Commodities & Energy Sector

Highlights Stock markets begin 2020 with fragile short-term fractal structures, which means there is a two in three chance of a tactical reversal. The bond yield impulse is now a strong headwind, which reliably predicts that bond yields are not far from a near-term peak. The oil price tailwind impulse is fading. German and European growth will lose some momentum in the first and/or second quarters of 2020. Tactically underweight equities versus bonds. But on a longer-term horizon, the low level of bond yields justifies and underpins exponentially elevated equity market valuations. Markets Are Fractally Fragile Stock markets begin 2020 with fragile short-term fractal structures. In plain English, this means that usually cautious value investors have become momentum traders, and their buy orders have fuelled a strong short-term trend. But the danger is that when everybody becomes a momentum trader, liquidity evaporates and the market loses its stability. After all, when everybody agrees, who will take the other side of the trade without destabilising the price? When everybody becomes a momentum trader, liquidity evaporates and the market loses its stability.  When a fractal structure is fragile the tiniest of straws can break the camel’s back. But the straw is simply the catalyst for a potential market reversal. The straw could be, say, US/Iran geopolitical tensions escalating, or it could be something else, or there might be no straw needed at all. The underlying cause of the potential reversal is the market’s fragile fractal structure and its associated illiquidity and instability (Chart of the Week). Chart of the WeekStock Markets Are Fractally Fragile Investment presents no certainties, only probabilities. Successful investing is about identifying and playing those probabilities right. When the market’s fractal structure is at its limit of fragility, the probability that the short-term trend reverses by a third rises to two in three, while the probability that the short-term trend continues uninterrupted drops to one in three. Hence, a fractal warning of a reversal will be right two times out of three, but it will be wrong one time out of three. Still, we can accept being wrong one time out of three if it means we are right the other two times! For further details please revisit our recent Special Report ‘Fractals: The Competitive Advantage In Investing’.1 Translating all of this into current index levels, there is a two in three probability that over the next three months the Euro Stoxx 600 sees 405 before it sees 435. Across the Atlantic, there is a two in three probability that the S&P500 sees 3150 before it sees 3400 (Chart I-2). Nevertheless, a better tactical trade might be to play a short-term reversal in stocks in relative terms versus bonds. Chart I-2Stock Markets Are Fractally Fragile The Bond Yield Impulse Is Now A Strong Headwind A commonly held belief is that a decline in bond yields causes economic growth to accelerate. For example, we frequently hear bold claims such as: financial conditions have eased, so economic growth is likely to pick up. Unfortunately, the commonly held belief is wrong. What causes growth to accelerate or decelerate is not the change in financial conditions but rather the change in the change – the impulse. If the decline in the bond yield is the same in two successive periods, growth will not accelerate. For example, a 0.5 percent decline in the bond yield will trigger new borrowing through an increase in credit demand. The new borrowing will add to spending, meaning it will generate growth. But in the following period, all else being equal, a further 0.5 percent decline in the bond yield will generate the same additional new borrowing and thereby exactly the same growth rate. Therefore, what matters for a growth acceleration or deceleration is whether the bond yield change in the second period is greater or less than that in the first period. In other words, what matters is the bond yield impulse. A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth.  Now look at the actual numbers. The euro area 10-year bond yield stands at a lowly 0.45 percent and the 6-month change is a seemingly benign +0.2 percent. Nothing to worry about, right? Wrong. The crucial 6-month impulse equals a severe +1 percent, because the +0.2 percent rise in yields followed a sharp -0.8 percent drop in the preceding period (Chart I-3). A similar story holds in the US, where the bond yield 6-month impulse now equals +0.5 percent, the highest level in two years (Chart I-4). Chart I-3The Euro Area Bond Yield Impulse Is Now A Strong Headwind Chart I-4The US Bond Yield Impulse Is A Headwind Too A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth. Hence, through the past decade, this impulse level has reliably predicted that bond yields are not far from a near-term peak (Chart I-5). Combined with fractally fragile stock markets, there is a two in three chance that equities underperform bonds by about 4 percent on a three month tactical horizon. Chart I-5When The Bond Yield Impulse Is A Strong Headwind, Bond Yields Are Near A Local Peak Yet on a longer horizon, the low level of bond yields also provides comfort to equity investors by underpinning elevated valuations. At ultra-low yields, bonds become a risky ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. As bonds become riskier, the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds (Chart I-6). Meaning that the valuation of equities resets at an exponentially higher level. Chart I-6Ultra-Low Bond Yields Justify Ultra-Low Returns From Equities As long as bond yields stay near current levels, long-term investors should prefer equities over bonds. The Oil Price Tailwind Impulse Is Fading The preceding discussion on the bond yield impulse applies equally to how the oil price can catalyse growth accelerations and decelerations. For the impact on inflation, what matters is the oil price change. But for the impact on growth accelerations and decelerations what matters is the oil price impulse. The German economy is especially sensitive to the oil price impulse. The German economy is especially sensitive to the oil price impulse. This is because its decentralized ‘hub and spoke’ structure requires a lot of criss-crossing of road traffic that relies on imported oil. Hence, when the oil price falls it subtracts from imports and thereby adds to Germany’s net exports, and vice versa (Chart I-7). But just as for the bond yield, what matters for a growth acceleration or deceleration is whether the oil price change in a given 6-month period is greater or less than that in the preceding 6-month period. In other words, the evolution of the oil price 6-month impulse. Chart I-7The Oil Price Explains Swings In Germany's Net Exports Oscillations in the oil price 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with an uncanny precision. The first half of 2019 constituted a severe headwind impulse, because a 30 percent increase in the oil price followed a 40 percent decline in the previous period, equating to a severe headwind impulse of 70 percent.2 But as the oil price stabilized in the second half of 2019, this flipped into a tailwind impulse of 30 percent (Chart I-8). Chart I-8The Oil Price Tailwind Impulse Is Fading Allowing for typical lags of a few months, this severe headwind impulse followed by a tailwind impulse explains why Germany experienced a sharp slowdown in the middle of 2019 followed by a healthy rebound which continued through the fourth quarter (Chart I-9). Chart I-9The Oil Price Impulse Explains Oscillations In German Growth However, even without any escalation of US/Iran tensions, the oil price 6-month impulse is now fading. Combined with the headwind from the bond yield 6-month impulse it is highly likely that German and European growth will lose some momentum in the first and/or second quarters of 2020. Next week, we will explain what all of this means for sector, country, and regional equity allocation in the first half of 2020. Stay tuned. Fractal Trading System* To repeat the main theme of the week, all of the major stock markets are fractally fragile. Play this by going tactically short stocks versus bonds. Our preferred expression of this is short the S&P500 versus the 10-year T-bond. Set the profit target at 5 percent with a symmetrical stop-loss. Chart I-10EUROSTOXX 600 In other trades, short GBP/NOK achieved its 2.5 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent comprising 19.7 wins and 12.0 losses. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘Fractals: The Competitive Advantage In Investing’, October 10, 2019 available at eis.bcaresearch.com. 2 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields   Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The US and Iran are not rushing into a full-scale war for the moment – and yet the bull market in US-Iran tensions will continue for at least the next 2-3 years (Chart 1). This means that while global risk assets can take a breather from Iran geopolitical risk – if not other risks to the heady rally – the breather is not a fundamental resolution and Iran will remain market-relevant in 2020. A Reprieve … Chart 1Bull Market In US-Iran Tensions On January 8 President Donald Trump spoke at the White House in response to a barrage of missiles fired by the Iranian Revolutionary Guards Corps (IRGC) at bases with US troops in al-Asad and Erbil, Iraq. Trump remarked that Iran “appears to be standing down,” judging by the fact that the missile strikes did not kill American citizens – Trump’s explicit red line – or cause any significant casualties or damage. Iran’s Foreign Minister Javad Zarif claimed that Iran’s strikes “concluded proportionate measures” in response to the US killing of Quds Force chief Qassem Soleimani in Baghdad on January 3, which itself followed unrest at the US embassy in Baghdad and American strikes on Iran-backed Iraqi militias (Map 1). Supreme Leader Ayatollah Ali Khamenei gave ambivalent comments, saying military operations were not in themselves sufficient but that Iran must focus on removing the US presence from the region. Map 1US And Iran Sparring Across The Region President Trump’s speech was transparently a campaign speech, not a war speech. He did not imply in any way that the US military would retaliate to the missile strikes, but said Americans should be “grateful and happy” that Iran did a “good thing” for the world by refraining from drawing American blood. Instead Trump focused on Iran’s nuclear program, denouncing the 2015 nuclear deal with Iran (the Joint Comprehensive Plan of Action or JCPA). He implored the parties of that agreement – the UK, Germany, France, Russia, and China – to join him in negotiating a new deal to replace it. The goal of the new negotiations would be to prevent Iran from ever obtaining a nuclear weapon and to halt its sponsorship of regional militants in exchange for economic development and opening up to the outside world. He called for NATO to take a more active role in the Middle East and he highlighted the US’s shared interest with Iran in combating the Islamic State in Iraq and Syria. The takeaway is that the Trump administration is not pursuing regime change but rather nuclear non-proliferation and a change in Iran’s regional behavior. The administration has often said as much, but the assassination of Soleimani escalated tensions and called into question Trump’s intentions. Financial markets will cheer the successful reestablishment of US deterrence vis-à-vis Iran, as it makes Iran less likely to retaliate to US pressure in ways that lead to a major military confrontation. The near-term risk of a massive oil supply shock will decline. Oil prices have already fallen back to where they stood before Soleimani’s death. … Amid A Bull Market In US-Iran Tensions Yet the saga does not end here. Iran’s ineffectual military strike could have been a feint, or Iran could follow up with more consequential retaliation later. Chart 2US Strategic Deleveraging From The Middle East Iran has the ability to dial up its nuclear program step by step, sponsor regional attacks with plausible deniability, and foment regional unrest in important oil-producing countries. It can do these things in ways that do not clearly cross America’s red lines but still cause market-relevant tensions or disrupt oil supply. After all, Iran is still under punitive sanctions and desirous of demoralizing the US to hasten its departure from the region. So far Iran has not irreversibly abandoned its nuclear commitments or crossed any red lines regarding levels of uranium enrichment, but we fully expect it to threaten to do so and use its nuclear program to build up negotiating leverage. We doubt any serious US-Iran negotiations will take shape until 2021 at the earliest – and any negotiations could fail and lead to another, more serious round of military exchanges. This means that today’s reprieve may be tomorrow’s negative surprise for the markets. The fundamental basis for this bull market in US-Iran tensions is that the US is seeking to withdraw its strategic commitment to the region to counter China (Chart 2), yet Iran is filling the power vacuum and could conceivably create a regional empire (Map 2). President Trump will not want to appear to have been chased out of Iraq in an election year, even if he is in favor of strategic deleveraging, but Iran may try to do exactly that. Iran will also try to solidify its influence among those left exposed by the US’s deleveraging, namely in Iraq. Map 2Iran's Strategic 'Land Bridge' To The Mediterranean Chart 3A Succession Crisis Looms Moreover President Donald Trump’s withdrawal from the 2015 nuclear deal sowed deep distrust between the US and Iran and discredited the reformist faction in Tehran, which faces a tough election in February. This makes it difficult for the two countries to find a new equilibrium anytime soon. The Iranian regime is at a crossroads. It has a large and restless youth population (Chart 3), an economy under crippling sanctions, and faces a leadership succession in the coming years that brings enormous uncertainties about economic policy and regime survival. At the same time, President Trump is a historically unpopular president who is being impeached and believes that showing a strong hand against terrorism – under which the US classifies Iran’s Revolutionary Guard as well as the Islamic State – is an important key to being re-elected in November. Terrorism and immigration are in fact the two clearest issues that got him elected (Chart 4). Economic growth is a necessary but not sufficient condition for his reelection. US-Iran tensions will persist at least until the US election is settled and likely beyond. The result is a cyclical increase in tensions between the two countries that will persist at least until after the US election is settled. The Iranians are loathe to reward President Trump for his tactics – it would be better for Tehran if Washington changed parties again. After November, the US and Iran will recalibrate. Ultimately, in the coming years, either President Trump will get a new deal, or a new Democratic administration will reinitiate diplomacy to update the JCPA, or “maximum pressure” tactics will persist and increase the odds of a major military conflict. There is room for many negative surprises in this time frame as the US and Iran jockey for better positioning. The writing on the wall is that the United States is deleveraging and this creates a transition period in which regional instability will rise. Even within 2020 the current de-escalation could prove short-lived. The US president has enormous leeway in foreign policy and even the economic constraint is limited. The US economy is less oil intensive and less dependent on imports for its energy, while households have ample savings and spend less of their disposable income on energy. While this may ultimately serve as a basis for withdrawing from the Middle East, it also enables the US president to take greater risks in the region. Even within 2020 the current de-escalation could prove short-lived. The Iranians would have to create and maintain an oil supply shock the size of the September attack in Saudi Arabia for four months in order to ensure that American voters would feel the negative impact at the gas station by the time of the election. Chart 5 illustrates this point by simulating a 5.7 million barrel-per-day oil outage for different time periods. The chart overstates the impact on gasoline prices because it does not take into account the inevitable release of global strategic petroleum reserves. In other words, Trump may believe he has a sufficient buffer for the economy – and he clearly believes saber-rattling is worth the risk amid impeachment and election campaigning. Chart 4Trump Benefits From Fighting Iran-Backed Militants Chart 5Gasoline Price Cushion Could Embolden Trump   Investment Conclusions Chart 6Close Long EM Oil Producer Trade The past month’s events have reached a crisis point and are tentatively de-escalating. We are booking gains on our tactical long Brent crude trade and our long emerging market energy producers trade (Chart 6). We are not changing our constructive view on China stimulus, commodities, and the global business cycle. Following BCA Research’s commodity strategists, we recommend going long Brent crude H2 2020 versus H2 2021 on the expectation that production will remain constrained, inventories will fall, and prices will backwardate further. The underlying US-Iran conflict will persist and create volatility in oil markets in 2020 and beyond. We also remain on guard for ways in which the Iran dynamic could affect Trump’s reelection odds and hence US policy and the markets over the coming year.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com  

Overweight The S&P energy index is sitting at a multi-decade low that has also served as support for the relative share price ratio (top panel). Importantly, two key macro drivers argue that investors favor energy stocks rather than throw in the towel. First, the greenback has given up its 2019 gains and is currently sitting flat on year-over-year basis. BCA’s 2020 house view calls for a lower US dollar that should pump energy stocks higher (second panel, trade-weighted dollar shown inverted). Second, the divergence between crude oil and relative share prices is unsustainable and there are high odds that a catch up phase materializes in the latter (third panel). Moreover, our relative earnings growth model that aggregates all the key drivers for the sector also reveals that the multi-decade support should hold and serve as a springboard for energy stocks.  Besides the promising macro data, rising geopolitical risk-related premia in oil due to increasing Middle East tensions could serve as a catalyst to unlock excellent value in the S&P energy space. Bottom Line: We reiterate our overweight call on the S&P energy sector.  ​​​​​​​

Special Report

Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Chart 2B... An Existential Challenge     Chart 3US Conflict Distracts From Domestic Woes This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Chart 2B... An Existential Challenge     Chart 3US Conflict Distracts From Domestic Woes This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Feature Recommended Allocation Since BCA published its 2020 Outlook,1 and the December GAA Monthly Portfolio Update,2 nothing has happened to make us fundamentally change our views. We see the global manufacturing cycle rebounding over the coming quarters, but major central banks remaining dovish. This combination of accelerating growth and easy monetary policy should be positive for risk assets. We accordingly continue to recommend an overweight on equities versus bonds, prefer the more cyclical euro zone and EM equity markets over the US, and selectively like credit (particularly the riskier end of the US junk bond universe). In the 2020 Outlook, we laid out a series of milestones that would indicate how our scenario is playing out: whether we need to reconsider it, or whether we should be adding further to risk (Table 1). Here is how those milestones are progressing. Table 1Milestones For The 2020 Outlook Chinese growth. Total Social Financing picked up in November (CNY1.75 trillion versus CNY619 billion the previous month) and the most recent hard data (notably retail sales and industrial production) showed improvement. But the momentum of credit creation and activity generally remain weak (Chart 1). We expect that Chinese growth will begin to accelerate in early 2020, due to the lagged effect of monetary stimulus in the first half of last year, and easier fiscal policy. Moreover, December’s annual Central Economic Work Conference pointed to greater government emphasis on growth stability.3 The clampdown on shadow banking also seems to be easing (Chart 2). However, we need to see further signs of Chinese growth accelerating before, for example, we become more bullish on Emerging Markets and commodities. Chart 1Chinese Credit And Activity Remain Weak Chart 2Clampdown On Shadow Banking Easing? Trade war. The last-minute agreement to cancel the December 15 rise in US tariffs on Chinese imports represents the “ceasefire” we expected, rather than “phase one” of a more profound agreement. It is still unclear whether previous tariffs will be rolled back (Chart 3). China’s supposed promise to increase imports of US agricultural products from $10 billion a year to $40 billion-$50 billion seems unrealistic. Progress on more fundamental topics such as China’s subsidies for state-owned companies seems far off. For now, President Trump has done enough to minimize the negative impact on the US economy in an election year. But there remains a possibility that trade war reemerges as a risk during 2020. Chart 3How Far The Rollback? Progress against these milestones suggests that our current asset allocation recommendation structure – moderately risk-on, but with hedges against downside risk – is appropriate for now. Global growth. Data confirming the rebound in the manufacturing cycle remain mixed. Economic surprises have generally been positive in the euro zone, but have slipped in the US and Japan, and remain soft in the Emerging Markets (Chart 4). In Germany, the manufacturing PMI slipped back to 43.7 in December, but the Ifo and ZEW surveys both rebounded (Chart 5). There is, however, still little sign that the weakness in manufacturing is spilling over into consumption and services. In Germany, unemployment remains at a record low and wages are strong. In the US, wage growth continues to trend up, and there is no indication in the weekly initial claims data that companies are starting to lay off workers at more than the seasonally normal pace (Chart 6). Market indicators of the cycle are also showing some positive signs. Among commodities, the price of copper – the most cyclical metal – has begun to rise. Chinese cyclical stocks are outperforming defensives. But the US dollar has not yet showed any significant depreciation (Chart 7). Chart 4Economic Surprises Mixed Chart 5Germany Showing Signs Of Bottoming   Chart 6No Problems In The Labor Market Chart 7Some Positive Signs From The Markets     US politics. President Trump’s approval rating has picked up slightly – we warned that its slipping might cause him to get aggressive on trade or foreign policy (Chart 8). Markets might worry at the possibility of “President Warren” given her focus on increased regulation of industries such as finance, energy, and technology. But she has fallen a little in the polls. Even in liberal California (where the primary will be unusually early next year – March 3), she is only level with Biden and Sanders in opinion polls. Our geopolitical strategists see US politics as one of the key geopolitical risks this year,4 but the risk seems subdued for now. Chart 8Trump’s Approval Rating Stable To Rising Fed tightening. Expansions usually end when inflation rises, either causing the Fed to raise rates to choke it off, or with the Fed ignoring the inflation and allowing debt and asset bubbles to form. Any signs, therefore, that inflation, or inflation expectations, are rising would signal that we are truly in the “end game”. For now, there are no such signs. US inflation is likely to soften over the next six months, as a result of the economic slowdown and strong dollar. And TIPS breakevens imply the market believes the Fed will miss its inflation target by an average of 80-90 BPs a year over the next decade (Chart 9). The Fed is likely to sound very dovish over the coming year. The review of its monetary policy framework, probably to be announced in July, may result in some sort of “catch-up” policy: under this, if inflation undershoots the Fed’s target, the target automatically rises the following year.5 Its efforts to support the repo market, including short-term Treasury securities purchases of $60 billion a month, will increase the Fed’s balance-sheet, and represent a “mini-QE” (Chart 10). The Fed is likely to be reluctant to turn more hawkish ahead of the presidential election. These dovish moves – and continued accommodative policies from the ECB and Bank of Japan – mean that monetary policy will be supportive for risk assets throughout 2020. Chart 9Inflation Remains Subdued These milestones suggest, therefore, that our current asset allocation recommendation structure – moderately risk-on, but with hedges (long cash and gold) against downside risk – is appropriate for now. Chart 10A "Mini-QE"? Equities: We shifted last month to an underweight on US equities, with an overweight on the euro zone, and neutral on Emerging Markets. The US tends to underperform during upswings in the global manufacturing cycle (Chart 11). Europe looks attractive because of its heavy weighting in sectors we like such as Financials, Autos and Capital Goods. Europe’s returns will also be boosted by the appreciation in the euro and pound that we expect (our equity recommendations assume no currency hedging). For EM, we would turn more positive if we saw a clear pickup in Chinese credit and economic growth. Chart 11US Underperforms When Growth Picks Up Chart 12Fed Won't Cut As The Market Expects   Fixed Income: Our positive view on global growth implies that long-term rates will rise. We see the US Treasury 10-year yield reaching 2.5% by mid-2020. The market still expects the Fed to cut rates once over the next 12 months. If it stays on hold, as we expect, that slight hawkish surprise would be compatible with a moderate rise in rates (Chart 12). Core euro zone rates might rise by a little less, perhaps by 30-40 BPs, and Japanese government bond yields by 10-15 BPs. We, therefore, continue to recommend a small underweight on duration and an overweight on TIPS which look particularly cheaply valued. Within credit, our preferences are for European investment grade (not as expensive as in the US, and with the ECB buying corporate debt again) and the lower end of the US junk-bond universe (since CCC-rated bonds missed out on 2019’s rally). In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued, and with speculative positions long the dollar. Currencies: In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued (Chart 13), and with speculative positions long the dollar (Chart 14). But its performance is likely to vary depending on the currency pair. Our FX strategists expect the dollar to weaken to 1.18 against the euro and 1.40 against the pound over the next 12 months, and even more against currencies such as the NOK, SEK, and AUD.6 But the dollar is likely to strengthen against the yen (an even more counter-cyclical currency) and against currencies in EM, where central banks will continue to cut rates and inject liquidity aggressively to support their economies. Chart 13Dollar Looks Expensive... Chart 14...And Speculators Are Long     Commodities: Supply in the oil market remains tight, with OPEC deepening its production cuts to 1.7 million barrels/day. The crude oil price was held down in 2019 by weakening demand, which should recover along with the cycle in 2020 (Chart 15). Our energy strategists expect Brent to average $67 a barrel in 2020 (compared to $66 now), with WTI $4 lower. Metal prices could rise in 2020 as Chinese growth recovers and the US dollar depreciates – the two most important factors that drive them (Chart 16). Given the uncertainty over both, we remain neutral for now, but would turn more positive (including on commodity-related assets, such as Australian or EM equities) if we see clear signs of their moving in the right direction. We see gold as a good downside hedge in a world of ultra-low interest rates, especially since central banks may allow inflation to overshoot over the coming years. Chart 15Supply/Demand Balance Points To Higher Oil Price Chart 16Metals Are Driven By The Dollar And China   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1 Please see "Outlook 2020: Heading Into The End Game," dated 22 November 2019, available at bca.bcaresearch.com. 2 Please see "GAA Monthly Portfolio Update: How To Position For The End Game," dated 2 December 2019, available at gaa.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Year-End Tactical Upgrade," dated 18 December 2019, available at cis.bcaresearch.com 4 Please see Geopolitical Strategy "Strategic Outlook: 2020 Key Views: The Anarchic Society," dated 6 December 2019, available at gps.bcaresearch.com 5 For example, if the Fed's inflation target is 2% but inflation is only 1.7% one year, the target would automatically rise to 2.3% the following year. 6 Please see Foreign Exchange Strategy, "2020 Key Views: Top Trade Ideas," dated December 13, 2019, available at fes.bcaresearch.com GAA Asset Allocation