Energy

The pace of U.S. oil supply destruction accelerated at the end of April, as yoy losses increased to 470 thousand barrels per day (Mb/d) for the week ended April 29.

Special Report

For the foreseeable future, Saudi Arabia will remain a price-taker, and not a price-maker in the oil markets; While the economy will face a growth recession, the kingdom has sufficient resources to weather the pain; Policymakers are dead serious about transitioning away from an oil-addicted economy, but will struggle to execute structural reforms; The ultra-conservative religious establishment is at risk of losing political power; Low oil revenues and a move to sideline conservatives will have profound geopolitical implications for the region. Writing in 2011, BCA's Geopolitical Strategy made three conclusions about Saudi Arabia:25 Saudi Arabia finds itself engulfed in a geopolitical morass. Bahrain and Yemen remain volatile to its east and south, respectively, and crisis in the Levant is never too far off. Iran is Saudi Arabia's main challenger in the region. With the U.S. withdrawing from Iraq and a relatively Tehran-friendly government in place in Baghdad, Iran feels emboldened and resurgent. Oil prices will be Riyadh's main weapon against Tehran. The forecast was three years too early on the Saudi decision to allow oil prices to fall (which is another way of saying it was wrong!). However, the geopolitical trends that have forced Saudi Arabia to take its foreign and economic policy into its own hands are now self-evident. The kingdom's decision to defend its oil market share rather than the price of oil has effectively ended OPEC as a price-setting cartel.26 There are three key geopolitical questions that investors need to answer about Saudi Arabia going forward: Will Saudi Arabia reverse its decision on oil production? Can Saudi Arabia evolve beyond an oil economy over the next decade? Will Saudi Arabia look to export its domestic risks by confronting Iran militarily? We do not see Saudi Arabia changing its decision on oil production, regardless of how low prices go. In fact, the strategy is already working by putting pressure on high-cost producers, both private (U.S.) and state-owned (Iraq, Nigeria, Venezuela, etc.). We doubt that the just-announced "Vision 2030" will lead to the country's successful transition away from oil; nonetheless, we think the document holds important information for investors. Finally, we believe that Saudi Arabia's foreign preferences will be constrained by a decade of low oil revenues. What does the future hold for Saudi Arabia? Tell us the oil price forecast for 2025 and we will give you an answer! In other words, this report eschews the media discussion of whether Saudi Arabia will "survive" the next decade. Ceteris paribus, it does. Rather, we try to answer a much more cogent and topical question: whether the country will be a source of global instability or stability. Surprisingly, we think it will be a factor of global stability, even as (or perhaps because) instability grows domestically. Will Saudis Cut Oil Production? BCA's Geopolitical Strategy has had a high-conviction view throughout 2015-2016 that Saudi Arabia would not participate in a deal that would cut its current oil production.27 There are three main reasons behind this: Geopolitical Rivalry With Iran: Saudi Arabia's only leverage over Iran is its wealth. Iran is more populous, its population is better educated, its economy less reliant on oil exports, its citizens far more resilient to economic pain, its military far more experienced in combat, and its geography practically impenetrable. In addition, Iran's Shia allies in Lebanon, Syria, Iraq, Yemen, and Bahrain surround Saudi Arabia and are geopolitically ascendant everywhere except in Bahrain. By contrast, Saudi Arabia's Sunni allies have either turned against the kingdom (the radical Sunni militants in Iraq), or are weak (Syrian anti-Assad rebels), or non-committal to Saudi foreign policy (Egypt and Pakistan). While Saudi Arabia's oil production strategy curtails Tehran's revenue, it also forces Iran to worry about domestic stability while limiting in the foreign direct investment (FDI) that Iran needs to boost its production. Shia Production Bloc: In the long term, Iran and Iraq are projected to catch up to Saudi production (Chart II-1). The only reason why their combined production does not already match Saudi Arabia's is geopolitical: Iran has been a pariah state since 1979 and Iraq since at least 1990. With the right mix of foreign technology and direct investment, both could catch up to Saudi output eventually. This is terrible news for the Saudis given that all three compete for the same market share among Asian refiners. As such, Saudi Arabia has no incentive to make room for its Shia rivals in the global energy marketplace. The Market Will Eventually Rebalance: Assuming stable demand growth over the rest of the year, our Commodity & Energy Strategy team expects oil markets to be in physical balance by 2016Q3 (Chart II-2), mainly due to loss of supply from the U.S. light tight oil (LTO) producers. It will then take around 18 months for U.S. producers to make up the lost production.28 In addition, we expect that geopolitical risk will rise in unstable countries with high budget breakeven oil prices, such as Algeria, Iraq, Nigeria, and Venezuela.5 The Saudis understand this and have no problem waiting for the physical market to rebalance, either through a "natural" process of high-cost production being shut-in, or an "unnatural" process of geopolitical risk taking production off line. At that point, the Saudi fiscal position will be much better due to a combination of budget cuts and higher oil prices. Chart II-1'Shia Bloc' Catching Up To Saudi Arabia Chart II-2House View Is Physical Balance By Q3 2016 We therefore expect Saudi Arabia to continue with its current strategy of maximizing production. What about the recent Saudi threat to increase production in order to force other producers to agree to a production cut or freeze? BCA's Energy Sector Strategy does not believe that Saudi Arabia can meaningfully increase production beyond current levels. Saudi Arabia has brought online 3.25 million b/d of new projects over the past decade, with another 550,000 b/d of expansions projected to come online over the next two years. However, its production has not increased much above the 9.6 million b/d it produced in 2005. Chart II-3Saudi Production: ##br##Already Running At Max If one assumes that Saudi fields have no decline rates at all, then the country's productive capacity today is above 13 million b/d, allowing the kingdom to ramp up production significantly. On the other hand, if Saudi Arabia has decline rates of 3% a year, which is a reasonable assumption, today's productive capacity is around its actual production (Chart II-3). We believe its real capacity is closer to the latter. Finally, the recent cabinet reshuffle that has claimed 20-year Minister of Petroleum and Mineral Resources Ali Al-Naimi suggests that the current oil policy will remain in place. Al-Naimi's authority and leadership were necessary in a world where Saudi statements moved oil prices. But in a new paradigm where physical supply and demand determine the price, a much more lower-profile minister will do. Bottom Line: Saudi Arabia is no longer a price-maker but a price-taker. This will significantly reduce Saudi oil revenues over the near term, and force the kingdom to seek alternative revenue-generating avenues, such as refining. We believe that the proposed IPO of state-owned oil producer Aramco is partly an acknowledgment of the new reality as well as an attempt to bring in FDI that would allow Saudi Arabia to become a major refiner in the Asia-Pacific basin.29 Can Saudi Arabia Evolve Beyond An Oil Economy? Given that OPEC is dead and that Saudi Arabia is now an oil price-taker, will the kingdom face a fiscal crisis that will break its back over the next three years? And what of the longer-term forecast for the country? The Short Term: Pain, But No Collapse Saudi Arabia's planned fiscal restraint is going to be too little to stave off a massive fiscal deficit for this year. Even assuming oil prices average an optimistic $45 per barrel this year, calculations by the BCA's Frontier Market Strategy suggest the following (Table II-1):30 Table II-1Saudi Arabia's Projected Debt Levels And Foreign Reserves The country will face a higher fiscal deficit of over 20% of GDP this year versus 16% in 2015. This is after assuming the government will reduce expenditures by an additional 5% this year following last year's 12% cut. We expect fiscal cuts to continue throughout the rest of the decade, particularly in defense spending, which currently accounts for a quarter of the budget. Furthermore, assuming that half the deficit will be financed by issuing new debt (and the other half by drawing down government deposits in the central bank), total government debt could rise to $150 billion by the end of 2017 from less than $40 billion now. Foreign reserves will plunge by over $140 billion in 2016. By the end of 2017 and 2018, reserves could fall to $350 billion and $250 billion, respectively, assuming oil prices average $50 and $55 in those years. These are dire figures, but they suggest that Saudi Arabia has sufficient bandwidth to withstand the current oil price environment. Forecasts of Saudi doom assume that its budget expenditure remains static (particularly on the military) and that its budget breakeven oil price remains static at around $100 a barrel. In our scenario analysis, we assume a worst-case scenario in terms of government spending, with a modest cut of 5% in 2016, followed by an increase in both 2017 and 2018. The more likely outcome is that the government will be forced to cut spending by double-digits, as it proved capable of doing in 2015, every year. The Long Term: Clouded Picture Threats to oil revenue from technology (electric vehicles) and new low-cost producers (U.S. LTO producers) are bringing into question the long-term viability of the Saudi economy. The Saudi leadership has responded to these threats by announcing "Vision 2030," a plan to develop the economy beyond oil.31 Restructuring the economy is a fearsome task. It is far from clear that economic bottlenecks can be resolved: Productivity growth in Saudi Arabia is extremely low, with an average growth rate of only 0.3% over the past 25 years. The level of productivity has actually fallen since the 2008 global credit crisis (Chart II-4). One reason behind this is insufficient capital expenditure in productive capacities. Even during the era of high oil prices, when the country's savings rate surged, capital spending remained rather low. Odds are that capital expenditure will remain muted in the foreseeable future (Chart II-5). The current reform agenda does not envision de-pegging the currency. But a pegged currency has forced the country to import U.S. interest rates (see Box II-1). As a result, real rates on bank deposits have remained negative for several years now, encouraging excessive consumption. Negative real rates have also brought on a migration out of banks' time and savings deposits. The share of the latter as a portion of total deposits has been shrinking since 2009, when real rates on bank deposits turned negative (Chart II-6). Short-term liabilities are not ideal to finance long-term capital assets. Chart II-4Saudi Productivity ##br## Gains Averaged Only 0.3% ##br##Per Annum Over The Past 25 Years Chart II-5Shrinking Domestic ##br##Savings Will Rein In##br## Capital Expenditures Too Chart II-6Negative Real Rates ##br##Caused Harmful Distortions ##br##In The Economy Box II-1 Will The Currency Peg Stay? Box Chart II-1Oil Prices And U.S. Interest ##br## Rates Moved Together Until 2008 By many academic accounts, the Saudi riyal and U.S. dollar should never have been pegged in the first place. The reason is that the structure and dynamics of the Saudi economy are very different from those of the U.S. economy. Their business cycles are different and their economies react differently to the same exogenous shocks, such as a surge or plunge in crude oil prices. In other words, the two countries do not constitute an optimal currency area, so it does not make sense for Saudi Arabia to be importing U.S. monetary policies via a fixed exchange rate. The reason the fixed exchange-rate system has managed to survive so long (since 1986) is that oil prices have historically been correlated with U.S. interest rates (Box Chart II-1). Higher oil prices used to represent a positive shock for the Saudi economy, which was counterbalanced by rising interest rates in the U.S., and therefore, in Saudi Arabia. This is no longer the case. Following the global credit crisis, oil prices surged to beyond $100 a barrel, yet interest rates remained low. Now oil prices have plunged, while the U.S. is gearing up to raise interest rates. Hence, keeping the riyal pegged to the U.S. dollar has become sub-optimal, and is now preventing adjustments in the real economy through financial variables such as interest rates and the exchange rate. If this continues, pressure points will build up and eventually policymakers will have no choice but to either de-peg the currency from the U.S. dollar or endure deep economic pain. That said, the authorities maintain a firm commitment to the peg given that Saudi Arabia imports almost all of its non-energy consumption. De-pegging would lead to a massive increase in import costs and thus a potential political crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years, which means that the peg will likely remain in place for the time being. Incidentally, forward markets are discounting only a 1% riyal depreciation over the next 12 months, and 2% over the next 24 months. By the end of next year, if oil prices remain at current levels, assuming SAMA has run down a significant amount of its foreign reserves, the possibility of de-pegging and devaluing the riyal will be much greater. A lack of productivity brews a lack of competitiveness. Net exports of goods and services have steadily declined over the past two decades (Chart II-7). Despite a rather young population (the median age in Saudi Arabia is 27 years), the country has failed to reap demographic dividends. The labor force participation rate among Saudi nationals remain low, and among women is extremely low. Most Saudi nationals are employed in cushy government jobs rather than the private sector. Expatriate workers dominate the country's labor force, and their share is rising (Chart II-8). Expat remittance outflows have surged in recent years, to $40 billion per annum (Chart II-8, bottom panel). This is now a significant contributor to the country's current account deficit. Chart II-7Saudi Economy ##br##Lacks Competitiveness Chart II-8Expat Workers Dominate Labor Force, ##br##And Their Remittance Outflows Are Booming Vision 2030: A Revealing Document Calling Vision 2030 a "plan" to address the above structural constraints would be too generous. It is a wish list of reforms that, if any were to get off the ground, would take a long time to take effect. However, several prominent themes in the Vision 2030 document reveal the preferences of the current Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion in educational reforms. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. Taken together, these items suggest that Saudi leadership, led by the young Deputy Crown Prince Mohammad Bin Salman Al Saud, is looking to steer the country towards modernity and away from the dominant conservative interpretation of Islam. Even if the reforms are likely to move at a snail's pace, investors should recognize that Saudi policymakers see the youth population, and its rising angst, as their main national security risk. Rather than cracking down against the youth, Saudi leaders are throwing in their lot with them, at the expense of the religious establishment. This is a smart strategy, given that over 50% of the Saudi population of almost 30 million is below 35 years of age (Chart II-9). The youth population is facing difficulty entering the labor force, with unemployment near 30% (Chart II-10). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart II-11). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,32 and Twitter has the highest level of penetration in Saudi Arabia out of any other country in the region.33 Chart II-9Still A Young Country Chart II-10A Potential National Security Risk Chart II-11Saudi Youth Is As Internet Savvy As Others The decision to steer domestic policy away from religious conservatives may also be motivated by security. In 2009, al Qaeda attempted to assassinate the then-head of the country's intelligence service, now Crown Prince and first Deputy Prime Minister Mohammed bin Nayef. This was a wake-up call for the kingdom in terms of the threat that radical Sunni terrorists pose. In 2015 and 2016, Islamic State militants targeted the country's Shia minority in the Eastern Province in an attempt to stir sectarian violence in the oil-rich province. So far, the efforts have backfired against the Islamic State, with support for the group in Saudi Arabia well below the regional average (Chart II-12). Chart II-12Saudi Arabia Is Worried About The Islamic State If our interpretation of Vision 2030 - and other recently-announced reforms34 - is correct, it is a very dramatic development given Saudi policy over the past half-century.35 Saudi support for a fundamentalist interpretation of Islam emerged in 1970s as the country's coffers became flush with cash. Ultra-conservative Sunni Islam became Saudi Arabia's bulwark against Egypt's secular Arab nationalism and Soviet-supported left-wing groups like the Palestinian Liberation Organization. Later, following the 1979 Islamic Revolution in Iran, Saudi support for conservative Islam also took on the Sunni sectarian hue it retains today. Since the Arab Spring revolts of 2011, however, these hyper-conservative Islamic movements have now become a threat to Saudi Arabia. First, the Muslim Brotherhood's co-optation of democracy as compatible with conservative Islam is a threat to non-democratic monarchies like Saudi Arabia. Second, the Islamic State has evolved from a group that may have received material support from within Saudi Arabia into an independent entity that threatens Saudi Arabia itself. To counter these forces, Saudi leaders are using geopolitical tensions with Iran, the war in Yemen, and the collapse in oil prices as opportunities. Judging by the behavior of Saudi policymakers, it would appear that they are (somewhat ironically) pursuing a strategy of Sunni Arab nationalism. In many ways, Saudi Arabia is de-emphasizing religion and re-emphasizing the nation-state. That is the main conclusion one should draw from Vision 2030. Sceptics would be right to point out that the links between the al-Saud royal family and the ultra-conservative Sunni Wahhabi religious movement lie at the foundation of the Saudi state.36 However, commentators who take the mid-eighteenth century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, Westerners may even be overstating the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.37 Although Saudi Arabia has not figured in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart II-13). In addition, Saudis identify with values of self-expression rather than survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart II-13Saudi Arabia: More Modern Than You Think High youth population, rising self-expression values, and widespread adoption of social media are ingredients of a potent brew for social unrest. It is naïve to think that such protest would take on radical Islamic characteristics in Saudi Arabia when they did not do so in Tunisia or Egypt amidst the Arab Spring, or in Iran during its "Green Revolution" in 2009. And in a negative economic context, student activism may not be isolated - it may merge with currents of discontent in other segments of society. Investors should not expect Saudi Arabia to change overnight, or even at all. However, Vision 2030 suggests that policymakers have moved to nip any youth rebellion in the bud by slowly easing the conservative establishment's hold on society. Religious conservatives may retaliate with protests or even militancy - and the attempt at controlled modernization could produce a flood of popular demands - so the execution of this strategy is risky. However, there is no evidence that the country's intelligence and security services are incapable of dealing with such episodes. In fact, Saudi policymakers may be hoping that a confrontation with religious conservatives devolves into violence so that they can de-legitimize and neutralize them. Bottom Line: Saudi leadership appears to have taken the side of modernity and youth over that of religious conservatism. In the long run, this bodes well for Saudi evolution away from the oil economy, even if it will not do much immediately to resolve structural problems. However, the process will be very long and halting. In the short and medium term, we expect resistance from conservative forces. This could have major implications globally, with Saudi Arabia evolving from a supporter of ultra-conservative Islamic militant groups to a supporter of stability around the Middle East and South Asia. Will Saudi Arabia Export Instability? Chart II-14Saudi Arabia: Lock And Load Saudi-Iranian tensions have been the fulcrum of the region since 2011. However, they appear to have peaked.38 Why? The simple answer is that a sustained geopolitical conflict requires resources and Saudi military expenditure is basically unsustainable: the country has overtaken Russia in third place in terms of absolute military expenditure (Chart II-14). The Saudi leadership is not signalling any drawdown in tensions with Iran. In fact, the two countries broke off diplomatic relations earlier this year. The deputy crown prince even explicitly promised that low oil prices would not change Saudi foreign policy, with on-budget military spending expected to rise by 24% in 2016. These are all bluffs. Just as the rhetoric surrounding oil production is bullish, so is the sabre-rattling with Iran. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart II-15). Political science research shows that the relationship is not spurious. Chart II-16 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes.39 Chart II-15Correlation Between Oil Prices And Military Disputes Chart II-16More Oil Revenue Equals More Aggression The air war against the Iran-allied Houthi rebels in Yemen alone costs up to $6 billion a month, or over $70 billion a year.40 Any direct Saudi intervention in Iraq or Syria would cost a lot more given the complexity of the battlefield and sophistication of the opposing forces. Thus, we are unsurprised by the April ceasefire in Yemen. Saudi officials have recently proclaimed victory there, but we fail to understand what they have accomplished, aside from gaining some valuable fighting experience. As we wrote in March 2015, the Yemen intervention provided an opportunity for Saudi Arabia to test its military capabilities and the willingness of its Sunni allies - other Gulf Cooperation Council countries, Egypt, Jordan, and Pakistan - to commit to joint military operations.41 The Saudi military proved competent, but the air force alone has not dislodged Houthi rebels from their strongholds. Meanwhile, only the UAE responded to the Saudi call for support with any vigor. As such, Saudis will likely conclude from Yemen that military operations are prohibitively expensive. Their thinking could change, of course, as the regional dynamic evolves. However, we doubt that Iran will look to confront Saudi interests with much vigor. Tehran is desperately looking to re-establish itself in the global economy, wants FDI flows to return, and is largely satisfied with the position that its allies in Syria and Iraq find themselves in. Bottom Line: Saudi Arabia is likely going to focus inward and eschew direct military entanglements in the region. The Yemen experiment has largely failed and has taught the Saudis a valuable lesson: you can't rely on allies to fight your land wars. Investment Implications In the short term, Saudi Arabia will have to focus on budget consolidation and domestic reform. These efforts will lead to a growth recession and political instability. Shrinking bank deposits will hamper private-sector credit growth, which at 88%, is already high (Chart II-17). As a result, banks face rising liquidity pressures and are selling their holdings of central bank bills and withdrawing their deposits to meet liquidity needs (Chart II-18). As Saudi Arabia is unlikely to cut oil production, prices will likely stay soft in the foreseeable future. Hence, the financing needs of government and quasi-government entities will stay high. This will crowd out the private sector from bank financing - a negative sign for the stock market. This is particularly negative for Saudi stocks given that they are not cheap relative to their counterparts in emerging and frontier markets (Chart II-19). Chart II-17Private-Sector Credit ##br##Is Set To Decelerate Chart II-18Surging Public-Financing Needs ##br##Are Straining Bank Liquidity Chart II-19Saudi Stocks##br## Are Not Cheap Sovereign spreads are likely to widen, given the country's mammoth fiscal borrowing needs for as long as oil prices stay low. Credit default swaps (CDS) have spiked three-fold in the past year, and may rise again (Chart II-20). Investors should consider going long 5-year CDS. Chart II-20...And Sovereign Spreads Will Rise At the same time, Saudi Arabia's domestic focus will reduce geopolitical tensions in the region. First, the fiscal crisis will constrain foreign adventures and force the kingdom to negotiate with Iran on sharing regional influence. Our earlier fears of a Saudi intervention in Iraq and Syria - always a low-probability risk - have receded given the economic constraints and the lessons of the Yemen intervention. Second, a move to curb the power of religious conservatives inside Saudi Arabia will likely be complemented with more discerning support for extremists outside of the country. It is no secret that Saudi Arabia has provided the funding for religious extremist groups and educational institutions around the world over the past half-century. This strategy will change as Saudi Arabia struggles to evolve beyond oil, a process that necessitates radical change in domestic factors. This particular trend has three main investment implications: Long Iran / Short Saudi Arabia: Both Saudi Arabia and Iran find themselves focused on a similar challenge: an angst-filled youth population. The youth do not see religious institutions as a source of inspiration but rather as tools of social or generational oppression. Iran is far more advanced in the process of domestic reform.42 It has begun to moderate both its foreign and domestic policy, while its economy has already undertaken the shock-therapy of developing non-oil sources of revenue. Saudi Arabia has only begun to contemplate reforms and we suspect that religious conservatives will push against them with vigor. Alternative Energy: The IMF forecasts that in the absence of energy reforms that curb consumption growth, Saudi Arabia will consume all of its refined product by 2022 and all of its oil production by 2042.43 The easiest way for Saudi Arabia to boost government revenues and cut its expenditure is to develop alternative sources of energy. Nuclear and solar power will allow Saudi Arabia to cut its energy subsidies and set aside more oil production for export. While Vision 2030 promises to develop alternative energy, we suspect that the initial investment opportunity will be in global companies. Defense Stocks: Vision 2030 intends to "on-shore" much of the kingdom's military expenditure over the next several decades, starting with maintenance and basic weapons manufacturing, and later developing a domestic aerospace industry. This should be relatively bullish for foreign defense contractors given that Saudis will need time to develop a native defense industry. In the long term, defense spending is unsustainable and will contract significantly. We suspect that the phase of purchasing major defense systems - such as fighter jets - is over. While this is undoubtedly bearish for global defense stocks, Saudi demand will erode only gradually and will be more than compensated by increasing geopolitical tensions in East Asia.44 We therefore continue to recommend that investors stay long defense stocks. Perhaps the most important investment implication of the oil price collapse is that it has created a massive constraint on all actors in the Middle East. Vast oil revenues have allowed Iran, Iraq, Saudi Arabia, and others to play an outsized role in global affairs, either by pursuing aggressive foreign policies, supporting various proxies, or propping up otherwise unstable regimes. In Saudi Arabia's case, oil revenue has allowed the country to delay dealing with the aspirations of its vast youth population. It was easy to expand public-sector jobs while the oil was flowing. Overflowing coffers also allowed Saudi policymakers to support extremism abroad and fight proxy wars against Iran across the region. As Saudi Arabia and Iran focus on domestic reforms, one consequence may be the waning investment-relevance of the Middle East globally. We suspect that this has already happened, given the collapse of oil prices despite a raft of conflicts in the region over the past two years. This geopolitical shift will ultimately support our view that markets continue to ignore geopolitical tensions in East Asia at their own risk. 25 Please see BCA Geopolitical Strategy Special Report, "Riyadh's Oil Gambit," dated October 11, 2011, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Monthly Report, "Annus Horribilis - Energy: Tug Of War Between Tailwinds And Headwinds," dated January 20, 2016, available at gps.bcaresearch.com. 28 Please see BCA Special Report, "More Bullish Than Consensus On Oil Recovery," dated March 29. 2016, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Frontier Markets Strategy Special Report, "Saudi Arabia: The Pain Will Linger," dated May 9, 2016, available at fms.bcaresearch.com. 32 Please see "Full text of Saudi Arabia's Vision 2030," available at alArabiya.net 33 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is useful for teenagers for, well, obvious reasons. 34 Please see Arab News, "Saudi social media users ranked 7th in world," dated November 14, 2015, available at arabnews.com 35 For example, the country's religious police - the hai'a - have been curbed. They no longer have the power to arrest - instead, they have to report violations of Islamic law to the police and are only allowed to work during office hours. Something tells us that most violations of Islamic law are likely to be committed after hours. 36 Please see Matthiesen, Toby, "The domestic sources of Saudi foreign policy: Islamists and the state in the wake of the Arab Uprisings," Rethinking Political Islam Series, Brookings Institute, available at brookings.edu. 37 Al Shihabi, Ali (2015). The Saudi Kingdom Between The Jihadi Hammer And The Iranian Anvil. London: The Choir Press. 38 World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge UP, 2005). For more information, please see http://www.worldvaluessurvey.org/index_html. 39 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back - Middle East: Saudi-Iranian Tensions Have Peaked," dated February 10, 2016, available at gps.bcaresearch.com. 40 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 41 Please see Riedel, Bruce, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 42 Please see BCA Geopolitical Strategy Client Note, "Does Yemen Matter?," March 26, 2015, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 44 Please see International Monetary Fund, "Saudi Arabia Selected Issues," October 2015, IMF Country Report 15/286, available at imf.org. 45 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com.

China's underlying final demand for crude and oil products (excluding changes in inventories) has been weaker than is suggested by its imports of crude oil. The government has used lower oil prices to accumulate strategic petroleum reserves (SPR). Commodities prices are at a risk from weaker China/EM demand going forward.

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.

China's reflation policies have succeeded in reviving iron ore and steel prices, which are up 45.6% and 52.6% from their January lows, along with the profitability of domestic steelmakers.

Special Report

This week <i>U.S. Equity Strategy</i> is sending you the latest <i>BCA Special Report</i>, where Mark McClellan and Anastasios Avgeriou tackle the questions of "Global Earnings Recession: How Deep? How Long?"

Special Report

Earnings-per-share (EPS) for the MSCI all-country world index are estimated to have fallen by 7% in the year to March, the fourth quarter in a row of annual decline. The length and depth of the profits recession is key to the appropriate equity allocation, especially given that stocks are not cheap, downside global growth risks abound and the FOMC is biased to lift rates. We created EPS growth models for the U.S., the Eurozone, Japan and the Global aggregate using a standard set of macro variables. We then simulated these models under three scenarios: bull, bear and base case. The good news is that we do not foresee a prolonged earnings slump. Global EPS year-ago growth will bottom by around the third quarter, due to the lagged effects of higher oil prices and an end to the global manufacturing recession. The bad news is that investors should not anticipate a quick return to robust profit growth either. Global EPS growth will not reach positive territory until the first half of 2017. As usual, bottom-up estimates are way too optimistic. A key conclusion is that it will be difficult for U.S. EPS growth to outperform that of the Eurozone or Japan over the next two years. In part, this reflects margin pressure in the U.S. that is largely absent in the other two economies. This result supports our recommendation to overweight Eurozone and Japanese stocks relative to the U.S. (currency hedged). However, the currency outlook is critical to relative profit performance. We assume that the U.S. dollar has more upside potential (more downside for euro and yen) in the "strong" growth scenario as the FOMC hikes rates along the "dot plot" path. This flatters Eurozone and Japanese profits relative to the U.S. Conversely, we assume that the dollar depreciates in the "weak" growth scenario. If, instead, the dollar depreciates when growth is reasonably solid across the three economies, model simulations show that U.S. earnings will have the edge. NIRP is weighing on global financials. In global portfolios, within a neutral financials weighting, we continue to prefer U.S. to both Eurozone and Japanese financials. Energy's gain is the consumer's pain; lift global energy stocks to benchmark and simultaneously downgrade consumer discretionary to underweight. Finally, our defensive-over-cyclicals preference remains intact. Table II-1Earnings Growth Corporate earnings rarely shrink outside of economic contractions, so investors can be forgiven for worrying that we are on the brink of a global recession. Earnings-per-share (EPS) for the MSCI all-country world index are estimated to have fallen by 7% in the year to March, the fourth quarter in a row of annual decline (Table II-1 and Chart II-1). This is by far the worst performance since the Great Recession. EPS growth in both the U.S. and the U.K. (local currency) is deep in negative territory. Profit growth is still positive, albeit decelerating, in the Eurozone and Japan in local currencies. Chart II-1Equity Prices And EPS How much more downside is there? When will EPS bottom and how strong will the recovery be? These are obviously key questions for the appropriate equity weighting within balanced portfolios, especially given that stocks are not cheap, downside global growth risks abound and the FOMC is biased to lift rates. It is difficult to justify being overweight equities without seeing some profit relief on the horizon. In this Special Report, we take a top-down approach to projecting EPS for the global index, the U.S., the Eurozone and Japan. The rebound in oil prices and some positive economic signs out of China have raised hopes that the profit recession is close to the end. Indeed, the good news is that world EPS annual growth should bottom in the third quarter. However, the bad news is that the climb back into positive growth territory will take time. Barring very strong (and unrealistic) growth assumptions for the rest of 2016, investors should not expect positive year-on-year global EPS growth until early in 2017. Bottom-up earnings estimates currently are too optimistic. On a regional basis, U.S. earnings growth will likely trail both Japan and the Eurozone over the next two years, although much depends on currency movements. Don't Expect An Extended Earnings Recession... Profit contractions normally occur during recessions, but there have been three exceptions since 1980: 1987, 1999 and a very brief period in 2012 (shaded portions in Chart II-2). All three cases involved a mid-cycle slowdown in nominal GDP growth, while labor compensation growth trended sideways (second panel). The deceleration in sales activity was evidently perceived to be temporary, such that business leaders did not respond by limiting wage gains, trimming payrolls or slashing capital spending. The absence of Fed tightening at the time likely calmed fears of an extended slowdown. Indeed, the Fed cut rates in 1987 and 1998, and implemented QE3 in 2012. The result was that the slowdown in top line growth and the margin squeeze proved shallow and short-lived. Chart II-2Three Examples Of Profit Recessions Without Economic Recessions We believe a similar phase is underway today. Several of the factors driving the profit recession appear to be at or close to their nadir. Commodity prices, and oil prices most importantly, have stabilized. Many key indicators of Chinese growth are rebounding, suggesting that monetary and fiscal stimulus is beginning to pay off. The global LEI has not yet turned up, but its slow erosion is in sharp contrast to the plunge that typically occurs before recessions. Purchasing managers' surveys have ticked higher in the U.S., Japan, Canada, the U.K. and China, signaling that the global manufacturing recession is ending. Bank profits could be near the worst as well, depending on the evolution of NIRP policies and net interest margins (see below). Moreover, the manufacturing recession has not spread to the service sector in the major economies, where job creation has held up. While persistently low productivity growth and a secular bottom in the labor share of income in the U.S. will remain a headwind for global earnings, they should be dominated by even a modest cyclical revival in global growth due to high corporate operating leverage. ...But Don't Expect An Imminent And Strong Upturn Either The implication is that we do not foresee a prolonged earnings contraction. Looking again at Chart II-2, global EPS surged following the modest profit recessions in 1987 and 1999. Output growth accelerated sharply, while commodity prices entered a robust bull phase. The global output gap shifted into "excess demand" territory, providing the business sector with some pricing power. Nominal GDP growth re-accelerated in absolute terms and relative to labor costs, contributing to a substantial rise in profit margins. The aftermath of the 2012 profit dip was an altogether different affair. Margins only edged higher due to the tepid rebound in nominal GDP growth. Commodity prices were roughly flat. Meanwhile, the still-large global "excess supply" gap robbed the business sector of pricing power. The result was that EPS growth barely climbed out of negative territory in 2013 and 2014. Today, the global output gap is closer to zero than was the case in 2012/2013, especially in the U.S. However, pricing power is still left wanting at the global level, based on the continued decline in global manufactured goods prices and depressed core consumer price inflation in most of the advanced economies. Oil prices have more upside potential given that the supply-side is responding to low prices, as discussed in the Overview. Nonetheless, our commodity experts do not foresee sustained price increases outside of oil anytime soon. Finally, the global leading economic indicator, a reasonably good bellwether for global EPS growth, has yet to turn higher (Chart II-2, bottom panel). The bottom line is that, while the profit recession will not be extended or deep, investors should not expect the kind of surge in EPS growth that followed the 1987 or 1997 earnings contractions. Model Simulations There are many special factors to consider at the industry level when gauging the outlook for global earnings. We will discuss some of the most important ones below, but this Special Report tackles the question using a top-down macro approach. We created EPS growth models for the U.S., the Eurozone, Japan and the Global aggregate using a standard set of macro variables. Industrial production does a good job of capturing pure growth effects on the top line. We also included the difference between nominal GDP growth and total labor costs as a proxy for changes in margins. Finally, the price of oil and the trade-weighted exchange rate (TWI) were included for obvious reasons. Most of the explanatory variables entered the model with a lag of 3-12 months, except the margin proxy, which is contemporaneous with the profit cycle. The historical fit is quite good for three of the four models (Chart II-3). The Japanese model fit is less impressive, but it is good enough for scenario work. All four models are well specified in that all coefficients are statistically significant, have the correct sign and are of a size that makes economic sense.1 Chart II-3Historical Fit Of Four EPS Macro Growth Models We then constructed three scenarios for profit growth using the following assumptions: Brent Oil Price: The price of oil in the base case follows the current forward curve, reaching $47/bbl by the end of 2016. It is held flat thereafter. We assume that Brent rises to US$60/bbl by the end of 2016 in the bull case, and falls back to US$30 by the end of this year in the bear case. Nominal GDP And Labor Compensation: In the base case, nominal GDP growth for the OECD countries is assumed to accelerate roughly in line with the latest IMF forecast from 3.6% (Q4/Q4) in 2015 to 4.1% in 2017. Labor compensation tracks the uptrend in GDP closely in Japan and the Eurozone, implying little change in margins in the base case. Nominal GDP growth is assumed to be about a percentage point higher/lower, respectively, in the bull and bear cases. Note that the bear case is not consistent with a recession, although growth is slow enough that unemployment would edge higher. Labor compensation growth is assumed to pick up in the bull case, although not by as much as GDP growth, leading to some margin expansion (less so in the U.S.). Conversely, we assume some margin compression in the low growth scenario (especially in the U.S.). We calibrated the implied margin shifts in the bull and bear cases using historical profit cycles. Industrial Production: The three paths for industrial production are designed to be in line with the GDP scenarios described above. The base case assumes that the maximum drag from the collapse in energy investment has passed, leading to a mild rebound in global output as CEO confidence gradually recovers. Global industrial production accelerates mildly from 0.5% in February to 2% by the end of 2016, and to 3% by the end of 2017. The bull case sees a stronger rebound; IP growth accelerates to 3½% by year end and to 5½% in 2017, similar to levels last seen in the years just prior to the Lehman shock. The bear case assumes that the energy drag has not yet reached its peak, weighing on CEO confidence and dragging down IP growth to zero this year. This is followed by a mild rebound in 2017 to 2%. Again, there is no recession in the bear case, although industrial production growth is quite depressed by historical standards for the next two years. Chart II-4Three Scenarios For Oil Prices The Impact Of Oil The model estimates that the collapse in oil prices has trimmed global EPS growth by about 3 percentage points (Chart II-4, top panel). The bad news is that, even if oil prices continue to rise consistent with the forward curve, energy profits will be a significant (albeit declining) drag on global EPS until early in 2017. This drag begins to lessen late in 2016, but does not contribute positively to global EPS until mid-2017 in the base case. The delay is due to the lags from changes in oil prices to company earnings. Indeed, at previous oil troughs, it took about a year before earnings in the Energy sector began to accelerate. The peak contribution to global EPS profits if oil prices follow the forward curve is about 2 percentage points in late-2017. Energy's EPS contribution reaches zero only a little earlier in the bull case, but the maximum contribution reaches +4 percentage points in early 2018. A dip back to $30/bbl would mean that Energy profits will remain a drag on global earnings through 2017. The impact on overall EPS may seem small but readers should note that these macro estimates reflect the combined impact of the drag on Energy profits from lower oil prices and the boost to profits in other industries that consume oil. The Outlook For Global Earnings The resulting global EPS scenarios are presented in Chart II-5. Global EPS growth drifts a little lower still before bottoming in the third quarter in both the base and bull cases. It is not until the second quarter of 2017 that year-over-year EPS growth turns positive in the base case. Profit growth turns positive in the first quarter of 2017 and accelerates to about 20% by the end of next year in the strong growth scenario, a level that has not been seen since early 2011. However, even our bull case falls short of current market expectations for the next year (indicated by the circle in Chart II-5). Chart II-5Global EPS Projections Under Three Scenarios The Outlook By Region Charts II-6-II-8 present the same three outlook scenarios for the U.S., the Eurozone and Japan. The country models include the same explanatory variables as the global model, except that we add the relevant trade-weighted exchange rate. The assumed currency shifts across the three scenarios will obviously have major implications for the profit outlook. In the strong-growth scenario, we assume that the FOMC would feel comfortable lifting rates at least as quickly as the current dot-plot foresees. Market expectations for the fed funds rate would shift up toward the "dots" as it becomes clear that the U.S. economy is exceeding market expectations. In contrast, the ECB and BoJ would continue with their NIRP and QE programs, even if growth positively surprises. There would be no hurry to scale back monetary stimulus, unless inflation were to surge (unlikely in our view). The result would be upward pressure on the dollar as the U.S. yield curve shifts up relative to the Bund and JGB curves. Conversely, the dollar would likely weaken in the event that growth disappoints and the FOMC is forced to abandon plans for rate hikes over the next year. For the purposes of our simulations, we assume that the U.S. dollar appreciates by 5% in trade-weighted terms in each of 2016 and 2017 in the bull case. It is unchanged at current levels in the base case, while it depreciates by 5% in each of 2016 and 2017 in the bear case. We assume the opposite for the euro and yen: both appreciate annually by 5% in the bear case and depreciate by 5% in the bull scenario. The simulations suggest that EPS growth in the U.S. is very close to a bottom (Chart II-6). The growth profile is quite V-shaped, largely because the model suggests that the impact of previous declines in oil prices and the manufacturing recession on profit growth will soon begin to fade. Nonetheless, it will not be until year-end that annual growth moves back into positive territory in the base case. The profit growth acceleration is even faster in the bull case, despite the stronger dollar, although it still falls short of current market expectations on a one-year horizon. Chart II-6U.S. EPS Projections Eurozone EPS growth (local currency) is in positive territory at the moment, but will dip to zero by mid-year under all three of our scenarios due to the lagged effects of euro strength (Chart II-7). The base and bull cases foresee profit growth accelerating by year end, while growth remains negative through 2017 in the bear scenario. Current market expectations for Eurozone profits in early 2017 are roughly in line with our base case. Chart II-7Eurozone EPS Projections Japanese EPS growth (local currency) is projected to remain in the high single digits in the coming months before dipping a little toward year-end (Chart II-8). This profile reflects a confluence of factors. The negative effect on profits from yen strength fades, but the drag from past weakness in industrial production growth intensifies in the near term due to lagged effects. EPS growth subsequently accelerates sharply in the base case and bull scenarios on the back of stronger growth and a cheaper yen (in the bull case). Chart II-8Japan EPS Projections As a side note, the Japanese scenarios assume that the VAT increase scheduled for next year is not implemented. If the VAT goes ahead, the IMF estimates that real GDP will contract by almost 1% on a Q4/Q4 basis in 2017. For exposition purposes, Chart II-9 compares our base case with an alternative scenario that is in line with the IMF forecast. There is no earnings recession in the alternative path, but EPS growth is substantially below the base case (no VAT increase) scenario. Chart II-9Japan: A VAT Hike Next Year Would Exact A Heavy Toll All the comments below on the Japanese outlook assume no VAT increase in 2017. U.S. EPS Growth To Lag The Eurozone And Japan... Table II-2 compares the year-end EPS projections for the three economies, both in level and growth rate terms. The U.S. lags both the Eurozone and Japan in the base case and bull scenarios for the following reasons: Table II-2EPS Model Projections Operating Leverage: The Eurozone and Japan have higher operating leverage relative to the U.S. which means that U.S. profits benefit less from the rebound in growth assumed in the base and bull cases. Profit Margins: The U.S. labor market has reached full employment which is placing mild upward pressure on wages. Without a corresponding rise in corporate pricing power, margins have been under downward pressure. We expect U.S. margins to continue eroding in the base case and rise only slightly in the bull case. In contrast, the Eurozone still has a large excess supply gap and wage growth is not under any upward pressure. Margins thus have more upside potential. Japan is a special case. As discussed in the Overview, firms are reluctant to hand out wage hikes despite a very tight labor market. This means that margins also have some upside potential in the base case and strong growth scenarios. Currency Shifts: Our currency assumptions mean that a stronger dollar would partially offset the benefits to U.S. corporate profits of faster output growth in the bull scenario. In contrast, a weaker yen and euro would magnify the positive impact on profits from a more robust economy in the bull case. It turns out that U.S. EPS growth also underperforms in the bear scenario. The assumed depreciation of the dollar and appreciation of the euro and yen favor U.S. earnings, but this is offset by a larger hit to profit margins assumed in the weak growth scenario. ...Although The Currency Assumptions Matter Of course, these currency assumptions are far from assured. It is certainly possible for the yen or the euro to appreciate even in a global environment where growth is rebounding and financial markets are "risk on". Indeed, both currencies have strengthened relative to the U.S. dollar in recent weeks. This may be due to the unwinding of carry trades funded in the Eurozone and Japan that necessitate currency short-covering. Our currency experts also remind us that valuation and the balance of payments backdrops favor both currencies versus the U.S. dollar. Moreover, because inflation expectations are rising in the U.S. relative to Japan and the Eurozone, the resulting increase in real bond yields in the latter two economies is supporting their currencies. In order to gauge the profit implications if the dollar does not follow our base case view, we re-ran the same three scenarios described above. This time, we assumed that the dollar falls in the bull case and appreciates in the bear case (still flat in the base case scenario). The assumptions for the euro and yen are reversed as well. The results are shown in Table II-3 (the base case is the same as in Table II-2 because there is no change to the currency assumption for that scenario). The weaker U.S. dollar in the bull case adds more than 2 percentage points to U.S. EPS growth in 2017, while profits decline by 4-6 percentage points in the Eurozone and Japan. U.S. EPS thus outperforms the Eurozone, although it still trails Japan in 2017. The reason Japan still outperforms as the yen rises is because corporate profits are so highly geared to growth, which is stronger in the bull scenario. Table II-3EPS Projections Assuming USD Falls In Bull Scenario & Rises In Bear Scenario The EPS effects are symmetric in the bear scenario, as dollar strength trims U.S. EPS growth by 2 percentage points and adds 4-6 percentage points to growth in the Eurozone and Japan. The result is that the U.S. underperforms both of the other countries in a low growth scenario in which the dollar appreciates. The bottom line is that it is difficult to see U.S. earnings growth bettering Japan and the Eurozone in local currency terms over the coming two years under most realistic growth scenarios, unless the dollar is headed significantly lower. Japan Vs. Eurozone In terms of the Eurozone versus Japan, our scenarios suggest that Japan has the edge across the three scenarios shown in Table II-2. This is because Japanese profits have a higher beta with respect to growth, which helps in the base case and bull scenarios. Japan outperforms the Eurozone even in the bear case where global growth is the weakest. This is because the starting point for Japanese industrial production growth (-5.3% year-over-year) is so depressed that, even in a tepid world growth environment, the rate of contraction is likely to moderate fairly quickly. The starting point for Eurozone growth is positive, and thus there is less room for a "snap back" effect when the global manufacturing recession ends. Chart II-10NIRP Weighing On NIMs Global Equity Sector Outlook: Space constraints prevent us from providing a detailed global sector outlook. Nonetheless, BCA's Chief Equity Strategist, Anastasios Avgeriou, comments on some key sectors below. Global Financials The impact of negative interest rate policy (NIRP) and QE on bank profits could not be incorporated in our EPS models given the short history of unorthodox monetary policy. The sharp narrowing in net interest margins (NIM) since 2010 has weighed on bank profits (Chart II-10). It is difficult to estimate how this earnings headwind will evolve in the coming years, as it depends on whether or not the ECB and Bank of Japan push deposit rates further into negative territory and what longer-term impact this will have on NIMs. NIRP puts an interest rate floor on deposit taking institutions that are reluctant to pass negative deposit rates onto their customers. Concurrently, NIRP forces banks to lend out new money (or roll over existing loans) at declining interest rates. As a result, net interest margins get squeezed. In its latest Global Financial Stability Report,2 the IMF presented estimates suggesting that every 10 basis point decline in NIMs has a substantial impact on pretax profits (Chart II-11). While central banks are taking steps to shield bank profits from negative deposit rates, further cuts in these rates could flatten the yield curves even more by signaling an intention to keep rates low for longer. Curve flattening would further undermine NIMs. It is impossible to disentangle the impact of negative deposit rates from quantitative easing on yield curves and NIMs. Nonetheless, for demonstration purposes, we present in Chart II-12 the hit to bank pretax profits if NIMs fall by 3 basis points for every 10 basis point cut in the deposit rate. We present estimates for a cut in the deposit rate ranging from 10 to 30 basis points. Eurozone banks suffer the most, enduring declines in pretax profits of between 6% and 18%. This is largely because the starting point for Eurozone bank profit margins is so low, and because their loan books reprice more quickly in response to lower central bank policy rates than in other countries. The hit to U.S. banks is the least onerous of the three economies, at between 2% and 6%. Chart II-11Global Banks: The Impact Of Falling NIMs Chart II-12Global Banks: The Impact Of Negative Interest Rates Importantly, Chart II-13 shows that U.S. bank NIMs have ticked higher, whereas Japanese and Eurozone ones have nudged lower. The already wide NIM divergence (140 BPs U.S. versus Eurozone and 190 BPs U.S. versus Japan) will likely become even more pronounced in the coming months owing to divergent monetary policies. Chart II-13U.S. Has The Upper Hand The implication is that U.S. banks have the upper hand compared with their Eurozone and Japanese peers. While we remain neutral on global financials, we continue to overweight U.S. financials at the expense of both Eurozone and Japanese financials that warrant a below benchmark allocation in global portfolios.3 Global Energy And Consumer Discretionary BCA's view of a global oil market rebalancing taking place in the back half of the year should lead to modestly higher oil prices. As discussed in the Overview, BCA's forecast is for oil demand to significantly outpace supply in the coming two years, a reversal of the dynamic in place for the past 18 months. Chart II-14 shows that if these forecasts are accurate, the pace at which consumption outpaces production would herald steady spot oil price gains. This "less bad" underlying commodity backdrop is reflected in our global energy sector EPS model that is signaling energy profit growth woes are abating (Chart II-15). The implication is that energy relative share prices have put in a cycle bottom, compelling us to upgrade the global energy sector to a benchmark allocation. Chart II-14Supply/Demand Imbalance Bodes Well For Oil Inflation Chart II-15Lift Global Energy Exposure To Neutral Concurrently, if oil prices recover on a sustained basis, eventually some of the disposable income benefits enjoyed by the global consumer will start working in reverse, undermining consumer discretionary spending power at the margin. This is corroborated by the almost perfect inverse correlation between relative global consumer discretionary performance and real oil prices over the past 40 years (Chart II-16). Chart II-16Energy's Gain Is The Consumer's Pain Under such a backdrop, consumer discretionary stocks are skating on thin ice and would suffer a sizable setback. Thus, it is prudent to downgrade the global consumer discretionary sector to underweight exposure, filling in the gap left by our upgrade of global energy to neutral. Global Cyclicals Vs. Defensives How does this sector positioning adjustment affect the defensive over cyclical portfolio tilt? While we are neutral global industrials4 and energy, we remain underweight materials and overweight consumer staples and utilities. This sustains our preference of safe-haven and higher-yielding defensives versus cyclicals. The recent broad market "risk on" phase has caused a rebound in the cyclicals/defensives ratio. Nonetheless, a number of macro variables have failed to confirm that this cyclicals outperformance phase has legs. Ultimately, relative profit trends will dictate the direction of relative performance. On that front, we are acknowledging that our relative EPS models have tentatively troughed and have moved in favor of cyclical sectors (Chart II-17). Chart II-17Better... Nevertheless, defensives profits will continue to outpace cyclicals earnings in the absence of (Chart II-18): Chart II-18...But Not Enough To Alter Our ##br##Defensives Over Cyclicals Preference a sustained depreciation in the greenback and related commodity reflation, a durable pickup in global growth and trade dynamics beyond China's recent green shoots, a clear turn in the inventory cycle, and a clear improvement in debt dynamics. Adding it all up, it still pays to hold a global defensive over global cyclical portfolio tilt. Investment Conclusions: We do not subscribe to the view that the global profit recession and the contraction in U.S. profit margins foreshadow a recession. Typically, margin contractions occur when an overheating economy causes wage pressures to escalate. The Fed then targets slower economic growth by lifting interest rates. It is the monetary tightening that causes the recession, not the profit squeeze. This time, U.S. wage gains have firmed a bit and margins are under pressure, but the FOMC is in no hurry to dampen growth. Indeed, the Fed wants to normalize interest rates slowly enough that it does not undermine economic momentum. Policymakers want to see wage inflation accelerate. The Fed could make a mistake and move too quickly but, as we saw following the last FOMC meeting, policymakers appear hyper sensitive to any hint of negative economic or financial news. Our "no recession" view is supported by a number of global leading economic indicators that have turned up, supporting the case that the manufacturing recession is ending (see the Overview section). Importantly, the Chinese economy is responding to policy stimulus. We expect global growth to accelerate modestly through the year and into 2017. Given this macro backdrop, our simulation models suggest that global EPS growth will bottom around the third quarter. An upturn in year-over-year U.S. EPS growth is imminent, although growth will not turn positive until late this year. Eurozone earnings growth will continue to decelerate and may edge slightly into negative territory before bottoming later in 2016. For Japan, earnings growth will stay positive but will also dip late in the year due to the lagged effects of yen appreciation. We expect EPS growth to accelerate in 2017 across all regions. A turning point for earnings growth will be constructive for equity markets. Nonetheless, it appears that a profit turn is already discounted in stock prices and EPS growth will fall short of current bottom-up estimates over the next year. As discussed in the Overview, the risk/reward profile does not warrant overweight equity positions within balanced portfolios. Comparing the major markets, we believe it will be difficult for U.S. earnings to beat those in the Eurozone and Japan over the next two years. The main reason is that U.S. profit margins have peaked and are likely to continue eroding. Several U.S. states are lifting minimum wages and some business leaders are boosting wages voluntarily. Other tailwinds that drove U.S. margins to secular peaks are fading as well. Moreover, U.S. margins will be pressured if the U.S. dollar resumes its uptrend, as we expect. Those countries most leveraged to the global economic cycle will benefit the most from modestly better growth momentum in the coming quarters. This will also favor Eurozone and Japanese profits relative to the U.S. A key risk to our view is Japan. Our EPS projection results for Japan may be difficult to believe are possible, given that the economy is sagging at the moment. Our forecast depends on a lot of things going right for Japan. The economy is in a vicious feedback loop at the moment, as weak growth undermines inflation expectations. This lifts real rates and places upward pressure on the yen, thereby further dampening inflation expectations. The Bank of Japan must act soon to break this feedback loop, or risk even further yen appreciation. Moreover, if the Ministry of Finance does not delay the VAT increase planned for 2017, the earnings outlook will be far worse than our base case suggests. For now, however, we remain overweight Eurozone and Japanese stocks versus the U.S. Mark McClellan Managing Editor Anastasios Avgeriou Managing Editor 1 We tried to incorporate the U.S. dollar TWI in the global model. However, it was insignificant, which makes sense because currency shifts should wash out once country earnings are summed into a world aggregate. 2 IMF, "Global Financial Stability Report", April 2016. 3 For a more detailed discussion, please see BCA Global Alpha Sector Strategy Weekly Report, "Happy Days?", March 18, 2016, available at gss.bcaresearch.com 4 For more details please see Global Alpha Sector Strategy Weekly Report, "A House Of Cards?", March 4, 2016, available at bca.bcaresearch.com

Saudi oil policy, like its defense policy, will be more aggressive and less predictable, following Deputy Crown Prince Mohammed bin Salman's apparent nullification of a production "freeze" deal at Doha.

Monday's upgrade of the energy sector to neutral and the exploration & production index to overweight does not mean that refiners are out of the woods. In fact, the opposite is true, because the crude oil supply glut will morph into a refined product glut. Refiners are still running full out, likely in response to strong gasoline demand, but that is creating a glut of distillate inventories and boosting overall fuel supplies. Overall refined product consumption is barely growing, underscoring that inventories will continue to build. Weakening overall demand for finished oil product is also evident in the plunge in railcar shipments, which heralds a potentially painful decline in relative stock performance (top panel). Part of the plunge in rail shipments of oil reflects reduced shale oil production, which will boost refiner input costs via higher crude oil prices. Keep in mind that refining margins are already under cyclical stress, because of the tight spread between Brent and WTI crude oil prices (third panel). Our refiner earnings model, based on refining margins and utilization rates, is plunging. Consequently, the odds of a sustained profit squeeze are high. We reiterate our high conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, TSO.

BCA's Energy Equity Strategy, our newest sector-specific service, recently published a report arguing for a rebalancing of global oil markets in the second half of this year, and modestly higher oil prices, a view which was not predicated on an OPEC production freeze. Instead, rebalancing should be driven by larger-than-expected production declines. Low prices are doing their job. Plunging cash flows and the resulting massive increase in capital constraints have strangled exploration budgets, particularly in U.S. shale formations. BCA's forecasts signal that consumption will outpace production significantly by yearend. Consequently, the heavily bombed out S&P energy exploration & production (E&P) index could surprise on the strong side as the year progresses, as relative E&P performance is highly correlated with oil prices, irrespective of the trend in production. In other words, even if production growth is contracting, as long as the latter leads to higher commodity prices, then share prices can outperform. Importantly, producers are enjoying the benefits of technology advancement in drilling techniques, which are driving down production costs. Massive overcapacity in the services industry means that producers will continue to dictate pricing terms. Consequently, we upgraded the S&P E&P index to overweight in yesterday's Weekly Report, which brings our overall energy sector weighting up to neutral, locking in a 14% profit from our underweight call.