War/Conflict

Highlights In the political economy of oil, an awareness of the speed at which policy in systematically important states can change can restrain risk taking and investment. This can keep markets in an agitated state of anticipation, awaiting the next policy shift – or the fallout from earlier decisions – and can separate prices from fundamentals. Crude oil markets are in such an agitated state. Fundamentally, oil markets are tight and likely will get tighter, as backwardations in benchmark forward curves indicate (Chart 1). Oil demand continues to grow, with EM growth offsetting DM declines (Chart 2). Production is being restrained by OPEC 2.0, and could remain so in 2H19. U.S. shale-oil producers appear to be taking capital discipline seriously, and prioritizing shareholder interests, which likely will keep production growth within the limits dictated by free cash flow. Chart of the WeekBackwardations In Brent & WTI: Evidence Of Tight Oil Markets Backwardations In Brent & WTI: Evidence Of Tight Oil Markets Backwardations In Brent & WTI: Evidence Of Tight Oil Markets Chart 2EM Continues To Lead Global Oil Demand Growth EM Continues To Lead Global Oil Demand Growth EM Continues To Lead Global Oil Demand Growth   The combination of these fundamentals will keep supply growth below demand growth this year, which means balances will remain tight (Table 1 below). This will drain inventories and keep forward curves backwardated (Chart 3). Globally, monetary policy will remain largely accommodative. However, policy risks – chiefly Sino – U.S. trade tensions and rising U.S. – Iran tensions – are taking their toll, increasing uncertainty re demand growth, and raising concerns over the security of oil supply from the Persian Gulf, which accounts for ~ 20% of global output. The combination of these policy-risk factors is putting a bid under the USD, which creates a demand headwind by raising the cost of oil ex-U.S.1 This is, in our view, keeping Brent prices below $70/bbl, vs. the $75/bbl we expect this year. Chart 3Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Highlights Energy: Overweight. U.S. National Security Adviser John Bolton declared Iran was responsible for naval mines attached to oil tankers off the coast of the UAE earlier this month, which damaged four ships, two of them belonging to Saudi Arabia. Bolton also said the Iranian naval operation was connected to a drone attack on the Saudi East – West pipeline two days later, and an unsuccessful attack on the Saudi Red Sea port of Yanbu.2 Base Metals: Neutral. Global copper markets continue to tighten: Fastmarkets MB’s Asian treatment and refining charges (TC/RC) weekly index dropped to its lowest level since it was launched June 2013 at the end of last week – to $58.30/MT, $0.0583/lb. Lower TC/RC charges reflect lower raw ore supplies available for refining. Global inventories remain low – down 22% y/y at the LME, COMEX, SHFE and Chinese bonded warehouses – and a threatened strike at on of Codelco's Chilean mines could tighten supplies further. We are re-establishing our tactical long July $3.00/lb Comex copper vs. short $3.30/lb Comex copper call spread at tonight’s close, expecting continued tightening in markets. Precious Metals: Neutral. Gold prices appear supported on either side of $1,280/oz, as trade, foreign and monetary policy risks remain elevated. Ags/Softs: Underweight. Heavier-than-expected rains are hampering plantings in the U.S. Midwest, which is driving grain prices higher. Corn, wheat, oats and beans surged Tuesday as markets re-opened from a long holiday weekend in the U.S. Feature Within the context of the political-economy framework we use to frame our analysis of oil markets, foreign policy and trade policy – particularly in the U.S. and China – are dominating fundamentals. Indeed, absent the threat of war in the Persian Gulf between Iran and the U.S., and their respective allies, and an uncertainty surrounding an expanded Sino – U.S. trade war, Brent crude oil would be trading above $75/bbl in 2H19, based on our modeling. As things stand now, we believe markets are under-pricing the risk of war in the Persian Gulf, and are over-estimating the short-term effects of the Sino – U.S. trade war. The longer-term consequences of a deeper and more protracted Sino – U.S. trade war, however, continue to be under-estimated. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Policy Risk Restrains Oil Prices Policy Risk Restrains Oil Prices U.S. – Iran War Risk Is Under-priced We have noted in the past the risk of an escalation in the military confrontation in the Persian Gulf remains acute for global oil markets, most recently in our latest balances report.3 In particular, we believe the risk of this scenario is not fully priced, given market participants’ mark-down of the probability of the price of Brent for December 2019 delivery exceeding $75/bbl and $80/bbl from 39% to 26% and 25% to 16% over the past month in options markets. The probability of Brent for March 2020 delivery exceeding $75/bbl and $80/bbl has similarly been marked down from 38% to 28% and 26% to 19% (Chart 4). Chart 4 An escalation of attacks on soft targets – specifically Saudi and UAE oil shipping and pipeline networks, as occurred earlier this month – likely would provoke a U.S. response against Iran or its proxies, given U.S. National Security Adviser John Bolton’s declaration this week re Iran, which we noted above. A direct attack on the U.S. military presence in the Gulf would be met with extreme force, according to U.S. President Donald Trump.4 A shooting war in the Gulf would, once again, raise the odds of a closing of the Strait of Hormuz, which has been threatened in the past by Iran. Some 20% of the world’s oil supply transits the Strait daily.5 A credible attack against shipping in the Strait would send oil prices sharply higher. If Iran were to succeed in blocking transit through the Gulf, an even sharper move in prices – above $150/bbl – could be expected. Markets Too Sanguine Re Sino – U.S. Trade War Commodity markets are not fully pricing the recent escalation of Sino – U.S. trade war, which were dialled up recently when Chinese President Xi Jinping declared China is embarking on a “New Long March” at a domestic political visit.6 The size of the tariffs thus far imposed by the U.S. against China and the EU are trivial in the context of global trade flows of ~ $19.5 trillion this year (Chart 5).7 According to the WTO, the USD value of merchandise trade rose 10% last year to $19.5 trillion, partly on the back of higher energy prices, while the value of services increased to $5.8 trillion, an 8% gain. Against this, U.S. tariffs of 25% on $250 billion worth of goods imported from China remain trivial. U.S. tariffs so far on EU imports by the U.S. are de minimis. Trade concerns do matter, however, in the longer run. Our geopolitical strategists make the odds of a no-deal outcome 50%, vs. a 40% chance of a deal being reached, and a 10% chance trade talks extend beyond the G20 talks scheduled for June. Chart 5 If markets become convinced the current Sino – U.S. trade war will evolve into a larger standoff between the U.S. and China – military or economic – capex and global supply chains will undergo profound changes. Globally, states likely will find themselves in the orbit of one of these powers, which will fundamentally alter investment flows and, ultimately, the profitability of global businesses. A full-blown trade war could become a Cold War, in other words, which would re-order global supply chains.8 Should this occur, an increase in demand for oil, bulks like iron ore, and base metals could ensue, as China ramps its fiscal and monetary stimulus, and the U.S. and others in its sphere of influence bid up commodity prices as they are forced to pay for other higher-cost alternatives for once-cheaper goods and services.9 USD Will Remain A Short-Term Headwind Globally, central banks remain accommodative, which will support aggregate demand domestically. However, the combination of rising U.S. – Iran tensions and the prospect of a widening Sino – U.S. trade war have put a bid under the USD in the short term. Our FX strategists expect the USD will appreciate another 2 – 3% before cresting and heading lower later in the year. In the short term, USD strengthening is a headwind for oil prices. A stronger dollar translates into higher prices in local currencies ex U.S., which reduces demand, all else equal. On the supply side, a stronger dollar lowers local production costs, which stimulates supply ex U.S. at the margin. Together, these militate against higher oil prices. Assuming the USD does weaken later in the year, as our FX strategists expect, oil prices could pick up a slight tailwind. However, policy risk and supply-demand fundamentals will continue to drive oil prices for the balance of the year. Bottom Line: Oil prices are being restrained by policy risk – particularly U.S. and Chinese trade policy and U.S. foreign policy in the Persian Gulf. We believe markets are under-estimating the odds of Brent prices being above $75/bbl for barrels delivering in December 2019, and in March 2020. A resolution of Sino – U.S. trade tensions is less likely than a no-deal outcome (40% vs. 50%), with the odds of trade talks continuing beyond next month’s G20 meeting being very slim (10%). A deepening of the Sino – U.S. trade war will have longer-term consequences for commodity demand – possibly positive in the wake of Chinese fiscal and monetary stimulus.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please see BCA’s Foreign Exchange Strategy Weekly Report titled“President Trump And The Dollar”, dated May 9, 2019, available at fes.bcaresearch.com. 2      Please see “Iranian naval mines likely used in UAE tankers attacks: Bolton,” published by reuters.com on May 29, 2019.  See also BCA’s Commodity & Energy Strategy Weekly Report titled “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity”, dated October 25, 2018, and BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report “U.S.-Iran: This Means War?”, dated May 3, 2019, both available at ces.bcaresearch.com. 3      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled“Policy Risk Sustains Oil’s Unstable Equilibrium” , dated May 23, 2019, available at cesbcaresearch.com. 4      Please see Trump issues harsh warning to Iran, tweeting it would meet its "official end" if it fights U.S. posted by cbsnews.com on May 20, 2019. 5      Please see BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report titled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic”, dated July 19, 2018, available at ces.bcaresearch.com. 6      For an excellent discussion of these developments, please see BCA’s Geopolitical Strategy Weekly Report titled “Is Trump Ready For The New Long March?”, dated May 24, 2019, available at gps.bcaresearch.com. The “New Long March” is a reference to the 8,000-mile retreat of Chinese Communist Party fighters so they could regroup and ultimately prevail in their civil war in 1934-35. In recalling the Long March, “President Xi … told President Trump to ‘bring it on,’ as he apparently believes that a conflict with the U.S. will strengthen his rule,” according to Matt Gertken, BCA Research’s Chief Geopolitical Strategist. 7      Please see “Global trade growth loses momentum as trade tensions persist,” published by the WTO April 2, 2019. The World Trade Organization expects the growth in merchandise trade volume to drop from 3% last year to 2.6% in 2019, with a slight improvement next year back to 3% growth. Importantly, the WTO notes this is “dependent on an easing of trade tensions.” 8      The odds of a “hot war” between the U.S. and China also are rising, particularly in the South China Sea, according to Adm. James Stavridis (USN, Retired). Please see Collision course in the South China Sea published by the Nikkei Asian Review May 22, 2019. 9      Please see BCA’s Commodity & Energy Strategy Weekly Report titled“Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals” dated May 9, 2019, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights The risk premium in crude oil prices is rising again, as policy risk – and the potential for large policy-driven errors – increases (Chart of the Week).1 This is not being fully reflected in options markets, where implied volatilities are trading close to their long-term average levels (Chart 2). In the past month, risks to oil flows – military and otherwise – and supply have risen, which is keeping a bid under prices. The Sino – U.S. trade war has worsened, and threatens to put global supply chains at risk, along with EM demand growth in the medium term. Meanwhile, amid global monetary easing, the USD has strengthened, producing a more immediate headwind for EM commodity demand. Against this backdrop of opposing forces, oil prices remain elevated and relatively stable in the low $70/bbl range for Brent. Our balances estimates and price forecasts have not changed materially this month. However, the balance of risks has widened in both tails of the price distribution. We expect implied volatilities in the crude oil options markets – particularly Brent – to move higher, as a result. As for prices, we continue to expect Brent to average $75/bbl this year and $80/bbl next year, with WTI trading $7/bbl and $5/bbl below those levels in 2019 and 2020, respectively. Energy: Overweight. The U.S. EIA moved closer to our fundamental assessment and Brent forecast in its most recent market update, lifting its Brent spot-price expectation for this year to an average of $70/bbl, ~ $5/bbl above its April forecast. The EIA’s revision reflects “tighter expected global oil market balances in mid-2019 and increasing supply disruption risks globally.” Base Metals: Neutral. In the wake of Vale’s January supply disaster at its Córrego do Feijão mine, iron ore shipments from Brazil were down 60% in April y/y. Cyclones disrupted supply in Western Australia, pushing 62% Fe iron ore prices to a 5-year high above $100/MT last week. Chinese steelmakers registered a 12.7% y/y gain in crude steel output last month, which, along with dockside iron ore inventory draws of ~ 20 MT ytd, is supporting prices generally. Precious Metals: Neutral. A stronger USD is weighing on gold. Global geopolitical tensions – chiefly in the Persian Gulf and in Sino – U.S. trade relations – are keeping prices above $1,270/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Severe weather conditions in the Midwest continues to delay corn planting, and is contributing to a rally this week in corn prices to $3.94/bushel on Tuesday, up $3.48/bushel from last week’s level. Feature The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz, where ~ 20% of global supply transits daily.2 Bellicose rhetoric from the U.S. – some of it directed at materially reducing Iran’s influence in Iraq – alternately is ramped up and walked back, while attacks on soft targets in the Kingdom of Saudi Arabia (KSA) – e.g., oil shipping and west-bound oil pipelines – draw attention to the exposure of this critical infrastructure, upon which global oil markets rely.3 Iran, meanwhile, uses the media to prepare its population for further economic deprivation, and to lob its own vituperative rhetoric at the U.S. Chart 1 Venezuela’s collapse as an oil producer and exporter continues unabated, keeping markets for the heavier sour crude favored by U.S. refiners tight. Civil war threatens to cut into Libyan production, which we are carrying at just over 1mm b/d, while whiffs of another Arab Spring can be detected in Algeria, where popular discontent with ruling elites grows.4 On the demand side, the summer driving season is about to kick off in the Northern Hemisphere, heralding increased gasoline demand. Countering that, the Sino – U.S. trade war shows signs of devolving into a Cold War, which could force a re-ordering of supply chains globally, lifting costs and consumer-level inflation in the process. Longer-term, this could work against central-bank easing globally, and retard growth in EM consumer demand. The risk of a military confrontation between the U.S. and Iran is higher than it was a month ago and rising. Should it erupt, such a confrontation would threaten oil exports from the Persian Gulf through the Strait of Hormuz. For the present, we continue to expect EM demand growth to hold up, expanding by 1.5mm b/d this year and 1.6mm b/d next year. This will be supported by continued monetary easing globally, and additional fiscal stimulus from China if its trade war with the U.S. worsens. There is a chance weakness in DM demand will persist, but we think the odds of a normal seasonal pick-up in 2H19 will continue to support demand overall (Chart 3). That said, given the threats to demand growth – an expanded Sino – U.S. trade war and stronger USD, in particular – we will continue to monitor the health of EM demand closely. Chart 2Brent Implied Volatility Will Move Higher Brent Implied Volatility Will Move Higher Brent Implied Volatility Will Move Higher Chart 3DM Oil Demand Growth Wobbles, EM Steady DM Oil Demand Growth Wobbles, EM Steady DM Oil Demand Growth Wobbles, EM Steady   OPEC 2.0 Maintains Production Discipline Chart 4OPEC 2.0's Production Discipline, Strong Demand Drained Inventories OPEC 2.0's Production Discipline, Strong Demand Drained Inventories OPEC 2.0's Production Discipline, Strong Demand Drained Inventories The goal of OPEC 2.0 from its inception at the end of 2016 has been to drain OECD inventories, which swelled to 3.1 billion barrels in July 2016, on the back of a market-share war launched by the old OPEC under the leadership of KSA, and a surge in U.S. shale-oil production. KSA continues to stress the need to restrain crude oil production so as to draw down global oil inventories, and has done much of the heavy lifting this year to make that happen (Chart 4). The other putative leader of OPEC 2.0, Russia, continues to express misgivings with such a strategy, arguing instead the producer coalition should make more oil available to the market. We are more aligned with Russia’s view, and continue to believe OPEC 2.0 will need to increase production. In our balances (Table 1), our base case assumes those producers that can lift production – core OPEC and Russia – will do so to keep prices below $85/bbl (Chart 5). We expect OPEC 2.0 will be able to offset the loss of ~ 700kb/d from Iran exports by increasing production gradually from May to September in proportion to its quota agreement. In our base case, we have Iranian exports falling to 600k b/d. We continue to expect OPEC 2.0 to be able to offset the loss of Venezuela’s production throughout the year, which we expect to fall to 500k b/d by December (vs. ~ 735k b/d presently). Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium Going into next month’s Vienna meeting, we do not expect KSA to dramatically increase production, but would not be surprised if it took production from its current 9.8mm b/d level closer to its OPEC 2.0 quota of 10.33mm b/d in 2H19. We also expect Russia to lift its production closer to 11.6mm b/d from ~ 11.4mm b/d at present. Even with OPEC 2.0 lifting production ~ 900k b/d in 2H19 vs. 1H19, the bulk of global production increases will be concentrated in the U.S., where we expect shale-oil output to grow 1.2mm b/d this year, and 840k b/d next year. This will account for 85% of the overall increase of 2.4mm b/d we expect in the U.S. this year and next. Our estimates of production growth in the U.S. shales is tempered by a growing conviction the large integrated oil majors and stand-alone E&P companies will continue to put the interests of shareholders above their desire to increase production just for the sake of increasing it, as was done in the past. This is driven by a desire to attract and retain capital, which will be critical to the majors and the big E&Ps in the years ahead.5 We continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories. Even with these production increases, we continue to see demand growth exceeding supply growth this year. This will produce a physical deficit, which will continue to drain inventories (Chart 6). Chart 5Core OPEC 2.0 Will Lift Production Core OPEC 2.0 Will Lift Production Core OPEC 2.0 Will Lift Production Chart 6Balances Continue To Tighten Balances Continue To Tighten Balances Continue To Tighten   Spare Capacity Will Be Stretched Chart 7 In addition to Iran and Venezuela, we are closely following what appears to be the early stages of another civil war in Libya, which threatens the ~ 1mm b/d of production flowing from there. In addition, we are seeing signs of growing civil discontent in Algeria not unlike that of 2011, which was sparked by popular dissatisfaction with ruling elites throughout the Middle East in the lead-up to the Arab Spring. We have maintained existing spare capacity can handle the loss of Iranian and Venezuelan production and exports we’ve built into our balances and price-forecast models. However, covering these losses will stretch the capacity of global supply to accommodate unplanned outages, which could leave markets extremely tight in the event of production losses in Libya or Nigeria, or in producing provinces prone to natural disasters (e.g., Canadian wildfires or U.S. Gulf hurricanes). At present, markets appear to be comfortable with OPEC 2.0’s ability to cover losses from Iran and Venezuela, given current spare capacity of ~ 3mm b/d, most of which remains in KSA, and continued growth in non-OPEC output (Chart 7). As inventories continue to draw globally, markets’ attention will turn more toward this spare capacity.   Expect Higher Volatility We remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. Chart 8Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Geopolitics, Increasing Backwardation Support Higher Brent Implied Volatility Our fundamental assessments of supply, demand and inventory levels remain fairly steady. Thus, our price forecasts – $75 and $80/bbl this year and next for Brent, with WTI trading $7 and $5/bbl under that – remain unchanged. With OPEC 2.0 maintaining production discipline and U.S. shale producers maintaining capital discipline, the rate of growth on the supply side will be restrained, and below the rate of growth in global demand. These forces combine to keep inventories drawing this year, which will lead to a steeper backwardation in forward curves, particularly Brent’s (Chart 8). Coupled with true uncertainty re how the U.S. – Iran confrontation in the Persian Gulf is resolved, and how the Sino – U.S. trade war plays out, this steepening backwardation will lead to higher implied volatility in crude oil options markets. Bottom Line: Our expectation of higher prices and steepening backwardation in forward curves is supported by our analysis of fundamentals and the current political economy of global oil markets, which emphasizes policy risk arising from the actions of geopolitically significant states. These factors also will push implied volatility in options markets higher. As a result, we remain long Brent call spreads in July and August 2019, which are up an average 101% since they were recommended in February. These positions benefit from higher prices and higher volatility. We also remain long 2H19 Brent vs. short 2H20 Brent futures in line with our view backwardation will increase; this position is up 155.4% since it was initiated in February, as a result of the steepening of backwardation in the forward curve. Steepening backwardation also will benefit our long S&P GSCI recommendation, which is heavily weighted to energy markets; this position is up 8% since inception. Lastly, we remain long spot WTI, which is up 34.6% since it was recommended in January.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 In the price decomposition shown in our Chart of the Week, we account for the contribution that changes in global supply, demand and inventory levels make to the evolution of Brent prices, using a proprietary econometric model. We treat the residual term of the model – what’s left of the price decomposition after these fundamental variables are accounted for – as a measure of the risk premium in prices. An expansion of the risk premium – in the positive or negative direction – is coincident with an expansion of the implied volatility of Brent crude oil options typically expands (sometimes with a lag or two), and vice versa. This is intuitively appealing, since risk premia and volatility expand as uncertainty in the market rises. 2 We considered this topic in depth in a Special Report written with BCA Research’s Geopolitical Strategy entitled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic,” published July 19, 2018, and in “Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf,” published July 5, 2018. Both reports are available at ces.bcaresearch.com. 3 Iran’s influence in Iraq is an internally divisive issue, and a focal point of the U.S., a view we share. Please see, “Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply,” a Special Report we published with BCA Research’s Geopolitical Strategy September 5, 2018. KSA and Western intelligence agencies allege Iran is behind the attacks on Saudi oil infrastructure. Please see “Saudi Arabia accuses Iran of ordering drone attack on oil pipeline,” published by reuters.com. The westbound pipelines in KSA are critical to maintaining the Kingdom’s export capacity, as we noted in “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity,” published by BCA Research’s Commodity & Energy Strategy October 25, 2018. This report is available at ces.bcaresearch.com. 4 Please see “Algeria Has a Legitimacy Problem,” posted on the LSE’s Middle East Centre Blog by Benjamin P. Nickels on May 20, 2019, and “Algeria’s Second Arab Spring?” by Ishac Diwan posted at project-syndicate.org March 28, 2019. 5 We will be exploring this topic in depth in a Special Report next month. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed in Policy Risk Sustains Oil's Unstable Equilibrium Policy Risk Sustains Oil's Unstable Equilibrium

Highlights So What? The Trump administration’s decision to apply maximum pressure to Iran fundamentally changes the investment landscape in 2019-20. Why? The impact of the Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity. However, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. Policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Feature What are the Trump administration’s foreign policy objectives? First, to confront the U.S.’s greatest long-term competitor, China, by demanding economic reforms and greater market access. Second, to force a decision-point upon rogue regimes with significant ballistic missile programs and nuclear-weapon aspirations: North Korea and Iran. Third, to maintain credible deterrence in Russia’s periphery. Fourth, to reassert the Monroe Doctrine through regime change in Venezuela. The common thread, even with Russia, is confrontation. It is not necessary for President Trump to pursue all of these objectives at once. So his decision last November to issue waivers for eight importers of Iranian oil suggested to us that he was prioritizing – and becoming more risk averse ahead of the 2020 election. Full enforcement of the oil sanctions at that time threatened to push oil prices up at the same time as the Fed was raising rates, a pernicious combination late in the cycle (Chart 1). Thus, after walking away from the 2015 nuclear accord with Iran, it made sense for Trump to delay any confrontation with Iran until his hoped-for second term in office. He could focus on building the border wall, resolving trade tensions with China, and making peace with North Korea instead. Chart 1Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Chart 2Sanctions Will Raise Risk Sanctions Will Raise Risk Sanctions Will Raise Risk   This view has now been proved wrong. The oil waivers apparently represented only a temporary delay in the administration’s hawkish Iran policy. Now that financial conditions have eased and growth has stabilized, Trump has declared the Iranian Revolutionary Guard Corps a foreign terrorist organization and announced that he will discontinue the waivers, demanding full compliance on energy sanctions from all states by the end of May. Volatility will move higher (Chart 2). Trump is emboldened by America’s newfound energy independence (Chart 3). While the shale boom can be used to reduce U.S. strategic commitments in the Middle East, it can also encourage Washington to believe it is invulnerable to traditional Middle Eastern risks. Trump’s advisers, Secretary of State Mike Pompeo and National Security Adviser John Bolton, apparently have won the Iran policy debate on this basis. Since Trump’s reelection is far from guaranteed, it would appear his advisers view re-imposing sanctions against Iran as a rare opportunity to achieve long-term strategic objectives. They may not have the chance in 2021. Chart 3The U.S. Is Energy Independent The U.S. Is Energy Independent The U.S. Is Energy Independent Chart 4Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes All the same, the problem for Trump is that, while the U.S. will survive any chaos ensuing from an Iran confrontation, his presidency may not. Full enforcement of the sanctions could spiral out of control and, through the oil price channel, come back to hurt Trump’s economy – and hence his re-election odds (Chart 4). The implication is that Trump has either been misled about the risks of his Iran policy, or he does not care as much about his re-election odds as we believed. Either way, the result is aggressive policy, which increases the geopolitical risk premium in oil prices. We can see this in our simulations (below), which are based entirely on spare capacity and compliance by consumers to the sanctions. We did not include an Iran-retaliation scenario in this modeling. Therefore, any threat to Iraqi supplies, or talks of disrupting the Strait of Hormuz will add to our prices forecasts. U.S. Administration Sailing Close To The Wind From their public comments, it would appear the U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of production in Iran and Venezuela. For the Trump administration, this view is supported by growing U.S. shale-oil supplies, and the administration’s belief the Kingdom of Saudi Arabia (KSA) and its Gulf allies stand ready to increase production to cover any losses arising from the re-imposition of Iranian oil-export sanctions by the U.S. This belief supports the administration’s end-game, which appears to be regime change in Iran, a position long favored by Trump’s national security advisor John Bolton. Frank Fannon, U.S. Assistant Secretary of State for Energy Resources, succinctly captured the administration’s view when he declared, “We are doing this ... in a favorable market condition with full commitment from producing countries.” He further stated, “We think this is the right time.”1 We believe the Trump administration is sailing close to the wind here. The U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of oil production in Iran and Venezuela. While increasing U.S. shale output does provide something of a cushion to global oil markets, it is not a substitute for the heavy-sour crude produced by Iran and Venezuela (and others), which is favored by refiners with complex units. The loss of Iranian exports hits these refiners harder than those able to process lighter, sweeter crude of the sort exported by the U.S. (Chart 5).2 As Iranian and Venezuelan barrels are lost to the market, these heavier crudes are getting more scarce relative to the crude produced in U.S. shales – typically classified as West Texas Intermediate (WTI) crude oil. This can be seen in tighter light-versus-heavy crude oil spreads, and the wider Brent-WTI spreads, which indicate WTI is relatively more plentiful (Charts 6A & 6B). Chart 5 Chart 6AWTI Relatively More Plentiful… WTI Relatively More Plentiful... WTI Relatively More Plentiful... Chart 6B…As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce It is true U.S. production continues to grow, which is causing crude oil inventories to increase as sanctions on Iran are being re-imposed. We expect U.S. shale-oil output to grow 1.2mm b/d this year – taking it to a record 8.4mm b/d on average – and 800k b/d next year. Caution is required regarding inventories, however: U.S. refiners are in the thick of their plant maintenance – known as turn-around season – and have loaded a lot of the maintenance they would normally have done in the Fall into Spring. As a result, U.S. refiners are running at reduced rates preparing for the Northern Hemisphere’s summer driving season and the January 1, 2020, implementation of the U.N. IMO 2020 regulations, which will require shippers to use lower-sulfur fuel to power their vessels worldwide.3 OPEC 2.0 Gains Control Of Brent Forward Curve Growing U.S. production and inventories might give the Trump administration comfort the market can absorb the loss of Iran’s exports – some 1.3mm b/d at present. However, our base case holds that Iran’s exports will stabilize at ~ 600k b/d after sanctions fully kick in. In most of the scenarios we run (Table 1), the impact of Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity (Chart 7).4 Indeed, many of the low-probability scenarios we run – including the “maximum pressure” scenario, in which the Trump administration succeeds in removing all of Iran’s exports – can be accommodated by current supply and spare capacity without sending Brent prices through $100/bbl (Chart 8). OPEC 2.0 holds ~ 1.5mm b/d of what we would describe as readily available spare capacity – mostly in KSA – that can be brought to market fairly quickly, as the ramp-up last year ahead of the first round of sanctions in November amply demonstrated. Another 1.5mm b/d or so is held by the Kingdom and its GCC allies, but it would take longer to bring on line. Table 1BCA Oil Market Scenarios U.S.-Iran: This Means War? U.S.-Iran: This Means War? Chart 7OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses Chart 8Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 In reality, once refiners are up and running at max capacity in the U.S. in a few weeks, U.S. inventories will begin to draw hard. This will support what we believe to be OPEC 2.0’s goal of backwardating the Brent curve – perhaps sharply. This will allow it some breathing space to gradually add barrels to the market in 2H19 as needed, as our balances and forecasts assume. It is important to remember OPEC 2.0 was formed to drain the massive storage overhang that resulted from the 2014-16 market-share war launched by KSA. The Kingdom’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. Throughout the ramp to renewed sanctions, he has steadfastly maintained the Kingdom will provide oil as Aramco’s customers need it, following the blind-side hit KSA took from the Trump administration in November when it granted Iran’s largest customers waivers on its export sanctions. U.S. Pressure On OPEC To Raise Output Will Grow We expect the Trump administration to continue to pressure OPEC – the old cartel, not OPEC 2.0 – to boost production post-sanctions. However, it is not entirely clear that this time OPEC’s – particularly KSA’s – interests are 100% aligned with President Trump’s. KSA and other producers were shocked by the administration’s decision to grant waivers after lifting supply sharply in response to Trump’s demands. This time around, we believe OPEC – KSA in particular – will be more cautious lifting output, even as the U.S. Navy very publicly displays its ability to project and sustain force in the Mediterranean and Persian Gulf regions (Map 1). With good reason: The U.S. holds ~ 650mm barrels of oil in its Strategic Petroleum Reserve (SPR), which can be released at a rate of 1mm to 1.3mm b/d for a year or so. Realistically, it is probably more like six to nine months, since, by the time much of the oil has been released to the market the reserves that are left likely will have higher concentrations of contaminants (e.g., metals and solids that migrated to the bottom of the storage while it was sitting idle), making buyers way more leery of using it. Chart After the shock of the waivers, KSA likely will minimize its exposure to another surprise from the U.S. as sanctions take hold. The risk to OPEC – KSA in particular – is that Trump again will pull a fast one as the U.S. general election approaches. Given Trump’s demonstrated sensitivity to U.S. gasoline prices approaching elections, it is not unlikely that he would hold on to the SPR barrels until mid to late summer 2020, then release them in time to reduce prices further. If, in the run-up to U.S. elections, OPEC has steadily increased production to build precautionary inventories then it runs a non-trivial risk the crude oil price would once again crash as SPR barrels are released. The Kingdom of Saudi Arabia’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. In this iteration of Iranian export sanctions, we expect KSA to adopt a just-in-time inventory management strategy, so that it is not caught out once again over-supplying the market ahead of a U.S. surprise. U.S. Shales Will Figure Into OPEC 2.0’s Calculus Chart 9U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained The other big fundamental OPEC 2.0 will be considering is the rate at which U.S. shale oil can be exported. Export capacity still is constrained by the shortage of deep-water harbor facilities in the U.S. Gulf. This is being addressed, but it has been slowed by additional requests for environmental impact statements from the federal and state governments. If prices start moving higher because KSA and OPEC 2.0 are responding to tightening markets with caution (and slowly), we’d likely see WTI production increase – it’ll have 2mm b/d of new pipe in the Permian to fill by end-2019 – but that crude could start backing up as storage in the U.S. Gulf fills. This would again widen the Brent vs. WTI - Houston spread, which will benefit refiners in the U.S. Gulf, but will lower prices received by U.S. shale producers (again) (Chart 9). Bottom Line: Trump’s decision not to extend the Iranian oil waivers suggests that he has plenty of risk appetite ahead of the 2020 election. His Iran policy is now the biggest geopolitical risk to the late-cycle bull market. It also risks tightening the oil market considerably as the election approaches. Can Iran’s Regime Withstand The Sanctions? Iran’s economic weakness was an added inducement for the Trump administration to take an aggressive turn. The sanctions against Iran’s crude oil exports have not yet been implemented in full force, but the economy is already showing signs of distress. For one, inflation is back near 40% – levels only reached during the previous round of sanctions (Chart 10). Given that food, beverages, and transportation are among the sectors experiencing the fastest growing prices, lower income groups – which the World Bank estimates spend almost half their income on food alone – will suffer disproportionately. Economic dissatisfaction has catalyzed protests in Iran in the past, and the squeeze from the U.S. sanctions could propel further unrest. Chart 10Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Chart 11 Moreover, soaring prices are coinciding with a slowdown in activity and consumption. On the surface Iran appears relatively well protected given that its economy is not as directly correlated with oil exports as some of its peers (Chart 11). However, Iran’s oil and non-oil sectors are actually closely intertwined. This is evident from weakness in the non-oil sector during the previous round of sanctions (Chart 12). The IMF expects the economy to contract by 6% this year – faster than its 3.9% estimate for last year – leaving Iranians to face a period of deepening stagflation. Chart 12 The jump in consumer prices is a reflection of the ongoing collapse of the currency. Despite the government’s best efforts to stabilize the foreign exchange market, heightened demand for foreign currencies caused a nearly 30% depreciation in the unofficial exchange rate vis-à-vis the U.S. dollar since the beginning of the year (Chart 13). Chart 13Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Chart 14Debt Burden Is Manageable Debt Burden Is Manageable Debt Burden Is Manageable To soften the impact of the weaker currency and the potential shortage of essential goods, authorities have introduced a three-tier exchange rate system, and banned the export of several products including grains and seeds, powdered milk, butter, and tea. Since the level of external debt remains manageable (Chart 14) the weak currency will pressure the economy through its impact on prices (highlighted above), with imported inflation eroding purchasing power. Furthermore, Iran will not benefit from any additional export competitiveness due to currency depreciation. The current account surplus is expected to deteriorate and eventually flip to a deficit amidst weak exports, and despite declining imports (Chart 15). The fact that Iran runs a non-energy trade deficit does not help. Chart 15Trade Surplus At Risk Trade Surplus At Risk Trade Surplus At Risk Chart 16Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint In terms of the fiscal purse, under normal circumstances, a weaker rial would raise government revenue from oil exports. However, given the restrictions on oil exports, the fiscal budget will not benefit from this relationship. Instead, the dominant impact will be greater government spending. Historically, expenditures tend to be countercyclical, aiming to mitigate the impact of the deteriorating economic environment on Iranian households (Chart 16). In the past, the Iranian government’s healthy fiscal balance allowed policymakers to implement social protection schemes to combat poverty and revitalize the economy. Now, however, the fiscal coffers are no longer so well-cushioned and the deficit will constrain this option. Stimulative fiscal policy in this environment would only raise inflation further. Furthermore, given that the lion’s share of Iran’s imports are capital and intermediate goods, the currency depreciation will spill over into the domestic industry and weaken demand, even for domestically produced goods. Investments have been lacking in many of the most essential services. The electricity sector is a prime example: while demand is rising, spare capacity is dwindling and causing recurring outages. Similarly, foreign direct investment will likely fall in this uncertain political environment. With the economy on the brink, Iran is not in a position to confront the United States directly. It must take total sanctions enforcement as a very grave risk and seek delaying actions and negotiations. However, this vulnerability will turn into desperation if the Trump administration proceeds with a full embargo without any “off ramp” for negotiations. Bottom Line: Full enforcement of sanctions threatens to destabilize Iran’s already vulnerable economy. Inflation is soaring, the currency is plunging, and the economy will likely be plagued by a twin deficit going forward. The implication is that Iran will eschew direct confrontation unless forced. Will Iran Retaliate In Iraq? Iran is also at risk of losing one of its great sources of leverage: Iraqi stability. Given its gloomy economic outlook, Iran is looking to expand ties with its neighbors in an attempt to soften the blow from the sanctions. Earlier this year president Hassan Rouhani and Iraqi prime minister Adel Abdul Mahdi signed several preliminary trade deals, with the ultimate aim to boost bilateral trade to $20 billion from its current ~$12 billion. However, natural gas exports to Iraq – a major traded good – are covered by the sanctions, so this target is probably unattainable. Although Iran is currently the only foreign supplier of natural gas and electricity to Iraq, the temporary halt in electricity supplies last summer coincided with violent protests in Southern Iraq.5 Growing anger over Iran’s inability to satisfy its commitments to Iraq highlights the tensions in the Iraq-Iran relationship. What’s more, the U.S. is pressuring Iraq to turn to other neighbors such as Saudi Arabia, Jordan, and Kuwait for its electricity needs.6 In March, it renewed a three-month waiver allowing Iraq to import Iranian gas. Then Saudi Arabia promised to connect Iraq to the Saudi electricity grid during a visit by its economic delegation to Baghdad on April 4.7 At that meeting, the Saudi delegation also agreed to provide Iraq with $1 billion in loans, $500 million to boost exports, and a sporting complex as a gift. Additionally, the Saudi consulate in Baghdad – which had been closed for almost 3 decades – reopened last month. Saudi Arabia and Iraq are starting to cooperate. Iraq’s new government is clearly taking a pragmatic approach to its regional relationships. This is also largely in line with growing domestic opposition to Iranian interference within Iraq. Influential Shia leaders such as Muqtada al-Sadr and Ayatollah Ali al-Sistani have been voicing concerns about Iran’s influence in Iraqi politics. As such, the new Iraqi government is attempting to walk a tight rope between placating Iran and taking advantage of new opportunities with its Arab neighbors to rebuild its economy. This trend raises the risk that Iran will strike rapidly in Iraq if it believes Trump’s maximum pressure strategy is succeeding in bringing oil exports to zero. Iraq is the logical target as Iran has great political and sectarian influence there, it is the geographic buffer with Saudi Arabia, and it is the necessary launchpad for Iran’s strategic opponents to undermine or attack the Iranian regime (Map 2). Chart Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a fullfledged conflict. Chart 17 Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. About 85% of Iraq’s crude exports flow through the southern port city of Basra (Chart 17). It is already home to recurrent protests and any disruptions there threaten around 3.5mm bbl shipping to international markets daily. Bottom Line: Iraq is caught in the strategic tug-of-war between Iran and Saudi Arabia, with the latter gaining influence at present. Sanctions could compel Iran to retaliate in Iraq, jeopardizing up to 3.5mm b/d of supply. What Comes Next? The latest data suggest that Japan is in full compliance with the U.S. sanctions against Iran as of April and that China has been front-running the sanctions and is now reducing imports, as it was at the time the waivers were first introduced. China may not go to zero, but it is apparently complying. This is important given that the Trump administration has essentially introduced a bold new demand – cut off all energy imports from Iran – at the eleventh hour of the U.S.-China trade negotiations. Our projections of spare capacity suggest that the Trump administration will believe it has room to enforce the sanctions fully (Chart 18). This is a risky approach, as a fairly standard unplanned outage anywhere else in the world could bring spare capacity much lower, but the data suggest that Trump’s team will not see it as a hard constraint. If necessary, the administration can later choose to soft-pedal enforcement on black market activity so as to calibrate the global impact. Chart 18 The Iranians, for their part, are unlikely to leap to the most aggressive forms of retaliation immediately – such as fomenting unrest in Iraq – because of their economic vulnerability. Small acts of sabotage or subversion are a way to send the U.S. a warning signal, but generally Iran will want to signal defiance while shifting the emphasis to negotiations. Hence it will primarily retaliate through diplomatic actions and calculated displays of force. A limited response enables Iran to appear innocent, divide the U.S. and EU, and thus isolate the U.S. over its belligerent policies. Previously, Trump has sought to negotiate with Iranian President Hassan Rouhani. The Iranians have so far rebuffed him, but Foreign Minister Mohammad Zarif’s initial response to the waiver announcement was to blame Trump’s advisers, instead of Trump himself, and offer an exchange of prisoners (And release of detained Americans happen to be one of the Trump administration’s key demands – see Table 2.) Negotiations could begin through back channels and an uneasy period of tensions could thus ensue without a full-blown war. Table 2Trump Administration’s 12 Demands On Iran U.S.-Iran: This Means War? U.S.-Iran: This Means War? The problem is that negotiations cannot work if Trump fully and immediately enforces the sanctions without offering Iran an “off ramp.” If the administration backs Iran into a corner it will have no option but to strike out forcefully. Negotiations also cannot work if Iran joins the U.S. in withdrawing from the 2015 deal and reactivating its nuclear program, specifically the suspected military dimensions of that program. This would force Trump to respond (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree U.S.-Iran: This Means War? U.S.-Iran: This Means War? In short, a period of “fire and fury” is about to ensue between Trump and Rouhani. It will be even more uncertain and disruptive than the summer 2017 showdown between Trump and Kim Jong Un of North Korea (Chart 19), which drove a 35 bps decline in the 10-year Treasury yield. Chart 19Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Kim Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown There is a pathway for Trump’s pressure tactics to succeed: Iran is vulnerable and the United States and its allies are in a position of relative strength in terms of global oil supply. Therefore, it is possible that Trump could fully enforce the sanctions and yet avoid any uncontrollable crisis or oil shock. However, this pathway, at a subjective 26% probability, is less likely than the combined 48% probability of the alternatives: either escalation short of war, or ultimatums leading to Middle Eastern instability and much higher odds of war. Bottom Line: The geopolitical risk of U.S.-Iran confrontation is not contained. But we do not expect Iran to overreact unless Trump plows forward with full and immediate sanctions enforcement and offers no realistic “off ramp” for negotiations. At that point Iranian retaliation will be concrete and escalation could spiral out of control. Investors should keep in mind that Iran is not North Korea. Unlike the hermit kingdom, Iran has the ability to retaliate with a number of different levers. Indeed, it has threatened to shut the Strait of Hormuz in the past, and could, at the limit, be backed into that corner. While the risk of this is extremely low, should it occur the consequences would be huge – close to 20% of the world’s daily oil supply passes through the Strait daily. Indeed, just this week Iran’s Oil Minister Bijan Zanganeh again threatened to take action against any OPEC member working against its interests. Following a meeting with the Cartel’s president, he is reported to have said, “Iran is a member of OPEC because of its interests, and if other members of OPEC seek to threaten Iran or endanger its interests, Iran will not remain silent.”8 Investment Conclusions The Trump administration’s decision to apply maximum pressure to Iran is a significant and unexpected injection of geopolitical risk that we believe fundamentally changes the investment landscape in 2019-20. While our base case is that the U.S. will enforce the oil sanctions gradually and in such a way as to avoid causing an oil shock, policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1 Please see Humeyra Pamuk and Timothy Gardner, “How Trump’s hawkish advisors won debate on Iran oil sanctions,” Reuters, May 1, 2019, available at reuters.com. 2 Heavy-sour crudes are those with low API gravity (a measure of how easily a crude flows) and higher sulfur content. Light-sweet crudes have higher API gravity and lower sulfur content. 3 Please see BCA Commodity & Energy Strategy Weekly Report, “IMO 2020: The Greening Of The Ship-Fuel Market,” February 28, 2019, available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition led by KSA and Russia, which was formed in 2016 to manage global crude oil output. Its goal is to drain the massive storage overhang caused by the market-share war launched by KSA in 2014. 5 Iran cited dissatisfaction with Iraq over the accumulation of unpaid bills as the cause of the halt in electricity exports to Iraq. This prompted Iraqi authorities – under pressure from domestic unrest – to send a delegation to Saudi Arabia in attempt to negotiate an electricity agreement. 6 Please see Edward Wong, “Trump Pushes Iraq to Stop Buying Energy From Iran,” The New York Times, February 11, 2019, available at nytimes.com. 7 Please see Geneive Abdo and Firas Maksad, “Iraq’s Place in the Saudi Arabian-Iranian Rivalry,” The National Interest, April 15, 2019, available at nationalinterest.org. 8 Please see Babk Dehghanpisheh, “Iran will respond if OPEC members threaten its interests: oil minister,” Reuters, May 2, 2019, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Chart 3 Chart 4 Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations ...And Lofty Valuations ...And Lofty Valuations Chart 6 Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy   Chart 8 If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule Chart A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 9 Chart 10Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Thai Confidence Has Bottomed Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. Chart 14 The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Chart 16 Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. Chart 17 There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism Chart 18 The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar

Highlights So What? Our “Black Swan” risks for the year reveal several potential wars. Why? While we think it is premature to expect armed conflict over Taiwan, an outbreak of serious tensions is possible. Russia and Ukraine may have a shared incentive to go renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, so it may continue to be provocative. Everyone has forgotten about the Balkans … but tensions are building. A “Lame Duck” Trump could stage a military intervention in Venezuela. Feature Over the past three years, we have compiled a list of five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s list of “Ten Surprises for 2018,” we do not assign these events a “better than 50% likelihood of happening.”1 Instead, we believe that the market is seriously underpricing these risks by assigning them only single-digit probabilities when the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Furthermore, some of our events below are obscure enough that it is unclear how exactly to price them. But before we get to our list of the five things that keep us up at night,2 a quick note on the question for financial markets in 2019: Will the economic policy divergence between the U.S. and China continue? At the moment, momentum is building behind the narrative that both the U.S. and China have decided to reflate. In anticipation of this narrative switch, we closed our long DM / short EM equity trade on December 3, 2018 for a 15.70% return (originally opened on March 6, 2018). How sustainable is the EM outperformance relative to DM? Will the rest of the world “catch up” to U.S. growth momentum, thus hurting the U.S. dollar in the process? The global central bank – the Fed – is already expected to “back off,” even though members of the FOMC have simply pointed out that they remain data-dependent. Granting our BCA House View that the U.S. economy remains in decent health, U.S. economic data will continue to come in strong through the course of the year. This means that there is scope for a hawkish Fed surprise for the markets, given that the interest rate market already has dovish expectations, anticipating 4.33 basis points and 16.74 basis points of cuts over the next 12 and 24 months respectively (Chart 1). Chart 1 Meanwhile, the global demand engine – China – may disappoint in its reflationary efforts. We refer to China as the “global demand engine” because the combined imports and capex of China and other emerging markets dwarf that of the U.S. and EU (Chart 2 and Chart 3).3 Chinese imports alone make up $1.6 trillion, constituting 23% of the $7 trillion total of EM imports and about half of EM investment expenditures. Given that large swaths of EM are high-beta to the Chinese economy, the EM-plus-China slice of the global demand pie is leveraged to Beijing’s reflationary policies. Chart 2EM/China Imports Are Much Larger Than U.S.'s And EU's Combined EM/China Imports Are Much Larger Than U.S.'s And EU's Combined EM/China Imports Are Much Larger Than U.S.'s And EU's Combined Chart 3EM/China Capex Is As Large As U.S.'s And EU's Combined EM/China Capex Is As Large As U.S.'s And EU's Combined EM/China Capex Is As Large As U.S.'s And EU's Combined Chinese policymakers have gestured toward greater support for the economy. The communiqué published following the Central Economic Work Conference (CEWC) in December called for a broad stabilization of aggregate demand as a focus of macro policy over the course of 2019. The language was still not very expansionary, but Beijing has launched stimulus despite relatively muted communiqués in the past. The massive stimulus of early 2016, for instance, followed a mixed CEWC communiqué in December 2015. So everything depends on the forthcoming data. Broad money and credit growth improved marginally in December, while the State Council announced that local government bond issuance could begin at the start of the year rather than waiting until spring. Meanwhile, a coordinated announcement by the People’s Bank of China, the Ministry of Finance, and the National Development and Reform Commission declares that a larger tax cut is forthcoming – that is, in addition to the roughly 1% of GDP household tax cuts that went into effect starting late last year. Monetary policy remains very lax with liquidity injections and additional RRR cuts. Before investors become overly bullish, however, we would note that Chinese policymakers are focusing their reflationary efforts on fiscal spending and supply-side reforms like tax cuts. The problem with the latter is that household tax cuts will not add much to global demand, given that consumer goods make up just 15% of China’s imports (Table 1). The vast majority of Chinese imports stem from the country’s capital spending. Table 1China’s Consumer-Oriented Stimulus Will Boost Different Imports Than Past Stimulus Five Black Swans In 2019 Five Black Swans In 2019 Fiscal spending, meanwhile, is as large as the overall credit origination in the Chinese economy (Chart 4). But without a revival in credit growth, more spending will mainly serve to stabilize the economy, not light it on fire. It is likely that part of the fiscal pump-priming will be greater issuance of local government bonds. However, even the recently announced 1.39 trillion RMB quota for new bonds this year is not impressive. And even a 2 trillion RMB increase would only be equivalent to a single month of large credit expansion (Chart 5). Chart 4China: Credit Origination Is As Large As Government Spending China: Credit Origination Is As Large As Government Spending China: Credit Origination Is As Large As Government Spending   Chart 5 As such, tactically nimble investors could profit from a reflationary narrative that sees both the global central bank – the Fed – and the global fiscal engine – China – turning more dovish and supportive of growth. However, we agree with BCA’s Emerging Markets Chief Strategist Arthur Budaghyan, who is on record saying that “Going Tactically Long EM Is Akin To Collecting Pennies In Front Of A Steamroller.” The bottom line for investors is that 2019 is the first year in a decade where the collective intention of policymakers – across the world – is to prepare for the next recession, rather than to prevent a deflationary relapse. This cognitive shift may be slight, but it is important. The Fed and Beijing are engaged in a macroeconomic game of chicken. Each camp is trying to avoid having to over-reflate at the end of the cycle. For the Fed, the goal is to have room to cut rates sufficiently when the recession finally hits. For China, the goal is to ensure that its leverage does not get out of hand. Into this uncertain macroeconomic context we now insert the five Black Swans for 2019. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months; Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk; Geopolitical: We must be able to identify the risk scenario through the lens of BCA’s geopolitical methodology. Genuinely unpredictable events – such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe – do not make the cut. Black Swan 1: China Goes To War With Taiwan One could argue that a military conflict between China and Taiwan in 2019 should not technically qualify for our list, as there has been chatter in the media about such an outcome. Indeed, our recent travels across Asia revealed that clients are taking a much greater interest in our longstanding view – since January 2016 – that Taiwan is the premier geopolitical Black Swan. We established this view well before President Trump won the election and received a congratulatory call from Taiwanese President Tsai Ing-wen, breaking diplomatic practice since 1979. Now, at the beginning of 2019, the exchange of barbs between the Chinese and Taiwanese presidents has raised tensions anew (Chart 6).4 Chart 6Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Nonetheless, Taiwan makes the cut here because we doubt that most of our global clients take the issue seriously. Furthermore, we are concerned that – with fair odds of a U.S.-China trade truce lasting through 2019 – cross-strait tensions could fall out of sight. The basis of our view is that there is a unique confluence of political developments in Beijing, Washington, and Taipei that is conducive toward a diplomatic or military incident that could escalate tensions: Taiwan’s pro-independence Democratic Progressive Party (DPP), in addition to taking the presidency in 2016, won control of the legislature for the first time ever (Chart 7). This means that domestic political constraints on President Tsai Ing-wen’s administration are lower than usual. Tsai has angered Beijing by seeking stronger relations with the U.S. and refusing to endorse the 1992 Consensus, which holds that there is only “One China” albeit two interpretations. China’s General Secretary Xi Jinping has removed term limits and placed greater emphasis on the reunification of Taiwan. Xi has consolidated power domestically and has pursued a more aggressive foreign policy throughout his term, including in the South China Sea, where greater naval control would enable China to threaten Taiwan’s supply security. Xi’s blueprint for his “New Era” includes the reunification of China, and some have argued that there is a fixed timetable for reunification with Taiwan by 2050 or even 2035.5 Some recent military drills can be seen as warnings to Taiwan. U.S. President Trump called the One China Policy into question at the outset of his term in office (only later reaffirming it), and has presided over an increase in U.S. strategic pressure against China, such as the trade war and freedom of navigation operations, including in the Taiwan Strait. Trump’s National Security Adviser John Bolton and Assistant Defense Secretary Randall Schriver are seen as Taiwan hawks, while the just-concluded Republican Congress passed the Taiwan Travel Act and the Asia Reassurance Initiative Act (ARIA), which imply an upgrade to the U.S. commitment to Taiwan’s democracy and security.6 Chart 7 These three factors suggest that, cyclically, there is larger room than usual for incidents to occur that initiate a vicious cycle of tensions. The odds of a full-fledged war are still very low – the U.S. has reaffirmed the One China Policy in its recent negotiations with Beijing, which seem to be progressing, while China has not changed its official position on Taiwan. Beijing’s reunification timetable still has a comfortable 30 years to go. The Chinese economy has not collapsed, so there is no immediate need for Beijing to dive headlong into a nationalist foreign policy adventure that could bring on World War III. However, the odds of diplomatic incidents, or military saber rattling, that then trigger a dangerous escalation and a multi-month period of extremely elevated tensions are much higher than the market recognizes. This is because the U.S. and China may still see strategic tensions flare even if they make progress on a trade deal, while a failure on the trade front could spark a spillover into strategic areas. Any cross-strait incident would be relevant to global investors – and not just Taiwanese assets, which would suffer the brunt of economic sanctions – because the slightest increase in the odds of a full-scale war would be extremely negative for global risk appetite. Over the next 12 months, we would mostly expect Beijing to eschew high-profile provocations. The reason is that President Tsai is unpopular and the recent local elections in Taiwan saw her DPP lose seats to the more China-friendly Kuomintang (Chart 8). An aggressive posture could revive the DPP ahead of the January 2020 presidential election, the opposite of what Beijing wants.7 Chart 8 On the other hand, Beijing could decide to ignore the 1996 precedent and choose outright military intimidation. Or it could attempt to meddle in Taiwan’s domestic politics, as it has been accused of doing in the recent local elections.8 Meanwhile, the U.S. and Taiwan are the more likely instigators of an incident over these 12 months, knowingly or not. Washington and Taipei have a window of opportunity to achieve a few concrete objectives while Presidents Tsai and Trump are still in office – which cannot be guaranteed after 2020. A similar window of opportunity caused a market-relevant spike in China-South Korea tensions back in 2015-17, when the United States, seeing that the right-wing Park Geun-hye administration was falling out of power, attempted to rush through the deployment of the Terminal High Altitude Area Defense (THAAD) missile system in South Korea. As a result, China imposed economic sanctions on its neighbor (Chart 9). Chart 9China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Something similar could transpire over the next year if the U.S. sends a high-level official – say, Bolton, or Secretary of State Mike Pompeo, or even Vice President Mike Pence – to hold talks in Taiwan. Or if the U.S. stages a major show of force in the Taiwan Strait, as it threatened in October, or U.S. naval vessels call on Taiwanese ports. The U.S. could also announce bigger or better arms packages (Chart 10), such as submarine systems, which have been cleared by the Department of State. Given the elevated U.S.-China and China-Taiwan tensions overall, such an incident could cause a bigger escalation than the different participants expect – and even more so than the market currently expects. Chart 10U.S. Arms Sales To Taiwan Could Provoke Beijing U.S. Arms Sales To Taiwan Could Provoke Beijing U.S. Arms Sales To Taiwan Could Provoke Beijing Bottom Line: Cyclically, the period between now and the inauguration of the next Taiwanese president in May 2020 brings heightened risk of a geopolitical incident. Depending on what happens in 2020, tensions could rise or fall for a time. Yet structurally, as Sino-American strategic distrust continues to build, Taiwan will continually find itself at the center of the storm. Black Swan 2: Russia And Ukraine Agree To Go To War Tensions are mounting between Russia and Ukraine in the run-up to the March 31 Ukrainian presidential election. Incumbent President, Petro Poroshenko, has been trailing in the polls for a year. His rival is the populist Yulia Tymoshenko, who has been leading both first-round and second-round polling. Both Poroshenko and Tymoshenko have, at various points in their careers, been accused of being pro-Russian. Poroshenko’s business interests, as with most successful Ukrainian businesspeople, include considerable holdings in Russia. Tymoshenko, on the other hand, was imprisoned from 2011 to 2014 for negotiating a gas imports contract with Russia that allegedly hurt Ukrainian interests. With the most pro-Russian parts of Ukraine either cleaved off (Crimea) or in a state of lawlessness (Donetsk and Luhansk), the median voter in the country has become considerably more nationalist and anti-Russian. It therefore serves no purpose for any politician to campaign on a platform of normalizing relations with Moscow. In this context, the decision by the Patriarchate of Constantinople – the first-among-equals of the Christian Orthodox churches – to grant autocephaly (sovereignty) to the Orthodox Church of Ukraine in January is part of the ongoing evolution of Ukraine into an independent entity from Russia. This process could create tensions, particularly as parts of the country continue to be engaged in military conflict (Map 1). From Moscow’s perspective, the autocephaly grants Ukraine religious – and therefore some semblance of cultural – independence from Russia. This solidifies the loss of a 43-million person crown jewel from the Russian sphere of influence. Chart Moscow is also not averse to stoking tensions. Although President Putin’s mandate will last until 2024, his popularity is nearly at the lowest level this decade. Orthodox monetary and fiscal policy, along with pension reforms, have sapped his political capital at home. In 2014, tensions over Ukraine spurred nationalist sentiment in Russia, rapidly increased popular support for both Putin and his government (Chart 11). Putin may calculate that another such recapitalization may be needed. Chart 11Non-Negligible Risk Of Russian Aggression Non-Negligible Risk Of Russian Aggression Non-Negligible Risk Of Russian Aggression The danger is therefore that domestic politics in both Ukraine and Russia may create a window of opportunity for a skirmish this quarter. Perhaps something akin to the naval tensions around the Kerch Strait that ultimately cost President Putin a summit with President Trump at the G20 meeting in December. While these incidents may benefit both sides domestically, and may even appear carefully orchestrated, they could also get out of hand in unpredictable ways. Bottom Line: While both Kiev and Russia may see a short-termed conflict as domestically beneficial, such an outcome could have unforeseen consequences. At the very least, it could sap already poor business confidence in neighboring Europe, as it did in 2014-2015. Black Swan 3: Saudi Arabia With A Blank Cheque One of the greatest geopolitical blunders of the twentieth century was Berlin’s decision to give its ally Austro-Hungary a “blank cheque.” Austro-Hungary was an anachronism at the turn of the century – a multiethnic empire held together by allegiance to a royal family. As such, the ideology of nationalism represented an existential threat, particularly given that 60% of the empire’s population was neither Austrian nor Hungarian. Following the assassination of its crown prince Archduke Franz Ferdinand by a pan-Slavist terrorist in Sarajevo, Vienna decided that a total destruction of Serbia was necessary for geopolitical and domestic political reasons. Today, Saudi Arabia is in many ways an anachronism itself. It is the world’s last feudal monarchy. Its leaders understand the risks and have begun an ambitious and multifaceted reform effort. Unlike Austro-Hungary, Saudi Arabia has learned to embrace nationalism. Riyadh is using the war in Yemen, as well as targeted actions against its own royal family and the religious establishment, to build a modern nation-state. The problem is that, much as nationalism was an ideological kryptonite for Vienna, democratic Islamism is an existential problem for Riyadh and its peers among the Gulf monarchies. Neighboring Qatar, a tiny peninsular kingdom enjoying an oversized geopolitical influence due to its natural gas wealth, has supported various groups across the Middle East that believe that democracy and conservative Islam are compatible. Turkey and Qatar have often cooperated in this effort, as the ruling Justice and Development Party (AKP) of Turkey has served as a model for many such Islamist parties in the region. Why Qatar hitched its geopolitical wagon to democratic Islamism is not clear. Perhaps its leaders felt that it was the only option unclaimed by an energy-rich sponsor. Regardless, Qatar’s support of the Muslim Brotherhood and other such groups has clearly irked Saudi Arabia and other Gulf monarchies, enough for them to kick Qatar out of the Gulf Cooperation Council (GCC). In 2017, with the pro-Saudi Trump administration ascendant in the White House, Riyadh felt emboldened enough to break off all diplomatic relations with Qatar and impose an economic blockade. Since 2014, another dynamic has emerged in the region that raises further concerns: a scramble for material resources brought on by the end of +$100 per barrel oil prices. Saudi public expenditures have been steadily rising since 2008, both due to population growth, social welfare spending in the wake of Arab Spring rebellions, and astronomical defense spending to counter the rising influence of Iran. And yet, 2014 saw oil prices plunge to decade lows in a matter of months. Saudi Arabia’s fiscal breakeven oil price has doubled, in a decade, from under $40 per barrel to $83 per barrel in 2018 (Chart 12). Meanwhile, Qatar’s GDP is a quarter of that of Saudi Arabia, even though its population is less than 2% of Saudi Arabia’s. Chart 12Saudi Arabia Has A Fiscal Problem Saudi Arabia Has A Fiscal Problem Saudi Arabia Has A Fiscal Problem Rumors that the U.S. Defense Secretary James Mattis prevented a Saudi invasion of Qatar in 2018 have largely been dismissed by the mainstream media. But should they be? If allegedly “rogue elements” of the Saudi intelligence establishment can dismember a journalist in a consulate, why couldn’t “rogue elements” of its military stage a coup – or an outright invasion – in neighboring Qatar? Such an outcome would truly be extraordinary, but so was the annexation of Crimea in 2014. Meanwhile, President Trump offered an extraordinary level of support for Riyadh by issuing what we can only refer to as a “blank cheque” following Khashoggi’s murder. In the November 20 statement, President Trump essentially created a new policy doctrine of standing with Saudi Arabia “no matter what.”9 Two weeks later, Riyadh “thanked” the U.S. President by slashing the OPEC oil output by 1.2 million barrels per day. From this dynamic, it appears that Washington has made a similar strategic blunder in 2018 that Berlin did in 1914. A weakened, stressed, and threatened ally has been given a “blank cheque” by its stronger ally. Such a sweeping offer of support may lead to unintended consequences as the weaker ally feels that its material and geopolitical constraints can be overcome. In Saudi Arabia’s case, that could mean a more aggressive policy towards Qatar, or perhaps Iran. Particularly now that the White House has seen several realist members of the Trump cabinet – such as Mattis and former Secretary of State Rex Tillerson – replaced by Iran hawks and Trump loyalists. Bottom Line: A combination of less independent-minded cabinet members in the White House and a clear “blank cheque” from President Trump to Saudi Arabia could cause geopolitical risk to re-emerge in the Middle East. In the near term, this could increase the geopolitical risk premium on oil prices – as measured by the residual in Chart 13. Chart 13 Black Swan 4: The Balkans Become A Powder Keg … Again Bismarck famously said in 1888 – 26 years before the outbreak of the Great War, that “one day the great European War will come out of some damned foolish thing in the Balkans.” The Balkans are far less geopolitically relevant today than in the early twentieth century. They are also exhausted following a decade-long Yugoslav rigor mortis in the 1990s which yielded at least three regional wars and now six (or seven, depending who is counting) independent states. The problem is that tensions have not disappeared. Two frozen conflicts remain. First, Bosnia and Herzegovina is a sovereign country made up of two political entities, with the Serb-dominated Republika Srpska agitating for independence and aligning with Russia. Second, tensions between Serbia and Kosovo took a turn for the worse late last year as Kosovo imposed an economic embargo on trade with Serbia and called for the creation of a military. Has anything really changed over the course of the decade? We think there are three causes for alarm: Tensions between Russia and the West have become serious, with both camps looking to score tactical and strategic wins across the globe. With the Syrian Civil War all but over, a new battleground may emerge. While Republika Srpska is essentially an outright ally of Russia, Serbia continues to try to straddle the fine line between an EU enlargement candidate and geopolitical neutrality. However, this high-wire act is becoming untenable as… Enlargement fatigue sets in the EU. There is no doubt that the EU enlargement process froze Balkan conflicts. Countries like Serbia and Kosovo have an incentive to be on their best behavior so long as the prospect of eventual EU membership remains. But in the current environment of introspection, the EU may not have enough of a coherent geopolitical vision to deal with the Balkans without a crisis. The global economic cycle may be ending, leading to a global recession in the next 12-to-24 months. While our BCA House View remains that the next recession will be a mild one in the U.S., we think that EM and, by extension, frontier markets could be the eye of the storm in the next downturn. As investors abandon their “search for yield” in riskier geographies, they could exacerbate poor governance, political tensions, and geopolitical cleavages that have been frozen in place by the last economic cycle. Finally, U.S. policy towards the Balkans is unclear. In the past, the U.S. asked all countries in the region to accept the status quo and prepare for EU integration. But with the U.S. now adopting an antagonistic view towards the EU bloc, it is unclear what Washington’s message to the Balkans will be. After all, Trump has personally encouraged all other world leaders to don their own version of the “America First” slogan. The only problem in a place like the Balkans is that “Serbia first” – or Croatia and Kosovo first – is unlikely to go down smoothly in the neighborhood, given the last twenty – or even hundred – years. Bottom Line: The powder keg that is the Balkans has not been dried for decades. However, several tailwinds of stability are gone, replaced with macro headwinds. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. If this were to occur, we would bank on greater European integration, especially in terms of military and foreign policy. However, it could also mark the first break in U.S.-EU foreign policy if the two decide to pick opposing sides in the region. Black Swan 5: Lame Duck Trump For our final Black Swan, we are sticking with one of our 2018 choices: a “Lame duck” presidency. “Lame duck” presidents – leaders whose popularity late in their terms have sunk so low that they can no longer affect policy – are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.10 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents can seek relevance abroad. President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains strong (Chart 14), his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 15). Now there is also a Democrat-led House of Representatives to stymie his domestic policy and launch independent investigations into both his administration’s conduct and his personal finances and dealings. Chart 14 Chart 15 We would also add the Senate to the list of problems for President Trump. The electoral math was friendly towards the Republicans in 2018, with Democrats defending 10 Senate seats in states that President Trump won in 2016. In 2020, however, two-thirds of the races will be for Republican-held seats. As such, many Republican senators may begin campaigning early by moving away from President Trump. What kind of adventures would we expect to see President Trump embark on in 2019? Last year, we identified “China-U.S. trade war,” “Iran jingoism,” and “North Korea” as potentials. In many ways, 2018 was the year when all three mattered. Going forward, however, we think that trade war and the Middle East might take a backseat. First, the bear market in equities has raised the odds of a recession. As such, the potential cost of pursuing the trade war further has been increased. So has an aggressive policy towards Iran that dramatically boosts oil prices. Furthermore, President Trump has signaled that he is willing to withdraw from the Middle East, calling for a full withdrawal from Syria and telegraphing one from Afghanistan. Instead, we see President Trump potentially following in the footsteps of previous U.S. administrations and finding relevance in Latin America. A military intervention in Venezuela, to ostensibly support a coup against the current regime, would find little opposition domestically. First, there is no doubt that Venezuela has become a genuine humanitarian disaster. Second, its oil output is on a downward spiral already, with only 1 million b/d of production at risk due to a potential military conflict (Chart 16). Third, the new Bolsonaro administration in Brazil may even support an intervention, as well as neighboring Colombia. This is a change from the last twenty years, in which Latin American countries largely stuck together, despite ideological differences, in opposition to U.S. interference in the continent’s domestic affairs. Chart 16On A Downward Spiral On A Downward Spiral On A Downward Spiral Finally, even the anti-Trump U.S. foreign policy establishment may support an intervention. Not only is there the issue of human suffering, but Russia and China have used Venezuela as an anchor to build out influence in America’s sphere of influence. Furthermore, the potential promise of Venezuela’s eventual energy production is another reason to consider an American intervention (Chart 17). Chart 17 Bottom Line: American presidents rarely decide to go softly into that good night. It is very difficult to see President Trump become irrelevant. With tensions with China carrying a high economic cost and military interventions in the Middle East remaining politically toxic in the wake of Iraq and Afghanistan wars, perhaps President Trump will decide to go “retro,” in the sense of a throwback Latin America intervention.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see, Blackstone, “Byron Wien Announces Ten Surprises For 2018,” dated January 2, 2018, available at blackstone.com. 2 A shoutout to another doyen of the financial industry, Alastair Newton! 3 Please see BCA Emerging Markets Strategy Special Report, “Deciphering Global Trade Linkages,” dated September 27, 2018, available at ems.bcaresearch.com. 4 Please see “Highlights of Xi’s speech at Taiwan message anniversary event,” China Daily, January 2, 2019, available at www.chinadaily.com.cn; and “President Tsai Issues Statement On China’s President Xi’s ‘Message To Compatriots In Taiwan,’” Office of the President, Republic of China (Taiwan), January 2, 2019, available at english.president.gov.tw. 5 Please see Xi Jinping, “Secure a Decisive Victory in Building a Moderately Prosperous Society in All Respects and Strive for the Great Success of Socialism with Chinese Characteristics for a New Era,” section 3.12, October 18, 2017, available at www.xinhuanet.com; and Deng Yuwen, “Is China Planning To Take Taiwan By Force In 2020?” South China Morning Post, July 20, 2018, available at beta.scmp.com. 6 Please see United States, H.R. 535, Taiwan Travel Act, 115th Congress (2017-18), available at www.congress.gov and S. 2736, Asia Reassurance Initiative Act of 2018, 115th Congress (2017-18), available at www.congress.gov. 7 This is precisely what occurred when China chose missile tests in 1995-96 and drove voters toward the very candidate, Lee Teng-hui, that Beijing least desired. The popular Taipei Mayor Ko Wen-je may run for president in 2020, and Beijing may see him as preferable to President Tsai. He has spoken of China and Taiwan as being part of the same family and he has held city-to-city talks between Shanghai and Taipei despite the shutdown in direct talks between Beijing and Taipei. 8 Please see Andrew Sharp, “Beijing likely meddled in Taiwan elections, US cybersecurity firm says,” Nikkei Asian Review, November 28, 2018, available at asia.nikkei.com. 9 Please see “Statement from President Donald J. Trump on Standing with Saudi Arabia,” The White House, dated November 20, 2018, available at whitehouse.org. 10 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him, while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the “surge” of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014.   Geopolitical Calendar

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Highlights So What? The bull market in defense stocks is global and only beginning. We construct a BCA Global Defense Index to give investors exposure to this theme. Why? Multipolarity will drive uncertainty and conflict, spurring arms demand to Cold War heights. Contemporary geopolitical hotspots require expensive and modern technology. Cold War-era weapon systems are long in the tooth and in need of replacement. Also... We close our long Energy / short S&P 500 portfolio hedge for a gain. Feature It is somewhat of a cliché to tell clients that one of our highest conviction calls is to be overweight defense stocks. We are, after all, geopolitical investment strategists! Our decision to go long S&P 500 aerospace and defense stocks / short MSCI ACW is up 14% since initiation in December 2016. In this report, we build on previous work focusing on U.S. defense stocks and expand our analysis to global plays. GPS' Mega-Theme: Multipolarity Is Good For War International affairs are characterized by an anarchic governance structure. In the absence of a global government, the vacuum of power is filled by powerful states. These states behave like bullies in the schoolyard. When a single, powerful bully dominates the lunch break, all other kids fall in line or suffer the bully's wrath. When two bullies split the yard into warring camps, proxy fights may emerge on the sidelines, but generally an equilibrium is preserved. Formal political science theory and history teach us that the further we are from a hegemonic global structure where one country (the hegemon) dominates and bullies all others, the closer we are to anarchy. The "offensive realism" school of International Relations theory further splits multipolarity into two types: Balanced multipolarity is characterized by a number of roughly equally powerful states, similar to the distribution of power of continental Europe during the "Concert of Europe" era in the nineteenth century. Unbalanced multipolarity is closest to contemporary geopolitics. In The Tragedy Of Great Power Politics, John Mearsheimer reviewed 200 years of European history and concluded that unbalanced multipolarity is by far the most volatile geopolitical system (Table 1).1 Table 1Global System Structure And War "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! A multipolar ordering of global power, therefore, produces the highest level of disorder (Chart 1). This finding is theoretically elegant, but normatively disturbing. Every country gets a voice and an opportunity to defend its sovereignty. But the international order is normatively ignorant and desires a bully or hegemon. Chart 1Multipolarity Produces Disorder Multipolarity Produces Disorder Multipolarity Produces Disorder Over the past fifty years, there have been three identifiable periods in the global arms market (Chart 2): Chart 2Further Upside In The 'War Bull Market' Further Upside In The 'War Bull Market' Further Upside In The 'War Bull Market' Cold War Arms Race - 1961-1982: The arms trade grew by a whopping 177% during this period, with an average annual growth rate of 5.5%; Disarmament - 1982-2002: Arms trade shrunk by 61% and average annual growth rate was -3.9%; Multipolarity - 2002-present: What started with the U.S. defense buildup following 9/11 has evolved into a truly global response to emerging multipolarity. The arms trade grew by 73% from 2002 to 2017, with an average annual growth rate of 3.4%. Bottom Line: In 2017, the total arms trade was 68% of its peak in 1982, signifying that we have more room to go in this recent "War Bull Market." Given that unbalanced multipolarity produces a higher volume of conflict than a bipolar system, we would expect the current phase to be more fruitful for the global arms race than even the Cold War era. The Pillars Of An Arms Bull Market Chart 3Global Defense Spending... Global Defense Spending... Global Defense Spending... In this report, we focus on the global arms trade, which is different from global defense spending (Chart 3). This is because global defense spending includes non-investible transactions, such as spending on salaries, buildings, health care, and pensions. The global arms trade was once 20% of global defense spending, but is now only 1.9% (Chart 4). Chart 4...Is Different From The Global Arms Trade ...Is Different From The Global Arms Trade ...Is Different From The Global Arms Trade The reason is that salaries and pensions now dominate defense budgets. In the U.S., they make up 42% of all expenditure. They are higher in much of the developed world (66% in Italy, for example). Moreover, many countries that in 1960 did not have an armaments industry have become quite adept at satisfying demand via domestic production. We nonetheless would expect the global arms trade to bounce off of its lows today. There are three main reasons. Evolving Conflict Zones: Asia And Europe The primary reason to expect a brisk pickup in the global arms race is that the global conflict zones are evolving. Multipolarity is causing shifting geopolitical equilibriums. We expect both East Asia and Europe - largely dormant as hotspots since the end of the Cold War - to catch up with the Middle East as zones of tensions. Periods of rising conflict tend to coincide with the rise in the global arms trade (Chart 5). Chart 5Rising Conflict Coincides With Escalating Arms Trade Rising Conflict Coincides With Escalating Arms Trade Rising Conflict Coincides With Escalating Arms Trade East Asia is our primary concern. Sino-American tensions have been brewing for decades, well before the trade war initiated by the Trump administration. Recently, the trade war has begun to spill into strategic areas (Table 2), creating a vicious feedback loop that could spark an accident or outright military conflict. Table 2Trade War Spills Into Strategic Areas "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! The South China Sea is the premier geographic location of U.S.-China strategic friction. It is a hub for international trade, a vital supply route for all major Asian economies, and the premier focus of China's attempt to rewrite global rules (Diagram 1). We update our list of clashes in this area in Appendix A. Diagram 1South China Sea As Traffic Roundabout "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! China has used its growing economic heft in the region to bully its neighbors into acquiescing to its geopolitical posture (Chart 6). It has used economic sanctions, trade boycotts, and tourism bans to get its way with the neighborhood. China's East Asia neighbors - including Japan - will look to balance their growing dependence on the Chinese economy with a desire to maintain sovereignty. One way to do so will be to rearm and present a formidable challenge to Beijing's regional hegemony. This means that not only the South China Sea but also China's entire periphery is at risk of friction, and this is true regardless of any U.S. interest in Asia. Chart 6China Uses Its Economic Might To Bully China Uses Its Economic Might To Bully China Uses Its Economic Might To Bully Europe is also growing as a potential source of global arms demand. Since the end of the Cold War, Europe has seen a decline in defense spending. One reason is the NATO alliance, which has allowed Europeans to pass the buck to the U.S. This has not only been the case with the safely cocooned Western European states. Poland, intimately familiar with the built-in geopolitical risks of its neighborhood, reduced its defense spending once it joined NATO. President Trump has made awakening Europe from its stupor a key pillar of his trans-Atlantic policy. A combination of Trump's pestering and concerns that the U.S. is trending towards isolationism with an evolving threat matrix that now includes terrorism, migration, and Russia should be enough to spur Europeans to meet their commitment to spend 2% of GDP on defense (Chart 7). Chart 7Europeans Will Be Swayed To Meet Defense Commitments... "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! If NATO member states and Japan were to respond to their evolving threats and commit to spending 2% of GDP on defense, the impact on global arms demand would be significant. The extra spending would be roughly $145 billion, a 14% increase from current levels (Chart 8). Chart 8...Raising Global Arms Demand "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! What about the Middle East? In the short term, we are concerned that President Trump's "maximum pressure" policy could lead to kinetic action against Iran. In the medium and long term, we expect some form of an equilibrium to emerge in the Middle East that would keep regional demand for weapons stable at current elevated levels. Saudi Arabia has been the primary importer of weapons, with 13% of total demand since 2002. Saudi purchases have accelerated as the U.S. has geopolitically deleveraged out of the region (Chart 9 and Chart 10). Chart 9As The U.S. Military Deleverages... As The U.S. Military Deleverages... As The U.S. Military Deleverages... Chart 10...The Saudi Arabian Military Leverages ...The Saudi Arabian Military Leverages ...The Saudi Arabian Military Leverages Evolving Technological Demands The U.S. invasion of Afghanistan and Iraq at the beginning of this century was probably the last large-scale mechanized conflict involving large formations of main battle tanks (MBT). The evolving threat matrixes in East Asia and Europe are likely to create a growing demand for naval, air superiority, and drone/autonomous technology. In East Asia, the two main risk theaters are the South and East China Seas. In Europe, the Mediterranean, the Baltic, and the Black Seas are increasingly becoming a risk vector due to the instability of North African and Middle East countries, as well as Russian assertiveness. This is good news for the arms industry as aircraft and ships are some of the most lucrative exports given the high level of technological sophistication that goes into developing them (Chart 11). A war fought in the trenches and jungles by soldiers and insurgents is unlikely to be very profitable, other than for small arms manufacturers. But tensions between sovereign nations across large distances and bodies of water will be highly lucrative for major defense manufacturers that specialize in anti-access/area-denial systems.2 Chart 11Aircraft And Ships Are Most Lucrative "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Furthermore, capital depreciation is advanced for the most sophisticated (and thus expensive) military technology that was introduced at the tail-end of the Cold War expansionary phase. The U.S. aircraft carrier fleet, for example, is mostly made up of Nimitz-class carriers, which have served for the past 43 years on average (Chart 12). Chart 12Capital Depreciation Is Advanced "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Our back-of-the-envelope calculations show that the cyclicality in U.S. aircraft carriers is apparent across the major defense systems. Looking at 40 countries and their respective aircraft and MBTs, the bulk of these weapons is beyond the average age of the previous generation when it was retired (Chart 13). Part of the reason for the extended life cycle is better technology, but we suspect the main reason is that these major weapon systems were developed at the height of the Cold War and have not been updated since then. Chart 13Weapons Are Beyond Retirement Age, Need Updating "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Population Aging The demographic trends of population aging and low birth rates have wide-ranging macroeconomic implications. But they will also impact the defense industry by encouraging automation. There are benefits to automation in the military sphere beyond simply replacing a shrinking pool of able-bodied youth. First, the likely geopolitical hotspots of this century - East Asian seas, the Persian Gulf, the Black Sea, the Mediterranean, and the Indian Ocean - are conducive to high-tech warfare. These bodies of water will be patrolled by drones and plied by autonomous surface vessels while hypersonic missiles deny access to the enemy. Second, by shifting the burden of fighting wars from humans to robots, policymakers will face lower constraints to conflict. This development will not only encourage policymakers to develop autonomous weapon systems, but might also increase the frequency with which they are used, destroyed, and thus re-ordered, shortening the hardware life-cycle and thus increasing the sales volume. Bottom Line: Global multipolarity has seen the U.S. geopolitically deleverage from the Middle East, threaten Europe with abandonment, and put pressure on China in East Asia. These are trends that we believe are here to stay irrespective of President Trump's success or failure in the 2020 election. They are all bullish for defense spending and arms trade. In addition, evolving technological demands and global demographic trends will buoy the arms trade. We expect this era of unbalanced multipolarity to be even more lucrative for global defense contractors. The U.S.: Remain Overweight Anastasios Avgeriou, BCA's chief U.S. equity strategist, recommends that investors remain overweight the pure-play BCA defense index and add exposure to it on any meaningful pullbacks while keeping it as a structural overweight within the GICS1 S&P industrials index. In the U.S., defense spending and investment have bottomed and will continue to accelerate. The Congressional Budget Office (CBO) continues to project that defense outlays will jump further next year (middle panel, Chart 14). We expect that this breakneck pace is actually sustainable, mainly because any fiscal compromise with Democrats on discretionary, non-defense spending would require acquiescence on GOP spending priorities, such as defense. Defense outlays will therefore continue to expand into the 2020s. Chart 14Upbeat Defense Outlays... Upbeat Defense Outlays... Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs and represents a boost to defense equity revenue growth prospects. Defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 15). Chart 15...And A Flurry Of M&A Is A Boon For Defense ...And A Flurry Of M&A Is A Boon For Defense ...And A Flurry Of M&A Is A Boon For Defense A closer look at operating metrics corroborates the view that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 16). Chart 16Firming Operating Metrics Firming Operating Metrics Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20% annually, or twice as fast as overall capex (Chart 17). Defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 18). Chart 17Industry Is Not Standing Still Industry Is Not Standing Still Industry Is Not Standing Still Chart 18Healthy Balance Sheet With High ROE... Healthy Balance Sheet With High ROE... Healthy Balance Sheet With High ROE... Valuations are on the expensive side and in overshoot territory (Chart 19). This is clearly a risk to the overall view. However, if our structural thesis pans out, then defense stocks in the U.S. will grow into their pricey valuations as happened in the back half of the 1960s. Chart 19...But Valuations Are Expensive ...But Valuations Are Expensive ...But Valuations Are Expensive Bottom Line: The secular advance in pure-play defense stocks remains in place. BCA's U.S. Equity Strategy recommends an above-benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLC, NOC, GD, and RTN. Global Stocks: Be Discerning Beyond the U.S., which global defense stocks are appealing? We believe that there are several market and structural factors to consider. We have ranked national defense sectors by market and structural factors in Tables 3 and 4. Further, Appendix B lists all the non-U.S. weapon manufacturers that we examined, as well as market performance by country. Table 3Russian Defense Sector Attractive On Market Factors "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Table 4European Companies Rank Highly On Structural Factors "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Momentum - We like stocks from equity markets that have momentum behind them, i.e. whose stock are above their 200-day moving average. Relative valuation - We like defense sectors that are at a discount relative to the U.S. plays. Performance since Trump - For any country that has outperformed the U.S. aerospace and defense sector since the inauguration of President Trump on January 20, the market believes in its competitiveness vis-à-vis the largest exporter. Geographical diversity - We have ranked country defense sectors by how diverse their sources of revenue are. The higher the figure, the more geographically diverse the revenue pool. Russian and Indian defense plays score very low on this variable as they depend solely on one source: themselves. Exposure to arms trade - We have ranked country defense sectors by how exposed their contractors are to defense as opposed to civilian production. Most companies have major civilian outlays. To fully capture our multipolarity theme, we have ranked companies based on how fully focused they are on producing and selling weapons. Share of global arms market - We recommend that clients buy defense companies in countries that already have a high share of the global arms market. Decisions on purchasing weapons often involve path dependency due to the need to acquire compatible systems. Defense spending - We penalize countries that are already spending 2% of GDP on defense. Their companies will see little boost to domestic demand. It is the other, under-spending countries that will significantly increase their outlays over the next decade. Russian companies score high on market factors. They have good momentum, are attractively valued relative to the U.S. aerospace and defense sector, and are structurally supported. Israel, Canada, Australia, and Brazil are also attractive. All of these are made up of only one stock. On structural factors alone, we like German, British, Italian, and Swedish defense companies. They are geographically diversified, have a respectable share of the global arms trade, and have both reason and room to increase domestic spending. French companies are also structurally attractive, although France may have less need to increase defense outlays. Putting it all together, we are creating a BCA Global Defense Basket. We would include the following global tickers in that basket: A:ASBX, F:AIRS, F:CSF, F:SGM, F:AM@F, C:CAE, D:RHM, D:TKA, I:LDO, I:FCTI, ULE, COB and W:SAAB. Clients may want to include in the basket the five U.S. tickers recommended by BCA's U.S. Equity Strategy: LMT, LLL, NOC, GD, and RTN. We recommend that investors buy this basket, in absolute terms, as a structural investment. Housekeeping We are closing two of our hedges today. First, we are closing long Brent / Short S&P 500 for a gain of 6% and our long U.S. energy / short U.S. information technology for a loss of 1.63%. We initiated the two tactical trades on October 3, which means we timed the market correction perfectly. However, concerns over a supply glut in the oil market meant that the "long" part of our trade did not work out. Furthermore, there have been leaks from the White House to the media that the U.S. may award exceptions to the oil embargo to several critical importers. This would suggest that the Trump administration is beginning to see the risks of its aggressive maximum pressure strategy toward Iran and therefore may be trying to backtrack from it. We still think that the odds of an oil spike due to geopolitics in 2019 are high, but they do appear to be declining, at least for the time being. As such, we are closing the two trades for a net gain. We will continue to monitor the Iran embargo carefully as we expect that geopolitical risks will again be understated in the future, offering investors another opportunity to be long energy. Jesse Anak Kuri, Consulting Editor jesse.anakkuri@mail.mcgill.ca 1 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: W.W. Norton & Company, 2001). 2 Anti-access/area-denial (A2/AD) is a strategy of preventing an adversary from occupying or transiting a geographic area. Defense systems that perform A2/AD functions in the modern era tend to be expensive and technologically sophisticated. They include anti-ship missiles, sophisticated radars, attack submarines, and air-superiority fighter jets. Appendix A Notable Clashes In The South China Sea (2010-18) "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Notable Clashes In The South China Sea (2010-18) (Continued) "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Notable Clashes In The South China Sea (2010-18) (Continued) "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Appendix B Appendix B Chart 20British Defense Stocks British Defense Stocks British Defense Stocks Appendix B Chart 21French Defense Stocks French Defense Stocks French Defense Stocks Appendix B Chart 22German Defense Stocks German Defense Stocks German Defense Stocks Appendix B Chart 23Italian Defense Stocks Italian Defense Stocks Italian Defense Stocks Appendix B Chart 24Swedish Defense Stocks Swedish Defense Stocks Swedish Defense Stocks Appendix B Chart 25Norwegian Defense Stocks Norwegian Defense Stocks Norwegian Defense Stocks Appendix B Chart 26Canadian Defense Stocks Canadian Defense Stocks Canadian Defense Stocks Appendix B Chart 27Australian Defense Stocks Australian Defense Stocks Australian Defense Stocks Appendix B Chart 28Korean Defense Stocks Korean Defense Stocks Korean Defense Stocks Appendix B Chart 29Japanese Defense Stocks Japanese Defense Stocks Japanese Defense Stocks Appendix B Chart 30Singaporean Defense Stocks Singaporean Defense Stocks Singaporean Defense Stocks Appendix B Chart 31Israeli Defense Stocks Israeli Defense Stocks Israeli Defense Stocks Appendix B Chart 32Russian Defense Stocks Russian Defense Stocks Russian Defense Stocks Appendix B Chart 33Brazilian Defense Stocks Brazilian Defense Stocks Brazilian Defense Stocks Appendix B Chart 34Indian Defense Stocks Indian Defense Stocks Indian Defense Stocks Appendix B Chart 35Turkish Defense Stocks Turkish Defense Stocks Turkish Defense Stocks Appendix B Table 1Key Aerospace And Defense Companies "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! Appendix B Table 1Key Aerospace And Defense Companies, Continued "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks! "War! What Is It Good For? - Absolutely Noth...." Actually, Global Defense Stocks!

Highlights So What? More downside to CNY/USD ahead. Why? The trade war is spilling into political and military arenas, making it harder to de-escalate and negotiate a trade deal. Official U.S. and Chinese rhetoric is increasingly antagonistic, reflecting once-in-a-generation policy shifts toward a new Cold War. Tensions will not subside after the U.S. midterm election - neither the U.S.-Mexico-Canada agreement nor any quick deals with Japan and the EU will speed up U.S.-China negotiations. Feature Clients know that BCA's Geopolitical Strategy has been alarmist on U.S.-China relations since we started as a service in 2012.1 This structural view is based on the long-term decline of U.S. power relative to China and the emergence of global multipolarity.2 However, the rise of General Secretary Xi Jinping in 2012 and President Donald Trump in 2016 have reinforced our view that "Sino-American conflict is more likely than you think."3 This includes military as well as economic conflict. Setting aside the risk of war, a geopolitical "incident" of some kind is becoming increasingly likely. As the two sides engage in brinkmanship, the probability of a miscalculation or provocation rises, and the probability of a grand new compromise falls. For investors, the takeaway is supportive of Geopolitical Strategy's current stance: long U.S. dollar, long U.S. stocks relative to DM, and long DM stocks relative to EM. We expect CNY/USD to fall further as markets question the ability to discount trade uncertainties via tariff rates alone (Chart 1). We continue to recommend a "safe haven" hedge of Swiss bonds and gold. Chart 1CNY/USD Has More Downside CNY/USD Has More Downside CNY/USD Has More Downside The risk is that China could respond to U.S. pressure by stimulating its economy aggressively. So far, the "China Play Index," devised by our Foreign Exchange Strategy, does not signal reflation. Nor do Chinese domestic infrastructure stocks relative to global, which our China Investment Strategy watches closely (Chart 2). Chart 2Small Stimulus Thus Far Small Stimulus Thus Far Small Stimulus Thus Far Trade Tensions Are Spilling Over A corollary of our view that U.S.-China tensions are secular and strategic in nature - i.e., not limited to the U.S. trade deficit - is the view that trade tensions will spill over into strategic areas, exacerbating those tensions and generating negative outcomes for investors exposed to the U.S.-China economic partnership.4 This strategic spillover is now taking shape. Since President Trump went forward with the second round of tariffs - 10% on $200 billion worth of imports, to ratchet up to 25% on January 1, 2019 - a series of negative events have taken place in U.S.-China relations (Table 1), culminating in the USS Decatur incident on September 30. Table 1Trade War Spills Into Strategic Areas A Global Show Of Force? A Global Show Of Force? The Decatur, an Arleigh Burke-class guided-missile destroyer, was conducting operations in the Spratly Islands in the South China Sea when it sailed within 12 nautical miles of Gaven and Johnson Reefs, which China claims as sovereign islands. At around 8:30am that Sunday morning, a Luyang-class destroyer from China's People's Liberation Army Navy "approached within 45 yards of Decatur's bow, after which Decatur maneuvered to prevent a collision," according to the U.S. Pacific Fleet spokesman. This was not an unprecedented incident in itself, but it came very close to a collision that could easily have resulted in a shipwreck, a full-blown U.S.-China crisis, and a global risk-off event in financial markets. The Decatur sailed close to the Chinese-claimed reefs because it was conducting a "Freedom of Navigation Operation" (FONOP) to assert the international right of free passage. A major point of contention between China and the U.S. (and between China and most of its neighbors and the western world) is that China claims outright sovereignty over about 80% of the South China Sea, including the Spratly Islands. In July 2016, the International Court of Arbitration ruled that none of the contested rocks and reefs in the sea qualify as islands and hence that they are not entitled to 12 nautical miles of "territorial" sea. China rejects this ruling and asserts sovereignty over the maritime features and much of the sea itself.5 In Diagram 1 we illustrate how a FONOP works based on a similar operation last year. The U.S. has conducted these operations for decades, but in late 2015 it began a series of FONOPs focusing on countering China's excessive claims in the South China Sea.6 This was also a way of opposing China's construction, reclamation, and "militarization" of the reefs under its possession. Diagram 1What Is A 'Freedom Of Navigation Operation'? A Global Show Of Force? A Global Show Of Force? It is not remotely a surprise that this year's trade tensions came close to exploding in the South China Sea. It is the premier geographic location of U.S.-China strategic friction: a hub for international trade; a vital supply route for all major Asian economies; and the primary focus of China's attempt to rewrite global rules (Diagram 2).7 The Appendix updates our list of clashes in this area. Diagram 2South China Sea As Traffic Roundabout A Global Show Of Force? A Global Show Of Force? The takeaway is that, far from capitulating to the Trump administration's trade demands, China is taking a more aggressive stance - and it is doing so outside the trade context. The U.S., for its part, has not diminished the significance of this incident, as it has often done on similar occasions.8 Instead, Vice President Mike Pence gave a remarkable speech at the Hudson Institute on October 4 in which he highlighted the Decatur, among a range of other "predatory" Chinese state-backed actions, to make a comprehensive case that China is a geopolitical rival seeking to undermine the United States and specifically the Trump administration.9 Pence's comments reflect a decision to "go public" with a shift in national strategy that has been developing in recent years, beginning - albeit tepidly - even in the Obama administration. A similar shift is underway in China - and has accelerated with the U.S.'s implementation of tariffs. Official Communist Party rhetoric increasingly characterizes the U.S. as an enemy whose real intention is to "contain" China's rise and has recently called for Chinese "self-reliance" in the face of U.S. sanctions.10 The two sides are bracing for conflict and are now seeking to mold public opinion more actively. Bottom Line: Investors should take note: markets were 45 yards away from a significant correction! The U.S.-China trade tensions are spilling outside of economic relations into political and military domains, as we expected. The South China Sea remains a hot zone that could be the setting of a geopolitical incident as tensions mount. What Is A Show Of Force? Notably, the U.S. military is said to be considering a "global show of force" during an unspecified week in November in order to deter China from its current policy trajectory. If this occurs, it will be market-relevant as it will be seen as a provocation by China and other U.S. rivals. A "show of force" is a formal military operation conducted by a nation with the purpose of demonstrating that it has both the will and the ability to use force in defense of its interests. It is fundamentally a political action, even though it utilizes military resources. The declared intention is to demonstrate resolve and prevent or deter an undesirable course of action by a rival state.11 Nevertheless, it is the equivalent of a dog baring its teeth and should not be taken lightly, especially when conducted by one major power against another. The U.S. holds shows of force fairly frequently. Over recent decades it has been the third most common type of operation for U.S. forces.12 However, for most of the past several decades, the U.S. conducted very few operations in the Asia Pacific not pertaining to the Vietnam War, and these were usually of limited length and intensity. They were often shows of force to deter North Korea from various acts of terrorism and sabotage. China was rarely involved - there was, for example, no U.S. deployment during the Tiananmen crisis. Nevertheless there are a few highly relevant precedents: By far the most important exception is the Third Taiwan Strait Crisis in 1996. This was a major show of force - and one whose shadow still hangs over the Taiwan Strait. In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded on March 1, 1996 by deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz even sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and the show of force concluded after 48 days on April 17. Of course, tensions simmered for years afterwards. The Taiwan incident was the only operation involving China in the 1990s, and the first to do so since a minor contingency operation upon the Chinese invasion of Vietnam in 1979. It is generally deemed successful in demonstrating U.S. commitment to Taiwan's security - but it also spurred a revolution in Chinese military affairs, such that China is today in a far better position to attack Taiwan than ever before.13 The market effects were pronounced: Chinese and Taiwanese equities sold off. American stocks were unaffected (Chart 3). Chart 3Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets The second major exception was the Hainan Island Incident, or EP-3 Incident. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea. The U.S. plane landed on China's island province of Hainan, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. Ultimately the U.S. issued a half-hearted apology and the crew was released. This was a much smaller show of force than the third Taiwan crisis. The U.S. Navy positioned three destroyers in the area for two days. Chart 4A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market This incident marked the peak of the cycle in U.S. equities ex-tech (Chart 4). In China, both A-shares and H-shares experienced volatility before selling off in subsequent months (Chart 5, top panel). Chart 5Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force The Cheonan and Yeonpyeong Island incidents occasioned a show of force. On March 26, 2010 a North Korean miniature submarine conducted a surprise torpedo attack against the Cheonan, a South Korean Corvette, sinking it and killing 46 sailors. The U.S. intended to respond by positioning the USS George Washington in the Yellow Sea, but was intimidated from doing so by China's fiercely negative diplomatic reaction. Instead it deployed the carrier to the Sea of Japan. Later that year, however, after North Korea shelled Yeonpyeong Island and killed four South Koreans, the U.S. responded with a beefed up version of regular military drills, including the George Washington, for four days in the Yellow Sea. This incident is significant in showing how aggressively China will oppose demonstrations of American naval power in its near abroad. Unlike in 1996, China is today much better positioned to react to U.S. naval action in its neighborhood. If Beijing was so resistant to a U.S. show of force against North Korea in the wake of a North Korean attack, it will be even more resistant to a U.S. display of might in China's nearby waters aimed at China in response to what China views as a defense of maritime-territorial sovereignty. Chinese A-shares sold off, while H-shares were somewhat more resilient, during this episode (Chart 5, second panel). Fire and Fury: The United States' latest significant show of force occurred in 2017 when the navy positioned three aircraft carrier strike groups in the region to deter North Korean nuclear and missile tests and belligerent rhetoric against the United States. This action ultimately led to Chinese enforcement of sanctions and North Korean capitulation to U.S. demands. Chinese stocks only briefly sold off during this episode (Chart 5, third panel). However, the U.S. 10-year Treasury yield fell during the peak of tensions in the summer. So what about the global show of force that the U.S. is considering in November? Details on the specific operation under consideration are scant because they fall under a "classified proposal," written by members of the U.S. Navy's Pacific Command and only partially leaked to the press (apparently to coincide with Vice President Pence's speech).14 The proposal is still being discussed by the Joint Chiefs of Staff and the Intelligence Community, so nothing is final. From the information that is publicly available, it is highly significant that the proposed show of force is supposed to be "global" in range. It would reportedly involve a "series" of military missions on "several fronts," including the South China Sea, the Taiwan Strait, an unspecified area near Russia, and the west coast of South America. It would also involve multiple military services - the navy, the air force, the marines, and potentially cyber and space capabilities. While the various missions would reportedly be "concentrated" and "focused," implying that the U.S. wants to manage the escalation of tensions carefully, the locations that have been named are extremely sensitive. A show of force in the Taiwan Strait and South China Sea would be provocative enough. A simultaneous show of force against both China and Russia in today's context would be truly extraordinary.15 In short, if the report is accurate, the U.S. is contemplating a rare and provocative display of its global power projection capabilities. Why would the U.S. stage such a grand demonstration merely because of a taunt by a Chinese ship? The Decatur incident is only the proximate cause. Washington is in the midst of attempting a very dangerous "two-front war" against China and Iran, the latter of whom faces oil sanctions from November 4.16 Moreover, this is a "three-front war" if today's historically bad relations with Russia are taken into account. Indeed, the U.S. may well be responding to the joint show of force by Russian President Vladimir Putin and Chinese President Xi in their own large-scale military exercises in September, in which Chinese soldiers participated in a Russian drill outside the auspices of the Shanghai Cooperation Organization for the first time.17 As such, we would not put any stock in the idea that a sudden drop-off in geopolitical tensions, with China or anyone else, will occur after the U.S. midterm election on November 6. Rather, investors should expect an increase in geopolitical risk. There is no combination of midterm election results in which Trump will be forced to pull back on his "Maximum Pressure" doctrine. The proposal is not final, and the idea alone is a low-level threat that could be used in negotiations. But under the circumstances, we think it more likely than not that the U.S. will go forward with it. Ultimately, the U.S. proposal epitomizes our mega-theme of multipolarity. The U.S. is in relative decline and is reasserting itself with a muscular national security policy, particularly against China and Iran but also against Russia. However, its actions are highly unlikely to cause a change in China's behavior now that Beijing has determined that the U.S. is seeking Cold War-style strategic containment. Instead, China will hasten its efforts to become self-reliant and to deter U.S. aggression in its near abroad. Global economic policy uncertainty, and trade policy uncertainty, are likely to increase, not decrease, in such an environment. Saber-rattling and supply-chain risk will weigh on EM Asia in particular. Bottom Line: The U.S. government is contemplating an extraordinary "global show of force" that could involve a series of joint military operations across the globe. The chief focus is China, but the unknown array of operations could also target Russia or Iran. We think such operations are plausible and will increase global economic uncertainty. We would expect them to create volatility in global markets, adding to jitters over China tariffs (supply-chain risks) and Iranian sanctions (oil prices). How Will China Retaliate? China does not have the ability to respond proportionately to the U.S. - it cannot hold a global show of force of its own. Because its own shows of force will appear diminutive next to American fireworks, it may not react immediately. Beijing is more likely to respond by changing its policies to address the underlying increase in antagonism with the United States and improve its national security. We would classify its potential responses into two main groups: the low road and the high road. The low road consists of policies meant to confront the U.S. directly and forcefully. In our view, these policies bring significant costs that will make China reluctant to embrace them fully: Raise the stakes in the South China Sea: China could go for broke and deploy the full range of military assets in the islands that it has repurposed. This would provoke an even larger international naval response from the U.S. and its allies.18 Remove sanctions on North Korea: China could reverse sanctions enforcement on North Korea (Chart 6) and undermine President Trump's signature foreign policy overture. The problem is that China would then provide the U.S. with a pretext for an even greater military presence in Northeast Asia. Chart 6China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement Flout sanctions on Iran: China could subsidize Iran (Chart 7) in the hopes of helping to create a huge American distraction comparable to the second Iraq war. But this confrontation would threaten China with an oil shock and economic dislocation, an even greater conflict with the U.S., and the risk of regime change in Iran.19 Chart 7China Could Flout Iran Sanctions China Could Flout Iran Sanctions China Could Flout Iran Sanctions Punish U.S. companies: China could raise the pressure on U.S. companies doing business on its territory. The problem is that the U.S. has already demonstrated, through the ZTE affair this year, that it can inflict devastating reprisals against the tech champions on whom China's economic future depends (Chart 8). Chart 8U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms Thus China is most likely to take the "high road," i.e. seeking alternatives to the United States throughout the rest of the world: Chart 9China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage Import more goods: China's greatest strength in winning friends is that its domestic demand remains relatively robust (Chart 9). China can substitute away from the U.S. by shifting to other developed markets. Emerging markets are becoming more connected with China and less so with the U.S. (Chart 10). Chart 10China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. Maintain outward investment: China's outward investment profile is expanding rapidly (Chart 11), but there is potential for a negative political backlash - as has occurred in Malaysia.20 China will need to focus on improving relations with those countries where it expands investment, including in the Belt and Road Initiative (BRI).21 Chart 11China's Outward Investment Strategy: Priorities Over The Past Decade A Global Show Of Force? A Global Show Of Force? Court U.S. regional allies: Relations with South Korea have already improved; Shinzo Abe of Japan is soon to make a rare state visit to China; and trilateral trade talks between these three have revived for the first time since 2015 (Chart 12). Both the Philippines and Thailand currently have governments that are friendly to China. Beijing will need to ensure that its growing trade surpluses do not get out of whack. Chart 12Can China Court U.S. Allies? Can China Court U.S. Allies? Can China Court U.S. Allies? Sign multilateral trade pacts: China is trying to position itself as a leader of free trade. This is a tough sell, but a successful completion of negotiations on the Regional Comprehensive Economic Partnership (RCEP) will generate some momentum. This Asia Pacific trade grouping is far larger in terms of total imports than its more sophisticated rival, the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the latter being shorn of U.S. participation (Chart 13). Chart 13RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP Play nice in the South China Sea: Now that the U.S. is proposing to push back against Chinese militarization of the islands, it makes sense for China to take a conciliatory approach. It is proposing joint energy exploration with the Philippines and others at least as long as offshore activity is depressed (Chart 14). China might also try to settle a diplomatic "Code of Conduct" for the sea with its neighbors. Chart 14A Reason For China To Play Nice A Reason For China To Play Nice A Reason For China To Play Nice The most important consequence is an alliance with Russia, whether formal or not. The security agenda of these two powers is increasingly aligned with their robust economic partnership (Chart 15).22 The differences and distrust between them cannot override their need to guard themselves against a more assertive United States. Chart 15Embrace Of Dragon And Bear Embrace Of Dragon And Bear Embrace Of Dragon And Bear Bottom Line: China's "high road" strategies are its best options when more aggressive options have higher risks of undermining China's own long-term interests. But an alliance with Russia is quickly becoming inevitable. Investment Implications A global show of force targeting China's "core interests" in Taiwan and the South China Sea will make trade negotiations even more difficult. China is not going to offer concessions when facing U.S. military intimidation in addition to tariffs.23 Investors should watch closely for any signs that nationalist protests and boycotts of U.S. goods are developing in China. Such a movement would not be allowed to continue for long without the Communist Party condoning it. A boycott would mark a form of retaliation that is much more impactful than tariffs. A deterioration in cultural ties is also in the cards. The United States is reported to be considering restrictions on Chinese student visas after intelligence assessments of non-traditional technological and intellectual property theft via graduate students in advanced programs such as artificial intelligence and quantum computing.24 U.S. markets remain insulated today, as in the last big rupture in U.S.-China relations in 1989, so we continue to expect U.S. equities to outperform Chinese (and global) stocks amid trade tensions and saber-rattling. Chart 16Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... However, an important takeaway from the 1989 episode is that China stimulated the economy (Chart 16). This time we think stimulus will remain lackluster, reflecting Xi's need to keep overall leverage contained (Chart 17). But conflict escalation with the U.S. is clearly the biggest risk to this view. Chart 17...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far One oft-discussed retaliatory option is that China could sell off its vast $1.17 trillion holdings of U.S. treasuries. Rapidly dumping them is not effective, but slowly tapering is precisely what China has been doing since 2011 (Chart 18). This will accelerate its need to invest in real assets abroad and to purchase alternative reserve currencies, such as the euro, pound, and yen. Chart 18China Weans Itself Off Treasuries China Weans Itself Off Treasuries China Weans Itself Off Treasuries Ultimately, the significance of Vice President Pence's speech is that the U.S. now views China as both a great power and a threat to U.S. supremacy. This raises the potential for a large share of the $33 billion in cumulative U.S. direct investment in China since 2006 to become, effectively, stranded capital (Chart 19). If that is indeed the case, it would mean that investors in S&P 500 China-exposed companies would have to take note and re-rate their investments. Companies with significant investment in China may have to make capital investments in alternative supply-chain options, leading to a significant hit to their profit margin. Chart 19Stranded Capital In China? A Global Show Of Force? A Global Show Of Force? Other countries in Europe and the rest of Asia stand to benefit from the U.S. getting squeezed out of China's market, unless and until the new Cold War forces them to choose sides. Their choice is by no means a foregone conclusion, underscoring that China's policy response will be to seek better bonds with its neighbors and non-U.S. partners. Over the longer term, we think that our mega-theme of multipolarity will produce the bifurcation of capitalism. Within each sphere of influence globalization will continue to operate, but between spheres, or in the border areas, it will become a much less tidy affair. In addition to our recommendations above on page 2, we are reinitiating our short U.S. S&P 500 China-exposed stocks relative to the broad market. These companies have sold off heavily in recent months but the negative backdrop suggests that there is farther to go. Housekeeping On a separate note, BCA's Geopolitical Strategy is closing our long U.S. high-tax rate basket relative to S&P 500 trade for a gain of 8.26%. This was a play on the Trump tax cuts that we initiated in April 2017. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and "The Looming Conflict In The South China Sea," May 29, 2012, available at gps.bcaresearch.com. 8 Comparable incidents in December 2013, August 2014, May 2016, December 2016, August 2017, and March 2018 did not receive such a high-level response from U.S. leaders, reflecting both the seriousness of the Decatur incident and the administration's sense of political expediency amidst the trade conflict and midterm election cycle. 9 Pence criticized Chinese President Xi by name for allegedly breaking his word on the militarization of the Spratly Islands. He suggested that China's outward investment should be understood in strategic rather than economic terms, implying that the Belt and Road Initiative is a Soviet-style plan to organize a "bloc" of nations under Chinese hegemony. And he hinted at a new defense of the Monroe Doctrine in his criticism of China's recent assistance to the collapsing socialist regime in Venezuela. Please see the White House, "Remarks by Vice President Pence on the Administration's Policy Toward China," dated October 4, 2018, available at www.whitehouse.gov. 10 The Trump administration's key document is Secretary of Defense James Mattis, "Summary of the 2018 National Defense Strategy of the United States of America," Department of Defense, 2018, available at dod.defense.gov. For the Xi administration, see Orange Wang and Zhou Xin, "Xi Jinping says trade war pushes China to rely on itself and 'that's not a bad thing,'" South China Morning Post, dated September 26, 2018, available at www.scmp.com; and the Information Office of the State Council, "The Facts and China's Position on China-US Trade Friction," September 2018, available at www.chinadaily.com. 11 For this discussion of shows of force please see W. Eugene Cobble, H. H. Gaffney, and Dmitry Gorenburg, "For the Record: All U.S. Forces' Responses to Situations, 1970-2000 (with additions covering 2000-2003)," Center for Strategic Studies, May 2005, available at www.dtic.mil. 12 See footnote 11 above. 13 Please see William S. Murray, "Asymmetric Options for Taiwan's Defense," Testimony before the U.S.-China Economic and Security Review Commission, June 5, 2014, available at www.uscc.gov. 14 Please see Barbara Starr, "US Navy proposing major show of force to warn China," dated October 4, 2018, available at www.cnn.com. 15 Even the South American location implies that Chinese, Russian, and Iranian influence on that continent is now deemed meaningful enough to require a reassertion of the Monroe Doctrine. Over the past decade, the U.S. has tended to regard these activities as limited, but now that may be changing. 16 Please see BCA Geopolitical Strategy Special Report, "2019: The Geopolitical Recession?" dated October 3, 2018, available at gps.bcaresearch.com. 17 Please see "Russia Holds Massive War Games, As Putin And Xi Tout Ties," Radio Free Europe, Radio Liberty, September 11, 2018, available at www.rferl.org. 18 Australia, Japan, and the U.K. have already begun enforcing freedom of navigation alongside the U.S. 19 The U.S. could also impose secondary sanctions on China for non-compliance. State-owned energy firm Sinopec, for instance, was said to be reducing imports of crude from Iran by half in the month of September. Our Commodity & Energy Strategy notes that Chinese refiners, like other Asian refiners, are preparing to run more light-sweet crude from the U.S. in the future, which gives a good yield in high-value-added products like gasoline. So far China has not imposed retaliatory tariffs on these imports from the U.S. Please see Chen Aizhu and Florence Tan, "China's Sinopec halves Iran oil loadings under U.S. pressure: sources," Reuters, dated September 28, 2018, available at uk.reuters.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 21 Please see BCA Emerging Markets Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at ems.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, and "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 23 Xi Jinping's refusal to meet with Secretary of State Mike Pompeo over the past weekend, and decision to visit North Korea for the first time in his term, underscores this point. 24 Please see Demetri Sevastopulo and Tom Mitchell, "US considered ban on student visas for Chinese nationals," Financial Times, dated October 2, 2018, available at www.ft.com. Appendix Notable Clashes In The South China Sea (2010-18) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force?

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic