Oil

Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact China's Property Bubble Intact China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation China's Constraint Is Debt-Deflation China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Trump Faces Pressure To Stage A Tactical Trade Retreat Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits China's Trade War Constraint? Animal Spirits China's Trade War Constraint? Animal Spirits   Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election Business Sentiment Threatens Trump Re-Election Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Chart 12Oil Price Constrains U.S. Policy Toward Iran Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Iran's Leverage Over Iraq Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Five Constraints For The Fourth Quarter Five Constraints For The Fourth Quarter Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit U.K.: Public Opinion Constrains Parliament And No-Deal Brexit U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.

The price differential at which Canadian heavy-sour crude trades to the North American benchmark WTI will be pushed to -$20/bbl into 1Q20, as transportation constraints continue to slow the marginal barrel’s egress from Alberta. Increasing demand for low-sulfur distillate fuels as global marine-fuel standards tighten under IMO 2020 regulations next year also will contribute to weaker Canadian crude oil prices. Over the next three to five years, domestic politics will determine whether the Canadian oil industry will be able to attract the investment needed for growth. And that will depend on how uncertainty around pipeline expansion is resolved. Allowing pipeline capacity to expand so that more crude can be shipped south could lead to a significant rebound in Canadian producers’ equity valuations. The industry’s breakeven costs now are on either side of $50/bbl for heavy oil delivered at Cushing, OK. As light-sweet production in the U.S. shales rises, the demand for the relatively scarce, heavier crude likely will pick up, redounding to the benefit of Canadian producers. Highlights Energy: Overweight. Operations at Saudi Aramco’s Abqaiq crude oil processing facility and the Khurais oil field were largely restored by the end of September, in line with management guidance. Capacity in the Kingdom is at 11.3mm b/d, while production is running at 9.9mm b/d. Abqaiq and Khurais were attacked by drone and cruise missiles, an operation the U.S. and Saudi Arabia believe was orchestrated by Iran. On Sunday, Crown Prince Mohammad bin Salman, speaking on CBS News’s 60 Minutes, agreed with U.S. Secretary of State Mike Pompeo’s characterization of the attack as an act of war by Iran, and warned, “If the world does not take a strong and firm action to deter Iran, we will see further escalations that will threaten world interests. Oil supplies will be disrupted and oil prices will jump to unimaginably high numbers that we haven't seen in our lifetimes.” In the interview with Norah O’Donnell, he followed that up with a declaration that the Kingdom prefers “a political and peaceful solution” to resolve its issues with Iran. The crown prince, striking a conciliatory tone, said President Donald Trump and the Kingdom are seeking peace, but that “the Iranians don’t want to sit down at the table.”1 Base Metals: Neutral. China’s steel output rose 9.3% y/y in August to 87.3k MT, according to the World Steel Association (WSA). This was 56% of global output, based on WSA data. Chinese output reached a record 89.1k MT in May. Precious Metals: Neutral. Precious metals' prices collapsed as the broad trade-weighed USD surged earlier this week. Platinum prices were down 5.5% from Friday's close by Tuesday, while gold and silver were down 1.3% and 2%, respectively. Ags/Softs: Underweight. Corn and soybean prices surged earlier in the week in the wake of a bullish USDA stocks report.  December corn was up 5.7%, while beans were up 4.1%.  Feature Canadian heavy oil demand is running strong in Asia, as seen in the surge of exports via the U.S. Gulf over the May-to-mid-September period. By ClipperData’s reckoning, 16mm barrels of Canadian crude were shipped over that period, more than doubling the entire volume shipped to Asia in 2018.2 Canadian demand is being boosted by the collapse of Venezuela’s oil industry, which has removed some 1.5mm b/d of heavy crude from the market since 2016. While Canadian exports into Asia markets are surging, the pick-up in this demand hints at an even greater opportunity if north-to-south pipeline capacity is expanded. Year-to-date exports of Canadian crude to the U.S. are up ~ 2.5% y/y to an average 3.5mm b/d, according to the U.S. EIA. This growth is restrained by slowly expanding export capacity.3 Canadian Oil Takeaway Constraints From 2010 to 2017, Western Canadian oil production grew by an impressive 6.5% p.a., pushing pipeline and storage infrastructure to maximum utilization (Chart of the Week). The development of supporting infrastructure failed to produce the required takeaway capacity, locking bitumen production within the Western Canadian Sedimentary Basin (WCSB). Consequently, Alberta crude oil inventories grew above normal levels and the Western Canadian Select (WCS) discount to Cushing WTI exploded, reaching -$50/bbl in 3Q18. While this incentivized crude-by-rail (CBR) shipments, prices received by Albertan producers fell below $20/bbl, a level significantly below breakeven levels required to sustain investment. Chart of the WeekHeavy Crude Output Surges ... Heavy Crude Output Surges ... Heavy Crude Output Surges ... Facing multiple delays in pipeline developments, then-Premier Rachel Notley announced in December the provincial government would impose mandatory oil production restrictions of ~ 325k b/d starting in January 2019. Moreover, her government secured contracts to lease 4,400 rail cars – ~ 120k b/d by mid-2020 – with Canadian National (CN) and Canadian Pacific (CP) to move crude out of the WCSB. The Alberta government’s intervention rapidly distorted the market’s price mechanism. Initially, the government-mandated production curtailment had the desired impact. The transportation component of the WCS-WTI discount began to narrow, and Alberta’s crude inventory started declining (Chart 2). Chart 2... But Infrastructure Lags ... But Infrastructure Lags ... But Infrastructure Lags However, the Alberta government’s intervention rapidly distorted the market’s price mechanism. To be profitable, moving oil by rail requires a WCS-WTI discount that is somewhere between -$12/bbl to -$22/bbl on top of a quality discount, and possibly higher when additional investments in trains and crews are needed (Chart 3). In January 2019, the transportation discount overshot its equilibrium – narrowing to -$2.90/bbl below the quality component – which weakened crude-by-rail volumes and led to a build in inventories. Chart 3Provincial Government Policy Distorts Market's Heavy-Oil Pricing Dynamics Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen The Great Balancing Act To address these imbalances, the provincial government gradually started easing production curtailments (Chart 4). But this is a work in progress: Ultimately, its goal is to find the right balance between production levels and the WCS-WTI spread – i.e. the necessary price incentive for the market to move further crude by rail (CBR). The following projects still are being advanced by developers. However, no significant additional pipeline takeaway capacity is expected before 2H20 (Chart 5): Chart 4Policy Remains A Work In Progress Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Chart 5Markets Are Attempting To Redress Takeaway Deficit Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Enbridge’s Line 3 replacement. This pipeline is part of Enbridge Mainline system. This project will restore the original capacity of the existing Line 3 pipeline to 760k b/d from 390k b/d. The replacement runs from Hardisty, AB, to Superior, WI in the U.S. Since its initial announcement in 2014, the project has faced multiple headwinds, most recently, a delay in permits from the State of Minnesota re the impact of a possible oil spill near Lake Superior. The company continues to expect the project will be completed in 2H20. The Canadian and Wisconsin portions are already completed. TC Energy’s Keystone XL. This is the largest of the proposed projects. It will increase Canadian export capacity to the U.S. by 830k b/d. The project was first proposed in 2008, and will run from Hardisty, AB to Steele City, NE. Recently, Nebraska’s Supreme Court approved the Keystone XL route, lifting one of the last remaining – and probably the most important – legal challenges facing the pipeline construction. This is a positive development for Canadian oil producers. Nonetheless, the project is still facing a federal lawsuit in Montana filed by environmental groups blocking President Trump’s new permit, which gave the project a green light. A hearing is scheduled on October 9, this is a crucial win for TC Energy.4 Reaching a Final Investment Decision (FID) before year-end makes a completion by end-2022 possible. Federally-owned Trans Mountain expansion. The initial application was filed in 2013 and is projected to add 590k b/d of capacity from Edmonton, AB, to Burnaby, B.C. The pipeline was bought for $4.5 billion last year by the Federal government. Earlier this month, a Federal Court of Appeals judge ruled out six of the 12 legal challenges to the expansion, dismissing claims centered on environmental issues. Construction will continue, the government expects the expansion will be operational by mid-2022. Capacity expansion at existing pipelines. We expect some marginal capacity increases at existing pipeline to take place between 3Q19 and 3Q20. Enbridge communicated it could add up to 450k b/d without building new pipelines by 2022. At the moment, we believe ~150k b/d will be gradually added before the end of next year. Additionally, Enbridge mentioned it could boost capacity on its Express line by ~60k b/d before the end of 2020. Lastly, Plains Midstream Canada announced additional capacity on its Rangeland line in both the North and South directions.5 This will assist Canadian producers awaiting for the 2H20 Line 3 replacement. Delays in bringing new takeaway capacity online forced the newly formed Conservative provincial government led by Jason Kenney, which came to power in April 2019, to extend the curtailment program until December 2020. We expect this balancing act to continue over the next 12 months.6 Short- and Medium-term outlook We expect CRB needs to surpass 450k b/d to balance the market In our March 7, 2019 report, we argued the transportation component of the WCS-WTI spread needed to increase by ~ $10/bbl to support incremental crude-by-rail volumes. From March to July, the transportation discount rose by only $4.80/bbl to ~$12/bbl – the floor of our estimated rail price range – and collapsed soon after that. This failed to catalyze sufficient rail volumes to clear the market overhang. Preliminary estimates of CBR volumes based on CN and CP data shows it was largely flat in August and September (Chart 6). Chart 6Crude-By-Rail Shipments Stall Crude-By-Rail Shipments Stall Crude-By-Rail Shipments Stall As the government continues to relax production curtailments – reaching 100k b/d in October – we continue to believe the transportation discount needs to rise from current levels. Recent movements in the discount, averaging $10.3/bbl since the beginning of the month, support our view, and we expect this to continue until it reaches ~$15/bbl. We expect CRB needs to surpass 450k b/d to balance the market until the Line 3 replacement is completed, somewhere in 2H20 (Chart 7). We also expect the quality discount for WCS crude oil to start rising as IMO 2020 approaches. YTD the quality discount has remained relatively narrow, due to the global shortage of heavy-sour crude supply (Chart 8).7 Starting in January 2020, demand for heavy crude will moderate as shippers adapt to the new marine-fuel regulation, offsetting some of the effect of the limited supply. We project this will add $5/bbl to the WCS-WTI spread. Chart 7Additional CBR Capacity Required Additional CBR Capacity Required Additional CBR Capacity Required Chart 8Heavy-Crude Market Remains Tight Heavy-Crude Market Remains Tight Heavy-Crude Market Remains Tight Combined, the quality and transportation discount should push the WCS-WTI spread toward -$20/bbl over the next 6 months, which will, we believe, hurt Canadian producers’ cash flows. We expect WCSB supply will remain flat y/y in 2019. Next year, output is expected to grow 4%, and in 2021 by another 1.2% y/y. Long-term Production Outlook Investment in the Canadian oil sector never truly recovered from the 2014 global oil price collapse, despite the pickup in oil prices (Chart 9). Canada’s total capex ex-oil and -gas has been increasing since 2016, pushing down the share of capex from oil and gas extraction to 14% from 27% in 2014 (Chart 10). This is showing up in our longer-term production forecast: We expect WCSB production will average 5.1mm b/d in 2022 vs. 5.3mm b/d being forecast by the Canadian Association of Petroleum Producers (CAPP). The finite pool of funding available to the Canadian oil and gas sector is competing with U.S. shale development. A favorable regulatory and tax environment, shorter investment cycles and faster initial returns attract most of the funds allocated to oil and gas development to the U.S. at the expense of Canada (Chart 11).8 Most recently, the divergence in investment flows centers on market access Chart 9Canadian Oil Investment Lags Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Chart 10Canada's Oil & Gas Sector Losing Weight Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Chart 11U.S. Perceived As Favorable Investment Alternative Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Foreign companies are exiting the Canadian oil patch, divesting more than $30 billion since 2017.9 The government’s intervention to curtail production led firms to postpone new projects in Alberta. The rig count in Canada remains weak and shows no sign of picking up (Chart 12).10 Nonetheless, the sector should offer an opportunity for investors in the coming years. Once uncertainty around pipeline completion is resolved, we believe there could be a significant rebound in Canadian producers’ equity performance (Chart 13). Technology improvement has reduced oil-sands’ breakeven costs to somewhere between $45/bbl-$55/bbl for oil delivered at Cushing.11 Moreover, the low decline rates of oil-sands supply makes it a more stable and predictable source of supply compared to shale production. Chart 12Capex Reductions Reduce Rig Counts Capex Reductions Reduce Rig Counts Capex Reductions Reduce Rig Counts Chart 13Energy Stock Prices Could Rebound Energy Stock Prices Could Rebound Energy Stock Prices Could Rebound The upcoming new pipeline capacity allowing more Canadian heavy crude oil to be delivered to the complex U.S. Gulf Coast refineries will revive sentiment towards Canadian oil sand projects. Canada is judiciously positioned to be the clear winner of the market-share war fought by heavy oil-producing countries to secure capacity at U.S. Gulf refineries. Canadian oil is already dominating PADD 2 imports, and has been increasing its share of PADD 3 imports (Chart 14). The above-mentioned shortage of heavy crude oil presents an excellent opportunity for Canada to capture additional space at PADD 3 refineries. The collapse of Venezuela and the recent attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) highlight the attractiveness of Canadian heavy crude to U.S. refiners. Chart 14Strong U.S. Demand For Canada's Oil Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Impact Of The Upcoming Canadian Federal Election Canada is gearing up for a federal election on October 21. The consensus holds that the Liberal Party of Prime Minister Justin Trudeau will remain in power with a minority government, or possibly in a coalition with the left-wing New Democratic Party (NDP) and/or the Green Party. Our Geopolitical Strategists think the chances of Trudeau maintaining a single-party majority are much higher than consensus (which is about 25%), given that he is running on the back of a fairly strong economy, a renegotiated trade deal with the United States, and a stable socio-political environment (Chart 15). Chart 15Canadian Political Risk Is Muted And Should Stay That Way Canadian Political Risk Is Muted And Should Stay That Way Canadian Political Risk Is Muted And Should Stay That Way While Trudeau’s popularity has waned, his approval rating still puts him in the higher range of Canadian prime ministers and he does not face a charismatic challenger. He has a firm base in both of the traditional bastions of political power, Ontario and Quebec, and seat projections show the Liberals leading in both provinces. The small parties are not polling well; the NDP is faring poorly in Quebec and unlikely to steal many Liberal votes. There could still be surprises but it is telling that the Liberals remain in the lead despite the scandals and last minute controversies threatening them. The Canadian election should produce a status quo result that does not change the energy sector outlook. For the energy sector, the most positive outcome is a Conservative majority; otherwise a renewed Liberal majority is the status quo and hence least negative outcome. Trudeau is criticized by the Conservatives and in Alberta for compromising Canada’s energy interests, yet his support of the Trans-Mountain pipeline has him at odds with the left-wing parties. The worst scenario for the energy sector is if Trudeau is forced to rely on these parties in parliament – and this is a real possibility though not our base case. Bottom Line: The Canadian election should produce a status quo result that does not change the energy sector outlook – however, it holds a non-trivial risk of forcing the Liberals into a coalition with left-wing parties whose stances are market-negative for the energy industry. If this outcome is avoided, expect the market to celebrate in the short term, although the long-term effects of a second Trudeau term are not positive on the energy front.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      Please see Mohammad bin Salman denies ordering Khashoggi murder, but says he takes responsibility for it, which aired Sunday September 29, 2019, on CBS News. In a related development last week, Saudi Arabia announced a limited ceasefire with the Iranian-backed Houthi Movement in Yemen, with which it has been engaged in a war since 2015; please see Saudi Arabia agrees to limited ceasefire in Yemen, published by Arabian Business September 28, 2019. 2      Please see Canada's heavy oil exports to Asia from U.S. surge: data, traders published September 27, 2019, by reuters.com. 3      Enbridge Inc.’s 100k b/d pipeline expansion scheduled to be operational by December will marginally increase Canadian shipments south Enbridge us the dominant oil pipeline operator in western Canada. It is attempting to get shippers to sign long-term contracts – vs. existing monthly contracts – during its current auction for pipeline space. Its regulator has “has concerns regarding the fairness of Enbridge’s open season process and the perception of abuse of Enbridge’s market power.” Please see Canada regulator orders Enbridge to halt pipeline overhaul plan due to 'perception of abuse' published by reuters.com September 27, 2019. 4      Please see Court affirms alternative Keystone XL oil pipeline route through Nebraska, published August 23, 2019, by reuters.com. 5      Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. 6      The new government made additional small changes to the previous policy. For instance, it will give producers 2 months’ notice of any changes to the limits, increased the base limit to 20k b/d from 10k b/d and allows the energy minister to use discretion to set production limits after M&A. Please see the oil production limit section of the government of Alberta’s website. 7           As discussed in our March 2019 report, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and sanctions on Iranian oil exports volume limits the supply of heavy crude available to consumers. 8              In June 2019, the Canadian government passed Bill C-69, called “The modernization of the National Energy Board and Canadian Environmental Assessment Agency.” This law changes the federal environmental assessment process. Critics argued this would repel energy investors and limit pipeline projects approval. Additionally, Canada’s Senate passed Bill C-48 – which aims to ban large oil tankers from waters off the north of B.C.’s coast. This law makes it harder for Alberta to ship its oil via northern B.C. export facilities. Companies are now testing shipment of semi-solid bitumen rather than in liquid form to avoid complying with the new legislation. Please see Oilsands crude sails from B.C., sidestepping federal ban, published by the Edmonton Journal on September 26, 2019. 9           Please see The $30-billion exodus: Foreign oil firms keep bailing on Canada's energy sector published by the Financial Post on August 22, 2019. 10             Rig count does not fully capture Canadian oil production. Bitumen production from mining represent ~30% of total production. However, we believe rig count remains a good proxy of capex in the sector. 11             Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Canadian Crude Oil Differentials Likely Widen Canadian Crude Oil Differentials Likely Widen

Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Credit Growth To Rebound In The Fourth Quarter, Then Fade Credit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse The Euro Area Bond Yield Impulse Leads Its Credit Impulse The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse The U.S. Bond Yield Impulse Leads Its Credit Impulse The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse The China Bond Yield Impulse Leads Its Credit Impulse The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter.  A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter German Car Production Rebounded In The Third Quarter German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity Growth To Rebound In The Fourth Quarter, But Fade In 2020 Growth To Rebound In The Fourth Quarter, But Fade In 2020   The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1  Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth The Oil Price Impulse Explains Oscillations In German Growth The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter.  How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows:  Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Global Equities Have Gone Nowhere For Two Years Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China Stay Overweight Europe Versus China Stay Overweight Europe Versus China   Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Nickel VS. Gold Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming First Signs Of Bottoming First Signs Of Bottoming Chart 2Surprisingly Strong Surprises Surprisingly Strong Surprises Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low? Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Gold: Sell Or Hold? Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? How Low Can They Go? How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid U.S. Growth Remains Solid U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials Upgrade Global Financials Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers Favor Linkers Favor Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation

Oil Risk Is Mispriced Oil Risk Is Mispriced High-Conviction Overweight The recent drone attacks on Saudi Arabia’s oil processing and production facilities have re-concentrated investors’ minds on reassessing geopolitical risk premia in the crude oil market. Given the heightened risk of a future oil price spike that BCA’s Commodity & Energy Strategy and Geopolitical Strategy services outlined recently,1 we remain overweight in the S&P energy sector and re-iterate our high-conviction overweight status. This crude oil supply disruption comes at an inopportune time as U.S. crude oil inventories have been depleting recently, which represents a source of support for the relative share price ratio (crude oil supply shown inverted, second panel). Also, non-OECD demand continues to expand. Importantly, BCA’s Global Leading Economic Indicator diffusion index is accelerating driven by the emerging markets and signals that recent easing of monetary policy in EM economies will put a lid under EM oil demand (third panel). As a result, still depressed relative S&P energy sales expectations should turnaround (bottom panel). Bottom Line: Stay overweight the S&P energy sector. This deep cyclical sector also remains on our high-conviction overweight list. Please refer to the following Weekly Report for more details.​​​​​​​   1      Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, “Policy Risk, Uncertainty Cloud Oil Price Forecast” dated September 19, 2016, available at ces.bcaresearch.com.

Overweight Crude Oil And E&P Are Joined At The Hip Crude Oil And E&P Are Joined At The Hip S&P oil & gas exploration & production (E&P) stocks have closely tracked crude oil prices, but recently a wide gap has opened and we reckon that it will likely narrow via a catch up phase in the former (top panel). Even natural gas prices have come out of hibernation and caught a bid of late and similarly suggest that relative share prices are uncharacteristically depressed by steeply deviating from the underlying commodities (second panel). There is so much pessimism ingrained in the E&P space with net EPS revisions sinking to “as bad as it gets” warning that even a modest rise in oil prices can serve as a catalyst to raise the profile of this unloved corner of the deep cyclical universe (bottom panel). Bottom Line: Continue to overweight the S&P oil & gas exploration & production index. Please refer to the following Weekly Report for more details. The ticker symbols for the stocks in this index are: S5OILP – COP, PXD, DVN, HES, APA, MRO, XEC, COG, CXO, EOG, FANG, NBL.

Highlights   Portfolio Strategy Firming relative profit prospects, rising likelihood of an oil price spike and higher geopolitical risk premia, bombed out valuations and extremely oversold technicals all signal that an overweight stance is warranted in the S&P energy sector. Rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. Recent Changes There are no changes to the portfolio this week. Table 1 The Oil Factor The Oil Factor Feature Equities were range bound last week, digesting the aftermath of the drone attacks on Saudi Arabia’s oil facilities and the kneejerk oil price spike, and the Fed’s at the margin hawkish interest rate cut (Chart 1). While the U.S./China trade war news headlines took the back seat, it is disquieting that the largest oil production disruption in recent memory came to the forefront. Crude oil prices spiked and oil volatility skyrocketed as market participants were not pricing in any geopolitical risk premium on crude prices (Chart 1). This is a wake-up call for market participants and there are longer-term ramifications if the previously dormant geopolitical risk premium returns with a vengeance in the oil markets as we expect. Chart 2 shows that historically, an oil price shock is coincident with a U.S. recession. Given that our Commodity & Energy Strategy (CES) service would not rule out another oil price surge in the coming months, a near doubling in oil inflation would likely be the straw that broke the camel’s back and check the final box for recession. Chart 1Mind The Oil Vol Spike Mind The Oil Vol Spike Mind The Oil Vol Spike Chart 2Doubling In Oil Prices Are A Bad Omen For Stocks Doubling In Oil Prices Are A Bad Omen For Stocks Doubling In Oil Prices Are A Bad Omen For Stocks To be precise, since the mid-1970s a 91% year-over-year oil price increase – using end of period monthly data – is synonymous with recession, with no false positives. In order for that prerequisite to be satisfied, WTI crude oil would have to surge to roughly $86/bbl by December (top panel, Chart 2). While this may seem as a tall order, our CES service has started assigning a rising probability to a sizable oil price jump in the coming months. With regard to equities, in all previous five oil price shocks the S&P 500 suffered significant losses, and if history at least rhymes, then the SPX would steeply contract anew (middle panel, Chart 2). While the U.S. economy is not currently in recession, it is fragile enough that an exogenous oil price shock would tilt it in recession. As a reminder, the U.S. benefits from the “good deflation” i.e. lower oil prices and suffers from oil spikes. Chart 3 depicts this inverse correlation. Importantly, re-reading James D. Hamilton’s “Historical Oil Shocks” NBER paper was insightful.1 In this piece Hamilton documents that “All but one of the 11 postwar recessions were associated with an increase in the price of oil, the single exception being the recession of 1960.” Hamilton then argues that “The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence…This is not to claim that the oil price increases themselves were the sole cause of most postwar recessions. Instead the indicated conclusion is that oil shocks were a contributing factor in at least some postwar recessions (emphasis ours)”. Chart 3GDP And Oil Are Inversely Correlated GDP And Oil Are Inversely Correlated GDP And Oil Are Inversely Correlated  This week, we update a deep cyclical sector and one of its key subcomponents. Table 2Real GDP Growth (Annual Rate) And Contribution Of Autos To The Overall GDP Growth Rate In Five Historical Episodes The Oil Factor The Oil Factor While only the energy sector benefits from the oil price shock, the consumer, and most other sectors of the economy, have to contend with rising energy input costs. Hamilton finally makes a key point on auto production and a link to output: “one of the key responses seen following an increase in oil prices is a decline in automobile spending, particularly the larger vehicles manufactured in the United States”. He shows this relationship in Table 2 that we have replicated.2 Chart 4 also shows a number of different automobile-related economic series, and the current message is grim. It is clear that, were an oil price shock to hit, the motor vehicle-related production destruction would subtract from overall output and raise the probability of recession. Chart 4What’s Up With Autos? What’s Up With Autos? What’s Up With Autos? In sum, geopolitical risk is getting priced into the crude oil markets and were an oil spike to take place near $86/bbl, then this external shock would most likely tilt the economy in recession as has happened in all previous such oil inflation surges since the 1970s. We would refuse the temptation to listen to pundits that, similar to the initial December 2018 yield curve inversion, would declare that “this time is different”. As a result of all this heightened uncertainty, we remain cautious on the prospects of the overall equity market. This week, we update a deep cyclical sector and one of its key subcomponents. Energy’s Time To Shine? The recent drone attacks in Saudi Arabia’s oil processing and production facilities have re-concentrated investors’ minds on reassessing geopolitical risk premia in the crude oil market (top panel, Chart 5). Given the heightened risk of a future oil price spike that BCA’s CES and Geopolitical Strategy services outlined recently, we remain overweight in the S&P energy sector and re-iterate our high-conviction overweight status.   Rising oil prices will also filter through to rising inflation expectations and further boost the allure of the S&P energy sector (middle & bottom panels, Chart 5). This crude oil supply disruption comes at an inopportune time as U.S. crude oil inventories have been depleting recently; this represents another source of support for the relative share price ratio (crude oil supply shown inverted, second panel, Chart 6). Chart 5Energy Catch Up Phase Looms Energy Catch Up Phase Looms Energy Catch Up Phase Looms Chart 6Energy Can Burst Higher Energy Can Burst Higher Energy Can Burst Higher On the demand front, non-OECD demand remains on an upward trajectory since the start of its recovery path in the aftermath of the 2015/2016 manufacturing recession. Importantly, BCA’s Global Leading Economic Indicator diffusion index is accelerating driven by the emerging markets and signals that recent easing monetary policy measures in EM economies will put a lid under EM oil demand (Chart 6). As a result, still depressed relative S&P energy sales expectations should turnaround (third panel, Chart 6). Turning over to the financial statements of this now niche deep cyclical sector, there are no major red flags waving. Net debt-to-EBITDA is near 2x, on a par with the broad nonfinancial sector, and interest coverage is at a respectable 5x (Chart 7). The sector has been more stringent with shareholder friendly activities and the dividend payout ratio has fallen back to the historical mean (not shown). In more detail, the S&P energy sector sports the highest dividend yield compared with the rest of the GICS1 sectors, a full 185bps above the SPX, offering a relatively safe home for yield hungry investors in the era of depressed global interest rates (bottom panel, Chart 7). In fact, the S&P energy sector is so extremely undervalued that all of its 28 constituents combined are now worth as much as one stock, Microsoft. Indeed, our relative Valuation Indicator has plunged and is now roughly two standard deviations below the historical mean, a three decade low (second panel, Chart 8). Chart 7Repaired B/S With The Highest GICS1 Sector Dividend Yield Repaired B/S With The Highest GICS1 Sector Dividend Yield Repaired B/S With The Highest GICS1 Sector Dividend Yield Chart 8Oversold And… Oversold And… Oversold And…   Energy sector technicals are also bombed out, with our relative Technical Indicator in deeply oversold territory. Such depressed levels have marked prior reversals and a violent snap back would not surprise us. Internal energy sector dynamics reveal a similarly extreme picture, with both the percentage of subgroups trading above the 40-week moving average and with a positive 52-week rate of change perched at the zero lower bound (fourth & fifth panels, Chart 8). Sell-side analysts are equally pessimistic, assigning a low probability in energy sector revenues and profits besting the overall market. This is not only a near-term phenomenon, but the sell side has also thrown in the towel on a 5-year time horizon (Chart 9). All of this extreme bearishness overshadowing the S&P energy sector is contrarily positive. One key risk to our overweight stance in the S&P energy sector is the U.S. dollar. Historically, the higher the greenback goes the lower oil prices and energy shares fall. This multi-decade inverse correlation remains intact and were the U.S. dollar to materially increase from current levels, it would heavily weigh on relative share prices (top panel, Chart 8). BCA’s U.S. Equity Strategy’s relative profit growth macro-models have an excellent track record in forecasting relative profit trends as they accurately capture most of the key profit drivers. Currently, the relative EPS models are in a slingshot recovery, which stands in marked contrast to the overly pessimistic sell side analyst community (second panel, Chart 9). Chart 9…Undervalued …Undervalued …Undervalued Netting it all out, firming relative profit prospects, rising likelihood of an oil price spike and higher geopolitical risk premia, bombed out valuations and extremely oversold technicals all signal that an overweight stance is warranted in the S&P energy sector. Bottom Line: Stay overweight the S&P energy sector. This deep cyclical sector also remains on our high-conviction overweight list. Double Down On Exploration & Production Stocks S&P oil & gas exploration & production (E&P) stocks have closely tracked crude oil prices, but recently a wide gap has opened and we reckon that it will likely narrow via a catch up phase in the former (top panel, Chart 10). Even natural gas prices have come out of hibernation and caught a bid of late and similarly suggest that relative share prices are uncharacteristically depressed by steeply deviating from the underlying commodities (second panel, Chart 10). There is so much pessimism ingrained in the E&P space with net EPS revisions sinking to “as bad as it gets” warning that even a modest rise in oil prices can serve as a catalyst to raise the profile of this unloved corner of the deep cyclical universe (bottom panel, Chart 10). While the energy default rate has risen lately, the high yield E&P option adjusted spread is neither surging a la 2015/2016 nor sending a distress signal. If anything, given the recent jump in oil prices and prospects of an oil price surge, independent oil producers’ bond holders should further breathe a sigh of relief (junk spread shown inverted, middle & bottom panels, Chart 11). Chart 10Primed To Follow Oil Prices Higher Primed To Follow Oil Prices Higher Primed To Follow Oil Prices Higher Adding it all up, rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. With regard to operating metrics, free cash flow has more than doubled since the 2016 trough and has now stabilized (second panel, Chart 12). This highly capital intensive industry has gotten forced to live within its means and be more careful with expansion plans financed by rising indebtedness. Use of cash has also come under scrutiny. Capex as a percentage of overall cash flow rose from 35% to over 60% at the recent cyclical peak and has now corrected to 47%, just above the two decade average (Chart 12). Chart 11No Yellow Flags No Yellow Flags No Yellow Flags Chart 12Cash Discipline Should Start To Pay Off Cash Discipline Should Start To Pay Off Cash Discipline Should Start To Pay Off Similar to the broad energy space, E&P stocks are compellingly valued irrespective of the valuation metric chosen. To name a few, the dividend yield differential is at 150bps versus the broad market, relative price-to-sales has corrected from 3x to par, and on an EV/EBITDA basis E&P stocks trade at a 35% discount to the broad market (Chart 13). Nevertheless, there is a risk to our still constructive view of the E&P index. Oil prices have to stay above the $50-$55/bbl range in order for the shale oil space to breakeven and sustain crude oil production at recent all-time high levels. As a reminder, an industry capex collapse is synonymous with oil price plunges and major relative share price drawdowns (Chart 14). Chart 13Bombed Out Valuations Bombed Out Valuations Bombed Out Valuations Chart 14Capex Collapse Is A Big Risk Capex Collapse Is A Big Risk Capex Collapse Is A Big Risk Adding it all up, rising oil price and natural gas price inflation, declining industry high yield spreads, higher capital expenditure discipline and compelling relative value all suggest that it pays to be overweight the S&P E&P index. Bottom Line: Continue to overweight the S&P oil & gas exploration & production index. The ticker symbols for the stocks in this index are: S5OILP – COP, PXD, DVN, HES, APA, MRO, XEC, COG, CXO, EOG, FANG, NBL.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   footnotes 1      https://www.nber.org/papers/w16790 2      Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The attack on Saudi Arabian energy facilities brought oil price shocks back onto investors’ radar screens: Benchmark crude prices in Europe and the U.S. blasted higher following the September 14th attacks on Saudi oil installations. Although the initial price spike largely unwound, the incident demonstrated that oil infrastructure is vulnerable: Saudi officials say output will be restored sooner than markets initially feared, but oil production is now in play for bad actors. The probability of supply-driven price shocks has increased. How vulnerable is the U.S. economy to an oil price shock?: A whole heck of a lot less than it was at the time of the 1973-74 oil embargo. The U.S. is the world’s largest oil producer, and is on its way to becoming a net exporter. Higher oil prices now amount to much more than a tax on U.S. households and corporations. Feature On Saturday, September 14th, Saudi Arabia’s Abqaiq crude-oil processing facility and its Khurais oil field were struck by air attacks that caused multiple explosions. Yemeni forces claimed responsibility, in retaliation for Saudi Arabia’s involvement in its protracted civil war, though the Saudi and U.S. governments asserted that Iran was to blame. As our Commodity & Energy and Geopolitical Strategy colleagues have written, Iran’s involvement makes the situation more ticklish.1 It is unclear where escalating rounds of provocations between the U.S. and Iran might end up, but the geopolitical, energy and economic impacts could be quite serious. There are a lot of moving parts, and we will not rehash our colleagues’ analysis here. From the U.S. Investment Strategy perspective, the biggest takeaway is that Middle Eastern oil infrastructure is more vulnerable to malign state and non-state actors than markets previously realized. It is remarkable that the world’s single most important oil processing facility could be so easily and precisely targeted, though anyone who began flying after September 11th would likely be amazed to learn that passengers once boarded planes without anyone giving the contents of their baggage a second thought. Regardless of how quickly Abqaiq operations are fully restored, Middle East oil infrastructure has been exposed as a soft target. The net economic impact of higher oil prices is the sum total of a broad range of gross subsidiary impacts. The global oil market is therefore more vulnerable to shocks from unplanned supply outages than previously assumed, and should begin to price in a terrorism premium. Any given economy’s exposure to oil price shocks is a more important consideration than it was before the attack on Aramco operations. In this Special Report, we examine the U.S. economy’s susceptibility to an oil price shock. The good news is that we find the U.S. to be considerably less vulnerable to an oil price shock than it was at the time of the Arab oil embargo; the net “tax” from higher oil prices is a good bit lower than it was then, and it is no longer exclusively paid to foreign entities. Six Channels Of Economic Impact We count six primary channels through which oil prices impact the U.S. economy: consumption, capital expenditures, corporate profits, the trade balance, employment and financial conditions (Figure 1). Higher oil prices are unequivocally bad for consumption, because they reduce households’ discretionary income. They should be a net positive for capital expenditures, because oil exploration and production is a capital-intensive pursuit that would likely outweigh incremental cutbacks in investment by businesses in the rest of the economy. They directly increase input costs for the wide range of goods that incorporate petroleum, and the goods and services that use oil as fuel, though other businesses’ reduced profits will be offset somewhat by domestic oil producers’ increased profits. As long as the U.S. remains a net oil importer, they will act to widen the trade deficit; once it becomes a net exporter, possibly within the next few years, they will narrow it. Their net impact on employment and financial conditions is mixed. Figure 1Oil Prices And The Economy Oil's Impact On The U.S. Economy Oil's Impact On The U.S. Economy Consumption Consumption is the linchpin of the oil-shock/recession narrative, as typified by the 1973-74 oil embargo. During the October 1973 war between Israel and a coalition of Arab states, OPEC members angered by American support for Israel ceased exporting oil to the U.S. and sharply reduced production. Although the embargo lasted just six months, oil prices tripled. Inflation surged, consumer confidence suffered mightily amid ubiquitous images of gasoline lines, and a sharp recession and punishing equity bear market laid siege to the U.S. economy. Chart 1The '70s Oil Shocks ... The '70s Oil Shocks ... The '70s Oil Shocks ... The overthrow of Iran’s pro-western monarch in 1979 generated a second oil price shock (Chart 1). The U.S. soon entered the first phase of the Volcker double-dip recession, and the notion that oil price shocks cause recessions became entrenched in the introductory macroeconomics curriculum. Filling up the tank consumes a much smaller share of household budgets today than it did in the ‘70s, however, so household spending is nowhere near as vulnerable as it was then (Chart 2). Energy is no more expensive relative to the PCE basket than it was at the end of the ‘70s (Chart 3), allowing fuel efficiency gains to translate directly to increased discretionary income (Chart 4). The household savings rate is lower, as well (Chart 5), clearing the way for consumers to spend more of their discretionary income.2 Chart 2... Took A Big Bite Out Of Consumers' Wallets ... Took A Big Bite Out Of Consumers' Wallets ... Took A Big Bite Out Of Consumers' Wallets Chart 3Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Chart 4New-Model Mileage Has Doubled New-Model Mileage Has Doubled New-Model Mileage Has Doubled Chart 5Consumers Are More Willing To Spend Than They Were In The '70s ... Consumers Are More Willing To Spend Than They Were In The '70s ... Consumers Are More Willing To Spend Than They Were In The '70s ... Bottom Line: Consumption will be undermined by higher oil prices, but not nearly to the degree it was in the 1970s, when fuel costs ate up a greater share of discretionary income. Corporate Profits Higher input costs stoked the wage-price cycle in the ‘70s, but low inflation expectations and supine unions have all but stamped out cost-push inflation pressures today. Chart 6... And Economic Output Is Far Less Dependent On Oil ... And Economic Output Is Far Less Dependent On Oil ... And Economic Output Is Far Less Dependent On Oil Higher oil prices’ negative impact on input costs is as clear-cut as their impact on consumption. Higher input costs helped trigger the ‘70s and ‘80s recessions, dragging down corporate profits and exacerbating cost-push inflation pressures as employees demanded higher wages to keep up with rising prices. That dynamic still applies, but its force is considerably attenuated, as tepid inflation expectations and the decline of unions’ collective bargaining power have all but wiped out cost-push inflation pressures. The continuing shift from manufacturing to services also limits the impact of higher input costs; the oil intensity of the U.S. economy is little more than a third of what it was at the time of the embargo (Chart 6). Growing energy self-sufficiency keeps some of the increased input costs from escaping the domestic economy. It is still valid to think of higher energy prices as a tax on businesses and consumers, but at least some of the tax revenue now accrues to U.S. parties. Shale drillers, pipeline companies, vendors and workers, and the states and localities where they reside, all share in the benefits. That limits the drag on domestic corporate profits, and the second-order drags on fixed investment, employment, consumption and creditworthiness. Capital Expenditures And The Other Channels Energy production’s increasing role within the U.S. economy came to the fore when crude prices collapsed from $107 to $26/barrel between June 2014 and February 2016. Per the ‘70s foreign-oil-dependency template, households would have gotten a huge discretionary income boost, while corporate margins would have surged. Employment and investment would likely have followed, and the consequent increase in consumption would have fed back into even more investment. Improved U.S. terms of trade would have improved living standards, and the trade balance would have narrowed. The U.S. economy no longer has a simple one-way relationship with oil price moves. Those happy growth outcomes did not materialize in the latest oil bust. Consumption growth was robust for the six quarters through 2Q16, but nonresidential fixed investment staggered across 2015 and into 2016 (Chart 7), failing to surpass its 4Q14 level (in real terms) for good until 3Q16. Swooning oil prices had no apparent effect on the trade deficit, which continued to grow at a steady pace (Chart 8). Chart 7Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Chart 8The Oil Bust Didn't Affect The Trade Deficit, ... The Oil Bust Didn't Affect The Trade Deficit, ... The Oil Bust Didn't Affect The Trade Deficit, ... Financial conditions tightened as high-yield credit spreads blew out, driven by bankruptcies and defaults in the oil patch (Chart 9, top panel). Oil patch capex evaporated as lenders and equity investors deserted the sector. That would happen in any oil bust, but it spread to the broader economy because shale plays had come to account for a close to a sixth of high-yield bond issuance (Chart 9, bottom panel). The net result was to reduce the supply of loanable funds for non-oil entities, while increasing their cost, bringing about a sharp tightening of financial conditions. Chart 9... But It Tightened Financial Conditions ... But It Tightened Financial Conditions ... But It Tightened Financial Conditions Employment suffered at the margin, as five years of steady oil and gas job gains from 2010-14 were wiped out in 2016 alone. Oil-related employment doesn’t account for a meaningful share of overall employment, but it has been a critical driver of new manufacturing employment since the crisis (Chart 10). The bottom line is that the economy’s failure to respond more positively to 2014-16’s long and steep oil price decline showed that it no longer has a one-way relationship with oil prices. Where sharply lower oil prices would previously have been an unmitigated boon for the economy, they now produce a range of offsetting effects. Chart 10Help Wanted In The Shale Patch Help Wanted In The Shale Patch Help Wanted In The Shale Patch Investment Implications Modeling the quantitative impact of a given rise in oil prices on any one factor is beyond the scope of this report, and there is no lack of published studies which have attempted to do so. Research recently cited by Dallas Fed President Kaplan suggests that a 10 percent increase in the real price of oil from a supply-driven oil price shock would lead to a roughly 10- to 30-basis-point decline in real GDP growth.3 In a general sense, we agree with both the direction and the magnitude of those studies’ conclusion. Higher oil prices would be a drag on the U.S. economy, but an increasingly modest one as domestic oil production rises and the country approaches true energy independence. Figure 1 shows that the modest negative net impact on the economy is the aggregation of several individual gross impacts, implying that the key investment takeaways are some layers below the broad macro level. When the arrows conflict within any of the individual channels in the figure, there may be an opportunity for investors to pair exposures. The need to protect vital oil infrastructure could bolster defense stocks, which have long been a favorite of our U.S. Equity Strategy and Geopolitical Strategy services. U.S. airlines, which (with one exception) scorn the idea of hedging their fuel costs, could be an attractive short/underweight candidate to pair with a defense overweight. From a macro perspective, the increased potential for oil price shocks enhances the appeal of TIPS relative to nominal Treasuries. As long as an oil supply shock would act as a headwind for U.S. growth, investors seeking to add some inflation protection to their portfolios should focus on shorter-maturity TIPS. A supply shock pushes inflation higher in the short term, but weighs on it in the long term, as investors revise their long-run inflation expectations lower upon factoring in its long-run growth-dampening effect.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 16, 2019 and September 19, 2019 Commodity & Energy Strategy and Geopolitical Strategy Special Reports, “Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response,” and “Policy Risk, Uncertainty Cloud Oil Price Forecast,” available at www.bcaresearch.com. 2 Disposable income is after-tax income. Discretionary income is what’s left of disposable income after the costs of necessities, like food, rent, clothing, gasoline and utilities, are backed out. 3 Kaplan, Robert S., “A Perspective on Oil,” June 19, 2018. Downloaded September 16, 2019 from https://www.dallasfed.org/-/media/Documents/news/speeches/kaplan/2018/rsk180619.pdf.

Energy Stocks Are Heading North Energy stocks are heading north Energy stocks are heading north Banks Clamoring For Higher Rates And A More Hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Homebuilding Stocks Are Catching Up To Housing Starts Homebuilding stocks are catching up to housing starts. Homebuilding stocks are catching up to housing starts. Will Global Trade Get “Fed-Exed”? Will Global Trade Get "Fed-Exed"? Will Global Trade Get "Fed-Exed"? Do Not Try To Bottom Fish… ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ... In Cyclicals Vs. Defensives ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ​​​​​​​