Geopolitics
Highlights The dollar rally is set to continue. The dollar tends to perform best when real rates are rising and above r-star. We are entering this environment and raising our DXY target to 98. Moreover, the rest of the world is likely to be more vulnerable to higher U.S. rates than the U.S. itself. Not only does the Federal Reserve set the cost of capital for the world, debt excesses are more prevalent outside the U.S. than in it. Additionally, the U.S. is less impacted by slowing global industrial activity than the rest of the world. Relative growth dynamics will therefore flatter the greenback. Italy is weighing on the euro, and any deterioration in the pricing of Italian risk will further hurt the common currency. However, EUR/USD does not even need Italian drama to depreciate. Relative growth and inflation are enough to push the euro toward 1.12. Feature The beginning of the year was a tough time for the dollar, with the DXY plunging nearly 4% from January 1 to February 15th. However, soon after Valentine's day, the market became enamored with the greenback, prompting the USD to rally a hefty 6%. Now that the dollar has hit our target of 94, it is time to pause and ask a simple question: can the U.S. currency rally further, or is it time to bail on the rally? While we do think the secular trend for the greenback is down, we also believe the current rebound has further to run. We are revising our DXY price target to 98. Essentially, we are entering a window where both U.S. monetary policy and the global growth backdrop will give the dollar an additional boost. The Over And Under On R-Star Table I-1Fed And The Dollar: Where We Stand ##br##Matters As Much As The Direction A common market lore is that the dollar tends to appreciate in anticipation of rising rates, but once the Fed actually begins to increase rates, the dollar weakens. There is some truth to this assertion. The 1994 and 2004 experiences do bear these facts. Moreover, the DXY fell 8.5% after the ill-fated December 2015 hike, and fell more than 11% as the Fed hiked rates through 2017. However, these kinds of simple heuristics can be deceiving. Where we stand in the hiking process matters just as much. In other words, it is not only whether interest rates are rising that counts, but whether or not they are rising above the neutral rate, or r-star. This distinction makes all the difference. As Table I-1 illustrates, the heuristic holds true when the Fed begins lifting rates but the real fed funds rate is below r-star. In this environment, the average annual return of the DXY since 1973 has been -5%, and the dollar has generated negative returns 75% of the time. However, the picture changes drastically if the real fed funds rate rests above the r-star. In this environment, the DXY rises alongside the fed funds rate, generating average annual gains of 4.7% 70% of the time. These results have been robust, independent of what was expected in interest rates futures. When the fed funds rate is falling, it is difficult to generate any strong views, as neither the expected returns nor the batting averages are statistically different from the expected outcomes of coin tosses. Chart I-1We Are Entering The Dollar-Bullish##br## Part Of The Fed Cycle Interwoven behind this picture is global growth. We have long argued that global growth is a key determinant for the dollar: When it is strong, the dollar weakens; when it is weak, the dollar strengthens.1 Essentially, when the fed funds rate rises but is still below r-star, global growth is improving, often even more so than U.S. growth, leading to a soggy greenback. When the fed funds rate moves above r-star, we tend to see hiccups around the world, essentially because the global cost of capital starts to rise, hurting the most vulnerable places. This helps the dollar. Sometimes, the most vulnerable country to higher U.S. interest rates happens to be the U.S., in which case the dollar does not respond positively to rising rates, even if they are above r-star. This is exactly what happened between 2005 and 2006. Today, we are entering an environment where the dollar is likely to receive a fillip from the Fed. As Chart I-1 illustrates, the real fed funds rate is about to punch above the Laubach-Williams estimate for r-star. It is true that the LW measure for r-star is only an estimate of this crucial but unobservable concept, and that it is subject to revisions, but the Fed is set to increase rates at least four times over the next 12 months, which in our view will definitely push the fed funds rate above realistic estimates of r-star. As a result, we should anticipate the dollar to rally further. Bottom Line: When we think about the Fed and the dollar, rising interest rates are not enough to boost the greenback. Actually, if U.S. real rates rise but are still below the neutral rate of interest, this generally results in very poor dollar performance, like what transpired in 2017 and the first month of 2018. If, however, the fed funds rate is both rising and above the neutral rate, the dollar rallies. We are entering this environment. Why Is This Time NOT Different? If one were to make the argument that the dollar will not rally as the fed funds rate moves above the neutral rate - which has happened in 30% of past occurrences - one needs to make the case that the U.S. is more vulnerable to higher U.S. rates than the rest of the world. We do not want to make this bet. First, there does not seem to be any obvious imbalances in the U.S. economy right now. Historically, periods of vulnerability in the U.S. have been preceded by an elevated share of cyclical sectors as a percentage of GDP. This was particularly obvious last cycle, when cyclical sectors represented 28% of GDP in 2006, and residential investment was particularly out of norm, at almost 7% of GDP (Chart I-2). Today, cyclical sectors represent 24.3% of GDP, in line with the average of 25.4% since 1960. Moreover, while there are rampant fears that the U.S. current account deficit will blow up, at the moment - thanks to decreasing oil imports - it only stands at -2.5% of GDP, much narrower than the levels that prevailed in 2006 (Chart I-3). Second, the key ingredient that would generate vulnerability in the U.S. is not present, but it is visible around the world: too fast a pace of debt accumulation. Not only do debt buildups make financial systems and economies illiquid, if the accretion is built swiftly it raises the probability of a misallocation of capital. After all, investing is a time-consuming activity, and if done too quickly chances are that due diligence was not very diligent. Today, it is true that there has been a deterioration in the quality of the corporate sector debt in the U.S., but nonetheless, the U.S. private sector has curtailed its debt load, and has been rather reluctant to re-lever. In the rest of the G-10, debt loads are as elevated as ever, and in fact are hitting record highs in Canada, Australia, and the Scandinavian economies. In EM and China, not only are debt levels elevated, they have also been rising briskly (Chart I-4). The vulnerabilities are therefore outside the U.S. and not in the U.S Chart I-2No Cyclical Imbalances In The U.S. Chart I-3Better External Balance As Well Chart I-4Debt: U.S. Robust, RoW Not So Much Third, global growth is facing an important headwind emanating from China. The Chinese economy has been in the process of slowing, and continues to do so: Leading the charge have been efforts by Chinese policymakers to diminish the pace of debt accumulation. As Chart I-5 illustrates, not only has the Chinese credit impulse rolled over, but the decline in working capital of small financial intuitions suggests that more pain is in the pipeline. Real estate activity is slowing down. The prices of newly built units in the main cities are contracting on an annual basis, and in second-tier cities price appreciation is slowing. As a result, construction activity is also downshifting. The growth of industrial profits has slowed considerably, hitting a 14-month low. Railway traffic, electricity production and excavator sales are all decelerating sharply. The Li-Keqiang index is also slowing and, according to our leading index based on credit activity, is set to continue to do so (Chart I-6). Unsurprisingly, Chinese import growth is also slowing significantly, implying that China is not providing as much of a shot in the arm for the rest of the world as it did 12 months ago (Chart I-6, bottom panel). Chart I-5Chinese Policy Tightening In Action Chart I-6The China Syndrome EM economies are particularly exposed to these dynamics. As we like to put it when we talk to our clients, if EM economies were a security, Chinese activity would drive cash flow growth, while U.S. monetary policy dictates the cost of capital. This is especially true today, as a record amount of EM-ex-China exports go to China, while USD-debt as a percentage of EM GDP, reserves and exports is at multi-decade highs (Chart I-7). This analogy suggests that EM economies are therefore the most vulnerable corner of the world to higher U.S. rates: Not only is their indebtedness high, but they are also facing a potent headwind from China. Hence, we expect EM financial conditions to deteriorate further, with negative implications for EM growth. However, EM have been the most dynamic contributor to global growth and global trade. This implies that if EM growth conditions deteriorate, so will global trade and global industrial activity (Chart I-8). As we have highlighted before, the U.S. is normally insulated from these dynamics as commodity production, manufacturing and exports represent a relatively low share of gross value added in what is fundamentally a domestically driven economy. Through this aperture, the relative resilience of the U.S. to the recent decline in global growth is unsurprising. To the contrary, we can expect this current bout of growth divergence to stay in place for much of 2018 (Chart I-9). Chart I-7EM Have A Lot Of Dollar Debt Chart I-8Weak EM Equals Weak Global IP Chart I-9Global Growth Divergences As a result, global growth dynamics are likely to buttress the bullish implications for the dollar of a Fed lifting rates above r-star. As Chart I-10 shows, slowing global growth is good for the dollar. This is likely to be especially true this time around as investors have yet to purge their overhang of short-dollar bets (Chart I-11). Moreover, as we highlighted five months ago, from a stylistic perspective, the dollar is the epitome of momentum currencies within the G-10.2 The indicator that has empirically best captured the momentum-continuation behavior of the dollar is the gap between the 1-month moving average and the 6-month moving average. Currently, this indicator is flashing an unabashedly bullish signal for the USD (Chart I-12). Chart I-10The Dollar Is A Countercyclical Currency Chart I-11Still Short The Dollar Chart I-12Momentum Currrently Favors The Dollar Bottom Line: This time will not be different, and the dollar should rise as the Fed pushes interest rates above r-star. The U.S. private sector has not experienced any material debt buildup in recent years, and is less vulnerable to higher rates than emerging markets. Since the U.S. is less sensitive to EM growth than other advanced economies, the U.S. is relatively insulated from any EM slowdown, explaining why the U.S. economy is not slowing like the rest of the world is right now. This is a positive backdrop for the dollar. Euro Weakness: More Than Just Italy The euro's weakness through the recent dollar rally has been particularly striking. Recent developments in Italy have supercharged this weakness, as investors are once again questioning the commitment of Italy to staying in the euro area - an assessment that is weighing on Italian assets (Chart I-13). However, Marko Papic argues in BCA's Geopolitical Strategy service that Italy is not on the verge of leaving the euro area.3 However, the Five-Star movement / Lega Nord coalition wants to challenge the EU's Stability and Growth Pact 3% limit on budget deficits. As Dhaval Joshi argues in BCA's European Investment Strategy service, Italy has a fiscal multiplier greater than one, and thus more spending is likely to help the Italian economy over the coming year - whether or not the now-infamous issuance of mini-BOTs are involved.4 And to be honest, the Italian economy needs all the help it can get (Chart I-14). Chart I-13Markets Are Worried About Italy Chart I-14Italian Economy Has Yet To Heal However, it remains to be seen how much Italy will be able to open the fiscal spigot. Much depends on the willingness of the bond market to finance this intended profligacy. So far, the move in Italian BTPs has been small, but any repeat of 2010-2012 will prevent the coalition government from implementing its desired spending plans. Such a confrontation between the bond market and Italian politicians could cause a sharp decline in the euro. To be clear, it is highly unlikely that the coalition will be able to increase the deficit by the EUR100bn planned in its manifesto. To note, Rob Robis has downgraded Italian bonds to underweight in BCA's Global Fixed Income Strategy service.5 While Italian risks have exacerbated the weakness in the euro, ultimately the weakness in the common currency simply reflects the greater shock to European growth resulting from a slowing China. As Chart I-15 illustrates, European growth tends to underperform U.S. growth when Chinese monetary conditions are tightened, or when China's marginal propensity to consume - as approximated by the growth rate of M1 relative to M2 - declines. We are currently facing this environment. Chart I-15AChina's Deceleration Is Filtering Into Europe (I) Chart I-15BChina's Deceleration Is Filtering Into Europe (II) In addition, not only is European growth falling behind the U.S., but the European economy is also feeling the pinch from the tightening in financial conditions vis-à-vis the U.S. that ensued following the furious euro rally of 2017. In response to these combined shocks, European core inflation is now weakening relative to the U.S., which normally portends to a weakening euro over the course of the subsequent six months (Chart I-16). Since investors have yet to clear their massive long bets on the euro, we think the euro will need to flirt again with fair value before being able to stage a durable rally (Chart I-17). While the euro's fair value is currently 1.12, we will re-evaluate the situation once EUR/USD moves below 1.15. Despite the upbeat picture we have painted for the dollar, the greenback still faces potent structural headwinds, which means that we cannot be too careful and need to approach any dollar rebound with a great deal of care, always keeping an eye open for potential risks to the dollar. Chart I-16Relative Inflation And The Euro Chart I-17More Downside In EUR For Now Bottom Line: Italian political developments are currently hurting the euro. The euro will suffer further if the bond market ends up rioting, unwilling to finance the coalition's deficit-busting proposals. While such dynamics would precipitate a sharp and violent fall in the euro, EUR/USD does not need Italian misadventures to weaken further. The euro continues to trade at a premium to its fair value, and the euro area is feeling the pain of a slowing China deeper than the U.S. is. Therefore, European growth and inflation are likely to weigh further on the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "More Than Just Trade Wars", dated April 6 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "Some Goods News (Trade), Some Bad News (Italy)", dated May 23, 2018, available at gps.bcaresearch.com 4 Please see European Investment Strategy Special Report, titled "Italy Vs Brussels: Who's Right?", dated May 24, 2018, available at eis.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report, titled "Is It Partly Sunny Or Mostly Cloudy?", dated May 22, 2018, available at gfis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to perform well with the Manufacturing and Services PMI coming in at 56.6 and 55.7, respectively, beating expectations. However, the dovish Fed minutes were the highlight of this week. While inflation seems to finally be making a comeback, members of the FOMC opined that it was "premature to conclude that inflation would remain at level around 2 percent". This implies a higher possibility of the Fed's pursuit towards a more "symmetric" inflation target, indicating that the Fed doesn't want to raise rates more aggressively than what is implied it the current dot forecasts. The 2-year yield fell by 7.1 bps, while the 10-year fell by 6.9 bps on the news. Furthermore, the Fed has become increasingly cautious in its communications in the face of a flattening yield curve. Despite these potential negatives, the dollar continues to appreciate as global growth softens. This rally could run further as European and EM data continues to disappoint. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Is King Dollar Facing Regicide? - April 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 This week was negative across the board for the euro area. French, German and overall euro area Manufacturing, Services and Composite PMIs all underperformed expectations. In addition to lackluster economic data, the eurosceptic M5S-Lega coalition is now putting the Brussels to the test. As expected, the BTP-Bund spread spiked to just below 2%, near levels that last prevailed in early 2017, and the euro has been suffering as a result of this. While the ECB's QE program is scheduled to end in September, the current situation is a threat and may necessitate a lower euro to ease monetary conditions. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: The Nikkei Manufacturing PMI came in below expectations, coming in at 52.5. This measure also decreased from last month's reading. Annualized gross domestic product growth for Qtk surprised to the downside, coming at -0.6%. Moreover, machinery orders yearly growth also surprised negatively, coming in at -2.4%. After rising by more than 2% the last couple weeks, USD/JPY has come back below 110 recently. We believe that the yen will most likely be amongst the best performing G-10 currencies, given that an environment of declining global growth and rising risk normally supports the yen. However, on a longer term basis, the yen is likely to see downside, given that the BoJ will not allow an appreciating yen from derailing the economy. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Headline and core inflation both surprised to the downside, coming in at 2.4% and 2.1% respectively. They also both decreased from last month's number. Industrial Production yearly growth also underperformed expectations, coming in at 2.9%. Finally, Halifax house price yearly growth also surprised negatively, coming in at 2.2%. GBP/USD has gone down by nearly 1.5% these past few weeks, dragged down by the euro's weakness. Overall, we remain bearish on cable, given that inflation should continue to surprise to the downside in the U.K, as a result of the appreciation of the pound last year. On the other hand inflation in the U.S. should outperform, as a result of the decreased excess capacity and tight labor market. This will force the Fed to raise rates more than the BoE, putting downward pressure on the pound. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data has been mixed recently: Westpac Consumer Confidence was negative in May, at -0.6%; The Wage Price Index annual growth remain unchanged at 2.1%, also in line with expectations; The unemployment rate picked up to 5.6% from 5.5%, however, the participation rate also increased by 0.1% to 65.6%; Employment grew by 22,600, with full-time employment at 32,700 and part-time contracting by 10,000; Governor Lowe spoke in Sydney this week at the Australia-China Relations Institute, citing Australia increased dependence on the second largest economy in the world, and the "bumpy" journey along the path of financial reform that China is likely to experience. This is likely to bring increased volatility to an Australian economy already replete with excess capacity. The RBA is unlikely to raise interest rates any time soon. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Both exports and imports surprised to the upside, coming in at 5.05 billion and 4.79 billion respectively. Additionally, the trade balance also outperformed expectations, coming in at -3.78 billion dollars. Finally, the Producer Input Price Index quarterly growth also surprised positively, coming in at 0.6%. The kiwi has declined by more than 1.5% this past weeks. Overall we continue to be bearish on NZD/USD, given that we expect the current environment of heightened volatility to persist. That being said, we are bullish on the NZD against the AUD, as Australia is much more exposed to a slowdown in the Chinese industrial cycle and as the Australian economy exhibits more signs of slack than New Zealand's. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar has managed to remain flat despite the recent broad-based selloff of commodity currencies against the greenback. Canada's inflation has been in line with the BoC's target. Furthermore, a resilient labor market and robust wage growth point to favorable domestic demand conditions and greater inflationary pressures in the coming quarters. External factors such as a favorable oil market, relative to metals, have helped the CAD against other commodity currencies, despite this week's weakness. Going forward, these variables are likely to continue to support the loonie against the likes of the Aussie or the Kiwi. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: The Producer Price index underperformed expectations, coming in at 2.7%. Moreover, headline CPI inflation also underperformed expectations, coming in at 0.8%. EUR/CHF has declined by almost 2% these past weeks. We continue to be bearish on this cross, given that an environment of continued risk aversion should hurt the euro, while giving a boost to safe heavens like the franc. Italy's political tumult only adds credence to this argument. However, on a long term basis we are positive on EUR/CHF, given that the SNB will maintain an extremely easy monetary policy, much more so than the ECB, in order to prevent an appreciating franc which would derail its objective of ever reviving inflation in Switzerland. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline CPI inflation outperformed expectation, coming in at 2.4%. Meanwhile, core CPI inflation came in line with expectations, at 1.3%. USD/NOK has been relatively flat in the month of May. Overall rising U.S. real rates relative to Norway should lift USD/NOK, even amid rising oil prices. That being said, the krone is likely to outperform other commodity currencies like the AUD or the NZD. This is because oil is less sensitive to China than other commodities, and the black gold is supported by a friendlier supply backdrop, especially as tensions in the Middle East are once again rising and Venezuela is circling down the drain. NOK should continue to appreciate against the EUR as well. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 While Swedish producer prices annual growth picked up to 4.9% from 4% in April - suggesting a resurgence in inflationary pressures, labor market conditions softened as the unemployment rate climbed to 6.8% from 6.5%. The Riksbank also released a commentary on household debt, citing a "poorly functioning housing market" and a "tax system not being well designed from a financial stability perspective" as reasons for the current predicament. There was also emphasis placed on the uncertainty of house prices going forward. While these factors are present, resurgent inflation will ultimately prompt the Riksbank to hike, albeit cautiously, in order to avoid having to raise rates too violently down the road, which could cause serious harm to a Swedish economy afflicted by considerable internal imbalances. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Chart 3China Already ##br##Imports U.S. Commodities... Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Chart 5... But Impedes Market Access For Higher Value-Added Goods Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Chart 7Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Chart 17Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Chart 20...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Chart 24Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.
Highlights Copper has been stuck in the $2.90-$3.30/lb trading range since late August, 2017. Offsetting supply- and demand-side effects are keeping us neutral: Concerns over restrictions on China's scrap imports and possible industrial action in Chile, along with continued worries over a slow-down in China will keep prices range-bound until we see a fundamental catalyst on one side of the market. Our updated balances model shows a physical surplus in 2018, followed by a deficit in 2019. Energy: Overweight. Rising crude oil prices and steepening backwardation in Brent and WTI, to a lesser extent, will be supportive of our energy-heavy S&P GSCI recommendation, as we expected. The position is up 17.1% since it was initiated on December 7, 2017. Base Metals: Neutral. Our updated balances model points to a physical surplus in the copper market by year end (see below). Precious Metals: Neutral. A stronger USD and higher real rates are pressuring precious metals lower. Our long gold and silver positions are down 1.8% and 0.8%, respectively, over the past week. Ags/Softs: Underweight. The USDA expects Brazil to surpass the U.S. as the world's largest soybean producer in the upcoming crop year, for the first time in history. Nevertheless - and despite U.S.-Sino trade tensions - the report also predicts record U.S. exports of the bean in the 2018/19 crop year. Feature Chart of the WeekStuck In A Trading Range Copper on the COMEX averaged $3.12/lb since the beginning of the year - slightly higher than our $3.10/lb expectation published in January (Chart of the Week).1 Fears of a slowdown in China -suggested by weaker readings of the Li Keqiang Index - as well as a stronger dollar have been headwinds to further upside. On the flip side, upcoming contract renegotiations at Escondida, China's ongoing environmental efforts, and global PMI readings above the 50 boom-bust line have kept bulls interested in the red metal. Our estimate of the refined copper balance is for a physical surplus this year (Chart 2). Strong demand from Asia, and to a lesser extent North America, will support a moderate pickup in consumption this year. This will be met by greater refined output - a ramp in primary refined output will more than offset the expected decline in secondary production (i.e. refined copper produced from the scrap metal). Upside risk to this outlook comes from supply-side disruptions at the ore mines - particularly in Chile - and at refined levels. The biggest downside risk remains China's growth trajectory: If policymakers are unable to manage the transition to sustainable, consumer- and services-led growth in the market that accounts for 50% of global demand, prices will fall. Longer term, our models point to a physical refined-copper deficit on the back of stronger consumption growth vis-à-vis output growth. The key to a breakout - up or down -lies in the evolution of financial and fundamental factors. On the financial side, the USD has been edging higher since mid-April. Absent an upward copper price catalyst, a continuation in the USD's path will prevent the metal from booking strong gains. On the fundamental side, we expect copper markets to be in surplus this year. However, downside risks from a greater-than-expected slowdown in China could easily tilt the balance. Ongoing Chinese tightening of scrap copper imports will resist sharp moves to the downside. Chart 2Updated Balances: Expect A Refined Copper Surplus This Year Any of these factors may emerge as a catalyst for a breakout or a breakdown in the copper market this year. Yet for now our model is pointing to a physical surplus and we are comfortable with our neutral outlook. We expect near term prices to trade in the $2.90 to $3.15/lb range. Nevertheless, the evolution of these known unknowns may tilt our balances to either side. A break lower would be reason to sell, while a break above the upper bound would support an outlook for higher prices. Geopolitical Risks On The Horizon Political tensions are spilling into the copper market, threatening supplies, and bringing with them the prospect of higher prices. This is not without reason: Supply-side shocks to mined output have historically been a source of upside risk to prices. Foremost among the potential shocks is labor action at the Escondida mine in Chile, the world's largest. June 4 is the deadline for contract renegotiations to begin. These talks will follow last year's contract renewal efforts, which led to a 44-day strike, a 63% y/y decline in the mine's copper output in 1Q17, and eventually, an 18-month contract extension. As the world's largest mine, Escondida accounts for 1.27mm MT out of the 22mm MT of world capacity, and contributes ~5% of global supply. Efforts to lock in an advance deal ended late last month to no avail.2 Nevertheless, Escondida's production in 1Q18 has been exceptional - more than triple the same period last year. Furthermore, copper was among the metals that caught a bid last month amid fears of further rounds of U.S. sanctions on Russian companies. Russian oligarch Vladimir Potanin has a 33% stake in Norilsk, one of the world's largest copper mines - accounting for 388k MT of output last year. While sanctions against Potanin have not been announced, he was named in the U.S. Section 241 Foreign Asset Control filing, suggesting that he may be targeted in future sanctions, putting Norilsk's future at risk, à la Rusal. While fears of U.S. sanctions on Russia appear to have eased, the risk of such action on global copper supply was a tailwind to the copper market last month. In addition to the upside from these potential supply-side shocks, ongoing environmental reform efforts in China remain a theme in metals markets globally. In the case of the red metal, restrictions on Chinese access to "foreign waste" will curtail scrap shipments going forward. World secondary refined production from scrap accounts for almost 20% of global refined copper. China produces more than half of the world's secondary refined copper. This means that China's secondary output makes up 10% of all world refined copper production (Chart 3). Chart 3China's Secondary Output Important To Refined Copper Supply... As such, scrap copper imports play an important role in China - they act as a buffer against high prices, rising when prices lift, and dwindling in times of low prices. Among the measures implemented to gain more control over scrap markets in China are the following: 1. For the period between May 4 and June 4, the Chinese customs inspection firm - China Certification and Inspection Group North America - announced it would suspend the issuance of export certificates for scrap material shipments, including scrap copper.3 The aim of the suspension is to inspect the waste material and ensure it complies with China's new environmental regulations. In general China imports 15% of its copper scrap from the U.S. - purchasing more than 500k MT of scrap copper from the U.S. last year (Chart 4). Since the U.S. is China's top supplier of scrap copper, this specific initiative and China's ongoing efforts for environmental reform could be consequential to secondary refined output. 2. This move comes in addition to ongoing restrictions on imported solid waste. Starting in 2019, Category 7 scrap copper imports - i.e., solid waste, which account for ~20% of all scrap - will be banned.4 Since the beginning of the year, import licenses were granted only to scrap end-users and, since March 1, hazardous impurity levels in scrap copper imports were limited to 1% by weight. A Metal Bulletin report late last month estimated import quotas for scrap copper were 84% lower so far this year.5 As such, Jiangxi Copper - the largest copper refinery in the world - estimates that these restrictions will culminate in a 500k MT decline in scrap copper imports this year. In fact, scrap copper imports have already been falling significantly, with Chinese purchases down 40% y/y in 1Q18. The near-term implication of these restrictions on China's scrap copper imports would be to raise imports of refined copper, or of ores and concentrates. Scrap copper displaced from these restrictions will likely be diverted to other countries where they will be refined and shipped to China for final consumption. While an eventual move by Chinese companies to Southeast Asian countries in a bid to set up processing facilities there would eliminate the long term price impact, there may be some upside to prices during the transition phase. As such, China's imports of copper ores and concentrates, and of the refined metal, have been strong. During the first four months of the year, imports of ores and concentrates were up almost 10% y/y, while inflows of the refined metal are 15% above last year's levels (Chart 5). Chart 4...But Scrap Imports Are Restrained Chart 5China's Copper Imports Still Going Strong As these policy measures have been known to the public for quite some time, we suspect they are already priced into markets, and do not foresee further upside risk arising from this source. Nevertheless, their impact will remain significant, given that limited ability to produce scrap copper, which will restrict supply, will keep the market resistant to significant downward price pressure. Moderate Consumption Growth This Year Our updated balances model does not include any significant changes to our demand outlook from our January estimate. This is consistent with our consumption estimates for other industrial commodities that share strong co-movement properties with copper demand. We expect lower global consumption and growth than what's being projected by the International Copper Study Group (ICSG) and the Australian Department of Industry, Innovation and Science in its Resources & Energy Quarterly report. While China will remain the world's major copper consumer, a slowdown in its economy remains the foremost demand-side concern for us this year. DM economies appear to be comfortably perched at an above trend level. Fiscal stimulus in the U.S. and solid growth figures from the rest of the world will help keep demand in DM economies supported (Table 1). Table 1Strong Global Growth Will Support##BR##Copper Consumption However, Chinese demand growth remains vulnerable to a slowdown. As we outlined in our March 29 Weekly Report, while there are fundamental reasons to be concerned about Chinese growth going forward, there are no signs of alarm just yet.6 Manufacturing PMIs have come down in recent months, but they remain above the 50 boom-bust mark. That said, it is worth pointing out that the most significant indicator of the Chinese economy we track - the Li Keqiang index -has also been slowing as of late. We continue to expect the government to be able to pull off the managed slowdown it has embarked on. However, we are alert for any sign the Chinese economy is sharply decelerating, as it would lead us to revise our consumption forecast. A Surplus...At Least This Year Our demand and supply expectations lead us to call for a surplus of refined copper this year. Further out, we expect consumption growth to outpace production next year. The upward adjustment in our balance to a surplus since January is a result of upside revisions to supply amid a stable consumption growth path (Chart 6). Copper inventories remain elevated (Chart 7). While current levels of inventories are not a predictor of future price movements, they do indicate there is sufficient cushion in the market to withstand near-term supply disruptions. Chart 6Solid Production Path Amid Stable Consumption;##BR##Surplus Will Emerge Chart 7Inventories Will Cushion##BR##Against Supply Shocks Of course, along with other commodity markets, copper prices remain vulnerable to USD movements. In fact, the red metal's performance over the past month is especially impressive given the relative strength in the USD as of late. BCA expects the USD will appreciate in the coming months. Absent fundamental changes - i.e. supply- or demand-side shocks - copper markets will likely be restrained from staging a break-out rally by a stronger USD going forward. Bottom Line: Fundamental and financial risks to the copper market are slightly skewed to the downside this year. We expect a physical surplus to emerge by year-end, given slightly higher output and slower demand growth as China slows. On the downside, prices are vulnerable to a stronger USD and muted demand growth in China. On the upside, they are supported by supply-side concerns, chiefly at the Escondida mine and due to restrictions on China's imports of scrap copper. Stay neutral the red metal. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see p.11 of BCA Research's Commodity & Energy Strategy Weekly Report titled "Stronger USD, Slower China Growth Threaten Copper," dated January 25, 2018, available at ces.bcaresearch.com. 2 Please see "Union at BHP's Escondida copper mine in Chile says no advance deal likely," dated April 24, 2018, available at reuters.com. 3 Please see "China to suspend checks on U.S. scrap metal shipments, halting imports," dated May 4, 2018, available at reuters.com. 4 Please see "China scrap metal firms face pressure from import curbs: official", dated April 26, 2018, available at reuters.com and BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 5 Please see "FOCUS: China's copper scrap import quotas down 84% so far this year," dated April 23, 2018, available at metalbulletin.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Summary of Trades Closed in
Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Chart 4German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Chart 24Voters Want Governance Improvements The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 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. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.
Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Chart 3GOP Retirements Are Unprecedented Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar