for supply that, for whatever reason, fails to materialize from these sources. In addition, as shales account for more of global oil supplies and "The Other Guys" continue to lose production to higher depletion rates, more and more shale - in the U.S. and, perhaps, Russia - and conventional Persian Gulf production will have to be brought on line simply to make up for accelerating declines. This evolution of the supply side is significantly different from what oil and capital markets have been accustomed to in previous cycles. Because of this, these markets do not have much historical experience on which to base their expectations vis-à-vis global supply adjustment and the capacity these sources of supply have for meeting increasing demand and depletion rates. Lower-Cost Production, Demand Worries On The Downside Downside risks, in our estimation, are dominated by higher production risks. Here, we believe the U.S. shales and Russia are the principal risk factors, as the oil industry in both states is, to varying degrees, privately held. Because firms in these states answer to shareholders, it must be assumed they will operate for the benefit of these interests. So, if their marginal costs are less than the market-clearing price of oil, we can expect them to increase production up to the point at which marginal cost is equal to marginal revenue. The very real possibility firms in these countries move the market-clearing price to their marginal cost level cannot be overlooked. For the U.S., this level is below $53/bbl or so for shale producers. For Russian producers, this level likely is lower, given their production costs are largely incurred in rubles, and revenues on sales into the global market are realized in USD; however, given the variability of the ruble, this cost likely is a moving target. While a sharp increase in unconventional production presently not foreseen either in the U.S. or Russian shales will remain a downside price risk, an increase in conventional output - chiefly in Libya - remains possible. As discussed above, we believe this is a low risk to prices at present; however, if an accommodation with insurgent forces in the country can be achieved, output in Libya could double from the 600k b/d of production we estimate for this year and next. We reiterate this is a low-risk probability (less than 25%), but, in the event, would prove to be significant additions to global balances over the short term requiring a response from OPEC 2.0 to keep Brent prices above $50/bbl. Also on the downside, an unexpected drop in demand remains at the top of many lists. This is a near-continual worry for markets, which can be occasioned by fears of weakening EM oil-demand growth from, e.g., a hard landing in China, or slower-than-expected growth in India. These are the two most important states in the world in terms of oil-demand growth, accounting for more than one-third of global growth this year and next. We do not expect either to meaningfully slow; however, we continue to monitor growth in both closely.1 In addition, we continue to expect robust global oil-demand growth, averaging 1.56 MMb/d y/y growth in 2017 and 2018. This compares with 1.6 MMb/d growth last year. OPEC 2.0's Next Move Knowing the OPEC 2.0 production cuts will be extended to March 2018 does not give markets any direction for what to expect after this extension expires. Once the deal expires, we expect production to continue to increase from the U.S. shales, and for the key OPEC states to resume pre-cut production levels. Along with continued growth from Russia, this will be necessary to meet growing demand and increasing depletion rates from U.S. shales and "The Other Guys." Yet to be determined is whether OPEC 2.0 needs to remain in place after global inventories return to long-term average levels, or whether its formation and joint efforts were a one-off that markets will not require in the future. Over the short term immediately following the expiration of the production-cutting deal next year, OPEC 2.0 may have to find a way to manage its production to accommodate U.S. shales without imperiling their own revenues. This would require a strategy that keeps the front of the WTI and Brent forward curves at or below $60/bbl - KSA's fiscal breakeven price and $20/bbl above Russia's budget price - and the back of the curve backwardated, in order to exert some control over the rate at which shale rigs return to the field.2 As we've mentioned in the past, we have no doubt the principal negotiators in OPEC 2.0 continue to discuss this. Toward the end of this decade, such concerns might be moot, if growing demand and accelerating decline curves require production from all sources be stepped up. Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see the May 18, 2017, issue of BCA Research's Commodity & Energy Strategy article entitled "Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts," in which we discuss the outlook for China's and India's growth. Together, these states account for more than 570k b/d of the 1.56 MMb/d growth we expect this year and next. The article is available at ces.bcaresearch.com. 2 A backwardated forward curve is characterized by prompt prices exceeding deferred prices. Our research indicates a backwardated forward curve results in fewer rigs returning to the field than a flat or positively sloped forward curve. We explored this strategy in depth in the April 6, 2017, issue of BCA Research's Commodity & Energy Strategy, in an article entitled "The Game's Afoot In Oil, But Which One?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories

Dear Client, I am visiting clients in Saudi Arabia, Abu Dhabi, and India this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Senior Vice President, BCA's Geopolitical Strategy service. Marko argues that the Middle East has reached a stable equilibrium, as much as is possible, and will not drive the news or markets in 2017. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The Middle East is not a major geopolitical risk in 2017. Saudi-Iranian and Russo-Turkish tensions will de-escalate, for now. The OPEC production cut will go through; oil prices will average $55/bbl in 2017. Geopolitical risk continues to rotate to the Asia Pacific region. Trump, Iranian elections, and Iraqi instability pose risks to the view. Feature The Middle East has dominated the news flow for the past five years, for good reason. The carnage in Syria and Iraq is tragic and reprehensible. However, the investment relevance of the various regional conflicts is dubious. For all the attention paid to the rise of the Islamic State, we would remind clients that the group's conquest of Iraq's second-largest city Mosul in June 2014 did not cause a spike in oil prices but rather marked the end of the bull market (Chart 1)! From an investment perspective, the only dynamic worth watching in the Middle East is the "Great Game" between regional actors, which have been looking to fill the vacuum left by America's dramatic geopolitical deleveraging (Chart 2). The U.S. strategy is permanent and driven by global interests, namely the rise of China and the need to shift resources towards East Asia. Given the incoming Trump administration's laser focus on China, we expect that the U.S. will remain aloof from the Middle East. Chart 1Ironically, Worry About The Fall Of ISIS Ironically, Worry About The Fall Of ISIS Ironically, Worry About The Fall Of ISIS Chart 2While The U.S. Military Deleverages... While The U.S. Military Deleverages... While The U.S. Military Deleverages... Does the recent détente between Russia and Turkey in Syria, and between Iran and Saudi Arabia over OPEC production cuts, signal that the Middle East has finally found geopolitical equilibrium? We tentatively think the answer is yes. This will reduce the importance of the region as the primary source of geopolitical risk premia, which BCA's geopolitical strategists have expected to shift to Asia for some time.1 Saudi-Iranian Tensions Are On Ice Chart 3...The Saudi Arabian Military Leverages Up ...The Saudi Arabian Military Leverages Up ...The Saudi Arabian Military Leverages Up Since the U.S. decision to deleverage from the region in 2011, Saudi Arabia has leveraged up, becoming one of the world's largest arms purchasers and involving itself overtly and covertly in several regional conflicts in the process (Chart 3). Saudi insecurity deepened following President Barack Obama's decision to leave no troops in Iraq. The last U.S. soldier of the main occupation force left Iraq on December 18, 2011. The very next day, on December 19, Iraq's Shia Prime Minister Nuri al-Maliki, a close ally of Iran, issued an order for the arrest of the Sunni Vice-President Tariq al-Hashimi. The move by al-Maliki set off what essentially became a civil war in the country, with the Sunni minority eventually turning to ever-more radicalized militant groups for protection. From the Saudi perspective, Iraq is a vital piece of real estate as it is a natural buffer between itself and its Shia rival Iran. While the Fifth Fleet of the U.S. Navy, based in Bahrain, continues to guard against any Iranian incursion via the Persian Gulf, there is very little space between the Saudi oil fields and Iran if Iraq falls into Iran's orbit. The subsequent five years saw Iran and Saudi Arabia fight several proxy wars in Iraq, Syria, and Yemen. These included direct military action by Iran in Iraq and Syria against Saudi-backed militants and by Saudi Arabia in Yemen against Iranian-backed militants. It also included oil politics, with Saudi Arabia announcing in November 2014 that it was ending years of its price-setting strategy. These strategies ultimately proved to be unsustainable and BCA's Geopolitical Strategy called the peak in Saudi-Iranian tensions in February 2016.2 Why? First, because oil prices collapsed! Geopolitical adventurism is a luxury afforded to those with the means to pursue adventures. The combination of low oil prices, domestic social outlays, and an expensive war in Yemen forced Saudi Arabia to burn through $220 billion of its foreign reserves between July 2014 and December 2016, equivalent to 30% of its central-bank holdings!3 There is a relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 4). Political science research shows that the relationship is not spurious. As Chart 5 illustrates, petrol states led by revolutionary leaders are much more likely to engage in militarized international disputes.4 This relationship is particularly pronounced when oil sells at above $70 per barrel. At that price, oil producing states become more prone to disputes than non-oil states, regardless of leadership qualities. Chart 4 Chart 5 Second, Saudi Arabia's military campaign in Yemen proved to be a disaster. The kingdom intervened in March 2015 to reinstate the democratically elected President Abdrabbuh Mansour Hadi, who had been removed from power by Iranian-linked Houthi rebels. The real reason for the intervention was for the Saudis to gauge their war-making capabilities, test their recently purchased military equipment, and put a check on Iranian influence in the region. A quick, successful war in Yemen would have been a template for future interventions in Iraq and Syria on behalf of Sunni allies, and would have cemented Saudi Arabia's position as a regional power in the wake of the U.S. withdrawal. As BCA's Geopolitical Strategy warned, however, defeating the experienced Houthis would not be easy and Saudi Arabia would ultimately hesitate to commit to a land war.5 The intervention has resulted in disaster for Saudi Arabia on several levels: Houthis remain in control of the capital Sana'a and largely the same territory that encompassed the former Yemen Arab Republic (North Yemen); The Saudis, desperate for a ground-force presence, have turned a blind eye to Al Qaeda's and ISIS's control of almost a third of the country in the south and coastal regions; Saudi forces have taken considerable losses, including some high-tech and high-priced items; The conflict has exposed severe military deficiencies, from the low level of strategic and tactical planning of senior staff, to the poor communication of units at the middle level, to the pervasive low morale and training of the rank-and-file. The biggest loss for Saudi Arabia has been that of leadership. What began as a pan-Sunni intervention led by Riyadh, with considerable involvement by the UAE and Egypt, has seen the Saudis lose almost all their allies. The UAE removed its troops in mid-2016 (in somewhat of a diplomatic spat with Riyadh) and Egypt has subsequently held military exercises with Russia, a Saudi rival in the region, and decided in December to provide military advisors to the Syrian Arab Army. All the talk about a "Sunni NATO" is over. Saudi Arabia's experience in Yemen, combined with the decline in its currency reserves, forced it to come to terms with reality, and eventually agree to an oil production cut with Russia and Iran. Thus it took Saudi Arabia exactly five years, from the U.S. withdrawal in Iraq in 2011, to realize the limits of its regional power. Bob Ryan, Senior Vice President of BCA's Commodity & Energy Strategy, correctly forecast the OPEC cut and expects the deal to be successfully implemented in 2017.6 One reason Bob is confident is that both Saudi Arabia and Russia are looking to privatize their energy sector significantly by 2018. Russia has sold 19.5% of Rosneft and the Saudis want to conduct an IPO of 5% of their state-owned oil company Aramco. It makes no sense to do this IPO in an environment of low oil prices. Furthermore, sovereign debt issuance to cover budget deficits will become cheaper when oil prices are higher. Geopolitics are aligning with Bob's view as well. Saudi Arabia's attempt to counter Iranian influence in the region has failed both militarily and via oil politics. Riyadh is focusing inwards, on its "Vision 2030" reforms, which will entail considerable domestic upheaval as a result of its comprehensive effort to remove the ultra-conservative religious establishment from power.7 This is now coming to light, with Deputy Crown Prince Mohammed bin Salman recently announcing harsh punitive measures for any cleric who incites or resorts to violence against the reform agenda. Bottom Line: Saudi Arabia's bid for regional hegemony is over, at least for now. The country is focusing inwards, on long-term political and social reforms and economic diversification. Its efforts to bring Iran to heel with low oil prices and with direct military confrontation in Yemen have failed. The oil production-cut deal between Saudi Arabia, Iran, and Russia should hold as a result of the de-escalation of Saudi-Iranian tensions and the socio-economic priorities of all three states. BCA's Commodity & Energy Strategy service is overweight energy relative to other commodities as a result.8 Is The Russia-Turkey Détente Sustainable? Turkey and Russia have concluded a political and military détente in Syria with surprising speed. This has made one of our major geopolitical risks for 2017 - a Turkish-Russian confrontation over Syria - already obsolete. Much as with Saudi Arabia, Turkey has had a bite of regional hegemony, did not like the bitter taste, and has decided to make a deal with its rivals instead. For Turkey, the real concern over the past five years has been American inaction in Syria. President Recep Tayyip Erdogan has spent a lot of political capital opposing Syrian President Bashar al-Assad. He had hoped that a successful revolution would create a new client state for Turkey, yielding Turkey overland access to Persian Gulf energy sources. Erdogan was therefore beyond dismayed when President Barack Obama failed to intervene in Syria in 2013 following Assad's use of chemical weapons. The chronology of what happened next is important: Russia intervened two years later, in September 2015, to stem the progress of anti-Assad rebels and save the regime from collapse. Two months later, a Russian Sukhoi Su-24 was shot down by Turkish F-16s in the Turkey-Syria border area. Turkey and Russia broke relations for a while, but tensions did not escalate. Ankara faced a coup attempt in mid-July 2016, which the ruling party linked to the U.S.-based Islamist preacher Fethullah Gülen. The Obama administration refused to extradite Gülen without concrete evidence of his involvement. By late July, Turkish officials were calling Russia a "friendly neighbor" and a "strategic partner." In early August, Erdogan met Russian President Vladimir Putin in St. Petersburg, after issuing a letter with an apology to the family of the shot-down pilot. Then, on August 24, Turkey invaded Syria. The military intervention, dubbed "Operation Euphrates Shield," was officially launched to fight the Islamic State, a common pretext these past three years. Erdogan officially stated that he also aimed to fight Assad's regime, but this appeared to put Ankara and Moscow back on collision course, and statements from the Turkish side have since been "corrected." The real reason for the intervention was not to fight ISIS or Assad, but rather to curb the gains made by the various Kurdish militias on the ground in Iraq and Syria. In particular, Ankara intervened to prevent the Kurdish People's Protection Units (YPG) - the armed wing of the Syrian Democratic Union Party, which is affiliated with the Turkey-based Kurdistan Workers' Party - from linking up with its now vast territory held in the north of Syria (Map 1). Chart The territory, which our map shows has expanded considerably as the YPG has claimed mostly Islamic State-held areas, is split between Rojava, the main territory east of the Euphrates river, and the Afrin enclave near the Mediterranean Sea. For Turkey, the proximity of such a vast Kurdish-held territory so close to its own Kurdish southeastern region presents a national-security nightmare. The operation's strategic goal was to capture Al-Bab, the stronghold of the Islamic State in northern Syria and a strategic point between the two YPG-held swaths of territory. However, it has taught the Turks that they have no experience fighting a prolonged battle, especially against local insurgents and militants who know the region. Since the first attack on Al-Bab's western part, the Turkish army has suffered three defeats and retreated to initial positions. With Turkey stuck in Al-Bab, the Russian air force has now begun to bomb Islamic State positions to help their tentative new ally. This level of operational coordination is notable and important. It suggests that Turkey, a NATO member state, is now reliant on Russian air strikes for ground support rather than on American sorties flying out of NATO's air base in Incirlik, Turkey. Turkey even claims that U.S. presence in Incirlik is obsolete if it receives no help from the U.S. Air Force around Al-Bab. How sustainable is the Turkey-Russia détente? We suspect it will be quite sustainable, at least in the short term. Ankara has moved away from demands for Assad to step down, with the Deputy Prime Minister, Numan Kurtulmus, recently stating that Turkey would not "impose any decision" on the Syrian people regarding future leadership. The assassination of the Russian ambassador in Turkey also failed to derail Russo-Turkish cooperation. Beyond the short term, however, the question remains what Turkey intends to do about Kurdish gains, which are considerable in both Syria and Iraq. The town of Manbij, for instance, is strategically located west of the Euphrates and was supposed to be ceded to Turkey by the Kurds. The situation could grow even more complicated for Turkey as the Kurdistan Regional Government (KRG) in Iraq may proclaim independence after the Islamic State stronghold of Mosul is liberated in early 2017.9 The YPG in Syria could then ask to join their fellow Kurds in Iraq in forming a unitary state. Although unlikely, this scenario is probably on Turkey's mind, as it would mean that the Kurds inside Turkey may intensify their anti-government insurgency. Note, however, that this scenario does not bother Russia. As far as Moscow is concerned, it has succeeded in keeping Assad in power, its Syrian naval base in Tartus is secure, and it has proven its ability to project power outside of its immediate sphere of influence (Ukraine, Crimea, Georgia, and the Caucasus), thus advertising its "Great Power" status. Bottom Line: For the time being, the Russian-Turkish détente will hold. The real risk is not a Turkish-Russian confrontation, but rather a wider Turkish engagement in both Syria and Iraq against the Kurds sometime in the future. We suspect that the Turkish military experience in Syria may make the Turks think twice about engaging in a large-scale war against the Kurds across three states. But given the erratic policymaking out of Ankara in recent years, it is difficult to say this with any confidence. The geopolitical risk of Turkish imperial overreach will continue to weigh on Turkish assets in 2017. Risks To The Sanguine View There are many reasons why investors should stay up at night in 2017, but the Middle East is not one of them. The process of U.S. deleveraging from the region has been painful and costly (from a human perspective especially), but it has ultimately forced regional powers to figure out how to carve out the leftover space between them. There are a few questions left to answer, starting with the Kurdish question. But, for the most part, we do not expect to see the major players - Iran, Saudi Arabia, Turkey, Russia, Egypt, or Israel - come to blows with each other. There are three major risks to this sanguine view. The U.S. Is Back! The current semi-stable equilibrium will definitely be thrown off track if the Trump administration decides to sink its teeth fully into the Middle East. We expect President-elect Donald Trump to authorize greater military action against the Islamic State, including more intense air strikes. However, this is not a qualitative reversal of Obama's deleveraging policy. A real reversal would be if Trump decided to follow the advice of Iran hawks in his government - of whom there are several - and increase tensions with Tehran. This is unlikely, given Trump's focus on China and his willingness to improve ties with Russia, a nominal ally of Iran. In fact, there has been almost no talk of Iran from either President-elect Trump or any of his advisors since the election. Furthermore, while U.S. oil imports from OPEC are no longer declining, they are still massively down since their peak in the mid-2000s (Chart 6). It is unlikely that Trump will commit resources to a region of diminishing importance to U.S. interests. Change Of Guard In Tehran. While the risk of Washington saber-rattling with Iran is overstated, what happens if the moderate President Hassan Rouhani is defeated in the upcoming May election? Hardliners are arguing that the nuclear deal with the West has done nothing for the economy, the main pillar of Rouhani's 2013 platform. This is not true. Headline inflation ticked up in late 2016, but remains well off the 40% levels in 2013, while GDP growth has been in the black throughout Rouhani's term, and net exports have bottomed (Chart 7). However, the flow of FDI into the country has been tepid, probably due to ongoing uncertainty with the government transition in the U.S. Both European and Asian businesses are waiting to see if the incoming Trump administration wants to revive sanctions. Meanwhile, skirmishes between U.S. and Iranian vessels - purportedly controlled by the hardline Islamic Revolutionary Guard Corps - have increased in the Persian Gulf. Perhaps the hardliners in Tehran are hoping that they can bait the hardliners in D.C. into a pre-election confrontation that sinks Rouhani. Iraqi Instability. Although the Iraqi government is set to take over Mosul from the Islamic State some time in Q1 2017, the fact remains that the country is bitterly divided between Sunnis and Shia amidst sluggish oil revenues. While the production cut deal will raise revenues marginally, revenues will still be well below their highs (Chart 8). Defeating the Islamic State militarily is one thing, but the real challenge is for Baghdad to reintegrate the Sunni population, which largely lives in territory devoid of oil production. A renewal of civil strife and terrorism targeting Iraqi civilians, which could happen as the Islamic State militants blend back into the wider population, may be a risk in 2017. Chart 6U.S. Imports From OPEC Remain Low U.S. Imports From OPEC Remain Low U.S. Imports From OPEC Remain Low Chart 7Iranian Economy Improves Under Reformist Rule Iranian Economy Improves Under Reformist Rule Iranian Economy Improves Under Reformist Rule Chart 8Iraqi Oil Revenues Still Down From Highs Iraqi Oil Revenues Still Down From Highs Iraqi Oil Revenues Still Down From Highs A word on Israel may also be in order. Israel has not played a major geopolitical role in the region for the past five years and we suspect it will not in the next five. It is secure from its neighbours, who cannot match it in terms of military capability, and remains preoccupied with domestic politics and internal security. Meanwhile, the days when the region unified against Israel are over. Sectarian and ethnic conflicts have gutted Israel's traditional enemies. And former foes, particularly Egypt and Saudi Arabia, are now close allies. The one geopolitical threat that remains is Iran. However, that threat remains dormant as long as Israel maintains nuclear supremacy over Iran and as long as the U.S. remains a security guarantor for Israel. We do not see either changing any time soon. Investment Implications The main investment implication of our thesis that the Middle East has found a new equilibrium is that the region will not dominate the news flow in 2017. Short of a major Turkish blunder in Syria and Iraq, we see the current status quo largely frozen in place. Saudi Arabia appears to have conceded, for now at least, its inferior place in the geopolitical pecking order. Investors have plenty of things to worry about in 2017, such as general de-globalization, a potential Sino-American trade war, geopolitical tensions in East Asia, and elections in four of the five largest euro-area economies. Our geopolitical team's long-standing thesis that geopolitical risk is rotating out of the Middle East and into East Asia is therefore fully playing out.10 Chart 9KSA-Russia Production ##br##Pact Aims at Lowering Inventories KSA-Russia Production Pact Aims at Lowering Inventories KSA-Russia Production Pact Aims at Lowering Inventories In the near term, the geopolitical equilibrium should allow Saudi Arabia, Iran, and Russia to maintain their six-month agreement to cut production by up to 1.8 million b/d. The stated volumes to be cut are comprised of 1.2 million b/d from OPEC, 300,000 b/d from Russia, and another 300,000 b/d from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels, which our commodity strategists believe will happen by the end of 2017 (Chart 9). Bob Ryan, of the Commodity & Energy Strategy, forecasts U.S. benchmark WTI crude prices to average $55/bbl in 2017. The incoming Trump administration will focus its Middle East policy on cooperating with regional actors against the Islamic State. Investors should expect to see more American "muscle" dedicated to the fight, perhaps at the risk of causing civilian casualties (which the Obama White House was careful to avoid). The downside of this strategy is that as the Islamic State loses its territory and ceases to be a caliphate, it will revert to being a more conventional terrorist organization. Its foreign fighters may return home to Europe, Russia, and elsewhere, while home-grown militants will seek to sow further Sunni-Shia discord, especially in Iraq. Unfortunately, this trend will keep our thesis of "A Bull Market For Terror" intact, which lends support to U.S. defense stocks.11 Marko Papic, Senior Vice President marko@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see "Middle East: Saudi-Iran Tensions Have Peaked," in BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 3 According to the estimates of BCA's Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 4 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behavior," Peterson Institute for International Economics, dated July 2014, available at iie.com. According to Hendrix, revolutionary leaders are "leaders who come to power by force and attempt to transform preexisting political and economic relationships, both domestically and abroad." The definition is broad and includes leaders who used force in order to gain prominence. 5 Please see BCA Geopolitical Strategy Client Note, "Does Yemen Matter?" dated March 26, 2015, available at gps.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," December 8, 2016, available at ces.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. See also Emerging Market Equity Sector Strategy, "MENA: Rise Early, Work Hard, Strike Oil," dated October 4, 2016, available at emes.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 9 Please see P. Ronzheimer, C. Weinmann, and K. Mössbauer, "Kurden Brauchen Mehr Deutsche Abwehrraketen," Bild, dated October 28, 2016, available at http://www.bild.de/politik/ausland/mossul/kurden-brauchen-dringend-milan-systeme-48495330.bild.html. 10 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 11 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

A combination of physical rebalancing in the oil markets and geopolitical risk have pushed oil prices above $50/bbl. We therefore close our recommendation - made jointly with BCA's Commodity & Energy Strategy team - to long a December 2016 WTI $50/$55 call spread for a 106.3% gain.

The old cyclical market axiom that "nothing cures low prices like low prices" has never held
truer than in today's oil market.