Energy

Highlights The not-so-veiled threat to Gulf Arab oil shipments through the critically important Strait of Hormuz by Iran's President Rouhani earlier this week was a response to the ramping up of maximum pressure by the Trump administration, which is demanding importers of Iranian crude reduce volumes to zero. This was a predictable first step toward what could become a chaotic oil pricing environment (Map 1).1 Map 1Iran Threatens Gulf Shipments Again Oil prices surged on reports of the Iranian threat Tuesday morning, sold off, and recovered later in the day. Pledges from the Kingdom of Saudi Arabia (KSA) to lift production to as much as 11mm b/d this month - a record high - were all but ignored by the market. The threat to safe passage through the Strait of Hormuz - where ~ 20% of global supply transits daily - raises the spectre of military confrontation between the U.S. and Iran, and their respective allies. The growing risks from tighter supply - markets could lose as much as 2mm b/d of Iranian and Venezuelan exports as things stand now - now must be augmented by the likelihood of a Gulf conflict. Energy: Overweight. We remain long call spreads along the Brent forward curve and the S&P GSCI, as we expect volatility, prices and backwardation to move higher. These recommendations are up 34.6% since they were recommended five months ago. Base Metals: Neutral. Treatment and refining charges are higher following smelter closings. Metal Bulletin's TC/RC index was ~ $80/MT at end-June, up ~ $3 vs end-May. Precious Metals: Neutral. Gold traded below $1,240/oz over the past week, but recovered above $1,250/oz as geopolitical tensions rise. Ags/Softs: Underweight. The USDA expects U.S. farm exports in 2018 will come in at $142.5 billion, the second-highest level on record, according to agriculture.com. Feature Oil pricing could become chaotic, as U.S. policy measures aimed at Iran are countered by responses that are not altogether unexpected. In addition to limited spare capacity, and increased unplanned production outages, markets now must discount the likelihood of renewed armed conflict (short of all-out war) in the Gulf between the U.S. and Iran, and their respective allies. To appreciate the significance of President Rouhani's not-so-veiled threat to deny safe passage through the Strait of Hormuz to oil tankers carrying Gulf Arab states' exports, one need only consider that some 20% of the world's oil supply flows through this narrow passage on any given day.2 The response of the president of Iran to U.S. policy - nominally directed at denying Iran the capacity to develop nuclear weapons, but arguably meant to force the existing regime from power - is a predictable next step in the brinkmanship now being played out between these long-standing rivals.3 Following the lifting of nuclear-related sanctions in 2015, Iran's production rose ~ 1mm b/d from 2.8mm b/d to 3.8mm b/d. We expect 500k b/d of Iran's exports will be lost to the market by the end of 1H19, as a result of sanctions being re-imposed November 4. Other estimates run as high as 1mm b/d being lost if the U.S. succeeds in getting importers to drastically reduce purchases. The ire of the U.S. also is directed at Venezuela, where the loss of that country's ~ 1mm b/d of exports would become all but certain, if, as U.S. Secretary of State Mike Pompeo pressed for last month, U.S. trade sanctions against the failing state are imposed.4 We estimate Venezuela's production is down close to 1mm b/d since end-2016, and will average ~ 1.07mm b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) BCA's Ensemble Forecast Includes Extreme Events In our updated balances modeling, our base case front-loaded the OPEC 2.0 production increase announced by the coalition at its end-June meeting in Vienna. Core OPEC 2.0's 1.1mm b/d increase (1H19 vs 1H18) is offset by losses in the rest of OPEC 2.0 amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. We assume Iran's exports fall 200k b/d by the end of this year, and another 300k b/d by the end of 1H19, resulting in a total loss of 500k b/d by 2H19. Global supply rises ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively, in our estimates. The bulk of this growth is provided by U.S. shale-oil output, which we estimate will rise by 1.28mm b/d this year, and 1.33mm b/d next year. On the demand side, we expect global growth to remain strong, powered as always by stout EM consumption. That said, rising trade frictions, signs the synchronized global growth that powered EM oil demand could move out of synch, and divergent monetary policies at systematically important central banks could take some of the wind out of our consumption-forecast sails (Chart of the Week). That said, if a supply-side event results in a sharp upward price move, we would expect demand growth to adjust lower in fairly short order. This is because many EM states removed or reduced oil-price subsidies in the wake of the prices collapse following OPEC's declaration of a market-share war in late 2014, which leaves consumers in these state more directly exposed to higher prices than in previous cycles. Our base case is augmented with three scenarios. In our simulations, the Venezuela collapse is met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. Our scenarios are: A reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks (Scenario 2, Chart 2); Venezuela production collapses to 250k b/d from current levels of ~ 1.07mm b/d, which allows it to support domestic refined product demand and nothing more (Scenario 3, Chart 2); Both of these occurring simultaneously in the Oct/18 - Sep/19 interval (Scenario 4, Chart 2). Chart of the WeekTight Supply, Strong Demand##BR##Remain Supportive of Prices Chart 2BCA's Scenarios Include##BR##Production Losses In Venezuela, Iran The Stark Reality Of Low Spare Capacity Chart 3Global Spare Capacity Stretched Thin Our scenario analyses - particularly Scenarios 3 and 4 - illustrate the stark reality confronting oil markets: Spare capacity will not be sufficient to keep prices below $80/bbl in the event Venezuela collapses, or if Iranian export losses are greater than the 500k b/d we currently are modeling. The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year. This will fall to just over 1mm b/d next year (Chart 3).5 As things stand now, idle and spare capacity of KSA, Russia and core OPEC 2.0 states that actually can increase production would be taxed to the extreme to cover losses of Iranian exports, if some of the higher levels projected by analysts - i.e., up to 1mm b/d - are realized (Chart 4). KSA's maximum sustainable capacity is believed to be ~ 12mm b/d; officials have indicated production will be raised to close to 11mm b/d in July, then likely held there. This record level of production will test KSA's production infrastructure, and would leave the Kingdom with 1mm b/d of spare capacity. Russia is believed to have ~ 400k b/d of spare capacity; it likely will restore ~ 200k b/d of production to the market over the near future, leaving 200k b/d as spare capacity. If just the two high-loss events described above are realized - i.e., Iran export losses come in at 1mm b/d instead of the 500k b/d we expect, and Venezuela's 1mm b/d of exports are lost because the state collapses - global inventory draws will accelerate until enough demand is destroyed via higher prices to clear the market at whatever level of supply can be maintained (Chart 5). Approaching that point, we would expect OECD strategic petroleum reserves (SPRs) to be released.6 Chart 4OPEC 2.0's Core Producers Would Be##BR##Taxed to Replace Lost Exports Chart 5A Supply Shock Would Draw##BR##Crude Inventories Sharply Chart 6Falling Net Imports Implies##BR##Current SPR Could Be Too Large It is difficult to forecast the price at which markets would clear if we get to the state described above. However, it is worthwhile noting that OPEC spare capacity in 2008 stood at 1.4mm b/d, or 2.4% of global consumption. The 1.8mm b/d of OPEC spare capacity EIA estimates is now available to the market represents 1.8% of daily consumption globally. By next year, the EIA's estimated 1mm b/d of OPEC spare capacity will represent a little over 1% of global daily consumption. It was in this economic setting that WTI and Brent breached $150/bbl in mid-2008, just before the Global Financial Crisis tanked the world economy.7 Bottom Line: Into the mix of tightening global supply and limited spare capacity, oil markets now confront higher odds of armed conflict in the Gulf once again. Oil pricing will remain volatile, and could become chaotic as brinkmanship raises the level of uncertainty in markets. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Rouhani says U.S. pressure to stop Iranian oil may affect regional exports," published by uk.reuters.com July 3, 2018. We explore the Trump administration's maximum pressure in a Commodity & Energy Strategy Special Report published June 7, 2018, entitled "Iraq is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. We are using the term chaotic in the sense of "... sensitive dependence on initial conditions or 'the butterfly effect'" described in "Weak Emergence" by Mark A. Bedau (1997), which appears in Philosophical Perspectives: Mind, Causation, And World, Vol. 11, J. Tomberlin, ed., Blackwell, Malden MA. 2 The U.S. EIA calls the Strait of Hormuz "the world's most important oil chokepoint" in its "World Oil Transit Chokepoints," published by the U.S. EIA July 25, 2017. By the EIA's estimates, 80% of the crude oil transiting the strait is bound for Asian markets, with China, Japan, India, South Korea and Singapore being the largest markets. 3 Please see "Mattis's Last Stand Is Iran," published by Foreign Policy June 28, 2018, on foreignpolicy.com. The essay describes the state of play within the Trump administration vis-à-vis Iran. President Trump's third national security advisor, John Bolton, has stated the goal of the administration's policy is not regime change, but denial of the capacity to develop nuclear weapons. However, Bolton repeatedly called for regime change in Iran prior to being tapped as the national security advisor, and has advocated going to war with Iran to prevent it from developing a nuclear weapons capability, in a New York Times op-ed published March 26, 2015, entitled "To Stop Iran's Bomb, Bomb Iran." 4 Please see "Pompeo calls on OAS to oust Venezuela," published by CNN Politics June 4, 2018. 5 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. On June 22, 2018, the coalition agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. The other core members of OPEC 2.0 are believed to have close to 300k b/d of spare capacity. Other estimates put the spare capacity as high as 3.4mm b/d. The ex-KSA estimates are pieced together by using the International Energy Agency's estimates for core OPEC and Citicorp's estimates for Russia. Please see "Russia's OPEC Deal Dilemma Worsens as Idled Crude Capacity Grows," published by bloomberg.com May 16, 2018. 6 In just-completed research, our colleague Matt Conlan writes the U.S. SPR, at ~ 660mm barrels, can cover more than 100 days of net U.S. crude imports (Chart 6). This coverage will rise to 140 days of net crude imports by the end of 2019. Please see "American Energy Independence And SPR Ramifications," published by BCA Research's Energy Sector Strategy July 4, 2018. 7 Please see the discussion of demand beginning on p. 228 of Hamilton, James D. (2009), "Causes And Consequences Of The Oil Shock Of 2007 - 08," published by the Brookings Institute. 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 May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@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 BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.

Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Chart 7U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 20China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Chart 23Trade In Intermediate Goods Dominates This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 27Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Chart 32The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap Chart 37When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Appendix B Chart 1Market Outlook: Bonds Appendix B Chart 2Market Outlook: Equities Appendix B Chart 3Market Outlook: Currencies Appendix B Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We have been cautious on asset allocation on a tactical (3-month) horizon for two months. The backdrop has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. Trim exposure to global stocks to benchmark and place the proceeds in cash on a cyclical (6-12 month) horizon. Government bonds remain at underweight. Our growth and earnings indicators are not flashing any warning signs. Indeed, while economic growth is peaking at the global level, it remains impressive in the U.S. Nonetheless, given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late. There are several risks that loom large enough to justify caution. First, the clash between monetary policy and the markets that we have been expecting is drawing closer. The FOMC may soon be forced to more aggressively tighten the monetary screws. The ECB signaled that it will push ahead with tapering. Perhaps even more important are escalating trade tensions, which could turn into a full-scale trade war with possible military implications. China has eased monetary policy slightly, but the broad thrust of past policy tightening will continue to weigh on growth. The RMB may be used to partially shield the economy from rising tariffs. Global bonds remain vulnerable. In the U.S., rate expectations in 2019 and beyond are still well below the path implied by a "gradual" tightening pace. In the Eurozone, there is also room for the discounted path of interest rates beyond the next year to move higher. Lighten up on both U.S. IG and HY corporate bonds, placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. We would consider upgrading if there is a meaningful correction in risk assets. More likely, however, we will shift to an outright bearish stance later this year or in early 2019 in anticipation of a global recession in 2020. Diverging growth momentum, along with the ongoing trade row, will continue to place upward pressure on the dollar. Shift to an overweight position in U.S. equities versus the other major markets on an unhedged basis. The risk of an oil price spike to the upside is rising. Feature The time to reduce risk-asset exposure on a cyclical horizon has arrived. Escalating risks and our assessment that equities and corporate bonds offered a poor risk/reward balance caused us to trim our tactical (3-month) allocation to risk assets to neutral two months ago. We left the 6-12 month cyclical view at overweight, because we expected to shed our near-term caution once the global slowdown ran its course, geopolitical risk calmed down a little, and EM assets stabilized. Nonetheless, the backdrop for global financial markets has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. It is not that there have been drastic changes in any particular area. Indeed, while profit growth is peaking at the global level, 12-month forward earnings continue to rise smartly in the major markets (Chart I-1). In the U.S., our corporate pricing power indicator is still climbing, forward earnings estimates have "gone vertical", and the net earnings revisions ratio is elevated (Chart I-2). The negative impact of this year's dollar strength on corporate profits will be trounced by robust sales activity. The U.S. economy is firing on all cylinders and growth appears likely to remain well above-trend in the second half of the year. Chart I-1Forward EPS Estimates Still Rising Chart I-2Some Mixed Signals For Stocks This economic and profit backdrop might make the timing of our downgrade seem odd at first glance. Nevertheless, valuations and the advanced stage of the economic and profit cycle mean that it is prudent to focus on capital preservation and be quicker to take profits than would be the case early in the cycle. BCA has recommended above-benchmark allocations to equities and corporate bonds for most of the time since mid-2009. There are several risks that loom large enough to justify taking some money off the table. One of our main themes for the year, set out in the 2018 BCA Outlook, is that markets are on a collision course with policy. This is particularly the case in the U.S. Real interest rates and monetary conditions still appear to be supportive by historical norms, but this cycle has been anything but normal and the level of real interest rates that constitute "neutral" today is highly uncertain. The fact that broad money growth has slowed in absolute terms and relative to nominal GDP is a worrying sign (Chart I-3). Dollar-based global liquidity is waning based on our proxy measure, which is particularly ominous for EM assets (bottom panel). Chart I-3Liquidity Conditions Are Deteriorating Moreover, our Equity Scorecard remained at 'two' in June, which is below a level that is consistent with positive excess returns in the equity market (please see the Overview section of the May 2018 Bank Credit Analyst). Our U.S. Willingness-to-Pay indicator reveals that investment flows are no longer favoring stocks over bonds in the U.S. (Chart I-2). Perhaps even more importantly for the near term are the escalating trade tensions, which could turn into a full trade war with possible military implications (see below). These and other risks suggest to us that the period of "prudent caution" may extend well into the 6-12 month cyclical horizon. For those investors not already at neutral on equities and corporate bonds, we recommend trimming exposure and placing the proceeds in cash rather than bonds. Fixed-income remains at underweight. There are risks on both sides for government bonds, but we believe that it is more likely that yields rise than fall. Trade Woes: Not Yet At Peak Pessimism The Trump Administration upped the ante in June by announcing plans to impose tariffs on another $200 billion of Chinese exports to the U.S., as well as to restrict Chinese investment in the U.S. We would expect China to retaliate if this is implemented but, at that point, China's proportionate response would cover more goods than the entire range of U.S. imports. Retaliation will therefore have to occur elsewhere. Tariffs are bad enough, but our geopolitical team flags the risk that trade tensions spill over into the South China Sea and other areas of strategic disagreement. The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.1 The Trump Administration has also launched an investigation into the auto industry, and has threatened to tear up the North American Free Trade Agreement (NAFTA). Congress will likely push hard to save the agreement because it is important for so many U.S. companies, especially those with supply chains that criss-cross the borders with Canada and Mexico. Still, Trump has the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on the two trading partners. This would really rattle equity markets. Many believe that Trump will back away from his aggressive negotiating tactics if the U.S. stock market begins to feel pain. We would not bet on that. The President's popularity is high, and has not been overly correlated with the stock market. Moreover, blue collar workers, Trump's main support base, do not own many stocks. The implication is that the President will be willing to take risks with the equity market in order to score points with his base heading into the mid-term elections. The bottom line is that we do not believe that investors have seen "peak pessimism" on the trade front. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. Can Trump Reduce The Trade Gap? One of the Administration's stated goals is to reduce the U.S. trade deficit. It is certainly fair to ask China to pay for the intellectual property it takes from other countries. Broadly speaking, rectifying unfair trade practices is always a good idea. However, erecting a higher tariff wall alone is unlikely to either shrink the trade gap or boost U.S. economic growth, especially given that other countries are retaliating in kind. During the 2016 election campaign, then-candidate Trump proposed a 35% and 45% across-the-board tariff on Mexican and Chinese imports, respectively. We estimated at the time that, with full retaliation, this policy would reduce U.S. real GDP by 1.2% over two years, not including any knock-on effects to global business confidence.2 Cancelling NAFTA would be much worse. The bottom line is that nobody wins a trade war. Moreover, the trade deficit is more likely to swell than deflate in the coming years, irrespective of U.S. trade policy action. The flip side of the U.S. external deficit is an excess of domestic investment over domestic savings. The latter is set to shrivel given the pending federal budget deficit blowout and the fact that the household savings rate continues to decline and is close to all-time lows. This, together with an expected acceleration in business capital spending, pretty much guarantees that the U.S. external deficit will swell in the next few years. This month's Special Report, beginning on page 18, discusses the consequences of the deteriorating long-term fiscal outlook and the associated "twin deficits" problem. We conclude that a market riot point will be required to change current trends. But even if disaster is avoided for a few more years, the dollar will ultimately be a casualty. In the near term, however, trade friction and the decoupling of U.S. from global growth should continue to support the dollar. We highlighted the divergence in growth momentum in last month's Overview. Fiscal policy is pumping up the U.S. economy, while trade woes are souring confidence abroad. Coincident and leading economic indicators confirm that the divergence will continue for at least the near term (Chart I-4). Policy Puts We do not believe that the current 'soft patch' in the Eurozone and Japanese economies will turn into anything worse over the next year. We are much more concerned with the Chinese economy. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart I-5). Chart I-4Growth Divergence To Continue Chart I-5China's Growth Slowdown The authorities will likely provide fresh stimulus if the trade war intensifies. Indeed, recent statements from the Ministry of Finance suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. Chart I-6U.S. Small Business Is Ecstatic However, the bar for a fresh round of material policy stimulus is higher today than it was in the past; elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with monetary or fiscal stimulus. The most effective way for China to retaliate to rising U.S. tariffs is to weaken the RMB, but this too could be quite disruptive for financial markets and, thus, provides another reason for global investors to scale back on risk. Similarly, the bar is also rising in terms of the Fed's willingness to come to the rescue. Policymakers have signaled that they will not mind an overshoot of the inflation target. Nonetheless, the facts that core PCE inflation is closing in on 2% and that unemployment rate is well below the Fed's estimate of full employment, mean that the FOMC will be slower to jump to stock market's defense were there to be a market swoon. Small business owners are particularly bullish at the moment because of Trump's regulatory, fiscal and tax policies. The NFIB survey revealed that confidence soared to the second highest level in the survey's 45-year history (Chart I-6). Expansion plans are also the most robust in survey history. With the output gap effectively closed, increasing pressure on resource utilization should translate into faster wage gains and higher inflation. This was also quite apparent in the latest NFIB survey. Reports of higher compensation hit an all-time high as firms struggle to find qualified workers, and a growing proportion of small businesses plan to increase selling prices. Despite the signs of a very tight labor market, the FOMC's inconsistent macro projection remained in place in June. Policymakers expect continued above-trend growth for 2018-2020, but they forecast a flat jobless rate and core inflation at 3.5% and 2.1%, respectively. If the Fed is right on growth, then the overshoot of inflation will surely be larger than officials are currently expecting. Risk assets will come under downward pressure when the Fed is forced to shift into a higher gear and actively target slower economic growth. We expect the Fed to hike more aggressively next year than is discounted, and lift the consensus 'dot' for the neutral Fed funds rate from the current 2¾-3% range. Bonds remain vulnerable to this shift because rate expectations in 2019 and beyond are still well below the path implied by a "gradual" quarter-point-per-meeting tightening pace (Chart I-7). Chart I-7Market Expectations For Fed Funds Are Below A ''Gradual'' Pace At a minimum, rising inflation pressures have narrowed the Fed's room to maneuver, which means that the "Fed Put" is less of a market support. Italy Backs Away From The Brink Last month we flagged Italy as a reason to avoid risk in financial markets, but we are less concerned today. We believe that Italy will eventually cause more volatility in global financial markets, but for the short-term it appears that this risk has faded. The reason is that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit to 7% of GDP. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. If this is wrong and there is another blowout in Italian government spreads, investors should fade any resulting contagion to the peripheral countries. Greece, Portugal, Ireland and Spain - the hardest-hit economies in 2010 - have undertaken significant fiscal adjustment and, unlike Italy, have closed a lot of the competitiveness gap relative to Germany. Spread widening in these countries related to troubles in Italy should be considered a buying opportunity.3 ECB: Tapering To Continue The ECB looked through the recent Italian political turmoil and struck a confident tone in the June press conference. President Draghi described the first quarter cooling of the euro area economy as a soft patch driven mainly by external demand. We agree with the ECB President; in last month's Overview we highlighted several factors that had provided extra lift to the Eurozone economy last year. These tailwinds are now fading, but we believe that growth is simply returning to a more sustainable, but still above-trend, pace. That said, rising trade tensions are a wildcard to the economic outlook, especially because of Europe's elevated trade sensitivity. Draghi provided greater clarity on the outlook for asset purchases and interest rates. The pace of monthly purchases will slow from the current €30bn to €15bn in the final three months of year and then come to a complete end (Chart I-8). On interest rates, the ECB expects rates to remain at current levels "at least through the summer of 2019". This means that September 2019 could be the earliest timing for the ECB to deliver the first rate hike. Chart I-8ECB Balance Sheet Will Soon Stop Growing We agree with this assessment on the timing of the first rate increase. It will likely take that long for inflation to move into the 1½-2% range, and for long-term inflation expectations to surpass 2%. These thresholds are consistent with the ECB's previous rate hike cycles. Still, there is room for the discounted path of interest rates beyond the next year to move higher as Eurozone economic slack is absorbed. The number of months to the first rate hike discounted in the market has also moved too far out (24 months). Thus, we expect that bunds will contribute to upward pressure on global yields. Bond investors should be underweight the Eurozone within global fixed income portfolios. In contrast, we recommend overweight positions in U.K. gilts because market expectations for the Bank of England (BoE) are too hawkish. Investors should fade the central bank's assertion that policymakers now have a lower interest rate threshold for beginning to shrink the balance sheet. The knee-jerk rally in the pound and gilt selloff in June will not last. First, the OECD's leading economic indicator remains in a downtrend, warning that the U.K. economy faces downside risks (Chart I-9). Second, Brexit uncertainty will only increase into the March 2019 deadline. Prime Minister May managed to win a key parliamentary vote on the Withdrawal Bill in late June, but the Tories will face more tests ahead, including a vote on the Trade and Customs Bill. The fault lines between the hard and soft Brexiteers within the Tory party could bring an early end to May's government. Either May could be replaced with a hard Brexit prime minister, such as Brexit Secretary David Davis, or the U.K. could face a new general election. The latter implies the prospect of a Labour-led government. Admittedly, this will ensure a soft Brexit, but Jeremy Corbyn would almost surely herald far-left economic policies that will dampen business sentiment. As a result, we believe that the BoE is sidelined for the remainder of the year, which will keep a lid on gilt yields and sterling. Corporate Bonds: Poor Value And Rising Leverage Our newfound caution for equities on a 6-12 month investment horizon carries over to the corporate bond space. Corporate balance sheets have been deteriorating since 2015 Q1 based on our Corporate Health Monitor (CHM). The first quarter's improvement in the CHM simply reflected the tax cuts and thus does not represent a change in trend (Chart I-10). Chart I-9Fade BoE Hawkish Talk Chart I-10Q1 Improvement In Corporate ##br##Health To Reverse The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart I-10, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. More importantly, the corporate sector has been leveraging aggressively, as we highlighted in our special reports that analysed company-level data from the U.S. and the Eurozone.4 We highlighted that investors and rating agencies are not too concerned about leverage at the moment, but that will change when growth slows. Interest- and debt-coverage ratios are likely to plunge to new historic lows (Charts I-11A and I-11B). Chart I-11ACorporate Leverage Will Come ##br##Back To Haunt Bondholders Chart I-11BCorporate Leverage Will Come ##br##Back To Haunt Bondholders Both U.S. investment grade (IG) and high-yield (HY) corporates are expensive, but not at an extreme, based on the 12-month breakeven spread.5 However, both IG and HY are actually extremely overvalued once we adjust for gross leverage (Chart I-12). Chart I-12U.S. Leverage - Adjusted ##br##Corporate Bond Valuation We have highlighted several other indicators to watch to time the exit from corporate bonds. These include long-term inflation expectations (when the 10-year TIPS inflation breakeven reaches the 2.3-2.5% range), bank lending standards for C&I loans, the slope of the yield curve, and real short-term interest rates or monetary conditions. While monetary conditions have tightened, the overall message from these indicators as a group is that it is still somewhat early to expect rising corporate defaults and sustained spread widening. That said, we have also emphasized that it is very late in the credit cycle and return expectations are quite low. Excess returns historically have been modest when the U.S. 3-month/10-year yield curve slope has been in the 0-50 basis point range. Similar to our logic behind trimming our equity exposure, the expected excess return from corporate bonds no longer justifies the risk. We recommend lightening up on both U.S. IG and HY corporate bonds, moving to benchmark and placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. Also downgrade EM hard currency sovereign and corporate debt to maximum underweight. We are already underweight on Eurozone corporates within European fixed-income portfolios due to the pending end to the ECB QE program. Conclusions The political situation in Italy and tensions vis-à-vis North Korea appear to be less of a potential landmine for investors, at least for the next year. Nonetheless, the risks have not diminished overall - they have simply rotated into other areas such as international trade. It is also worrying that the FOMC will have to become more aggressive in toning down the labor market. What makes the asset allocation decision especially difficult is that the economic and earnings backdrop in the U.S. is currently constructive for risk assets. Nonetheless, recessions and bear markets are always difficult to spot in real time. Given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late and go over the cliff. This does not mean that we will recommend a neutral allocation to risk assets for the remainder of the economic expansion. We would consider upgrading if there is a meaningful correction in equity and corporate bond prices at a time when our growth indicators remain positive. More likely, however, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of global recession in 2020. The divergence in growth momentum between the U.S. and the rest of the major economies, along with the ongoing trade row, will continue to place upward pressure on the dollar. We envision the following pecking order from weakest to strongest currency versus the greenback: dollar bloc and EM commodity currencies, non-commodity sensitive EM currencies, the euro and yen. The Canadian dollar is an exception; we are bullish versus the U.S. dollar beyond a short-term horizon due to expected Bank of Canada rate hikes. Tightening financial conditions are likely to culminate in a crisis in one or more EM countries; as a share of GDP, exports and international reserves, U.S. dollar debt is at levels not seen in over 15 years. Slowing Chinese growth and trade tensions just add to the risk in this space. The recent upturn in base metal prices will likely reverse if we are correct on the Chinese growth outlook. Oil is a different story, despite our bullish dollar view. OPEC 2.0 - the oil-producer coalition led by Saudi Arabia and Russia - agreed in June to raise oil output by 1 million bpd. The coalition aims to increase production to compensate for an over-compliance of previous deals to trim output, as well as production losses due to lack of investment and maintenance (Chart I-13). The bulk of the losses reflect the free-fall in Venezuela's output. Our oil experts believe that OPEC 2.0 does not have much spare capacity to lift output. Meanwhile, the trend decline in production by non-OPEC 2.0 states is being magnified by unplanned outages in places like Nigeria, Libya and Canada. While U.S. shale producers can be expected to grow their output, infrastructure constraints - chiefly insufficient pipeline capacity to take all of the crude that can be produced in the Permian Basin to market - will continue to limit growth in the short-term. In the face of robust demand, the risk to oil prices thus remains to the upside. A stronger dollar will somewhat undermine the profits of U.S. multinationals. U.S. equities also appear a little expensive versus Europe and Japan based on our composite valuation indicators (Chart I-14). Nonetheless, the sector composition of the U.S. stock market is more defensive than it is elsewhere and relative economic growth will favor the U.S. market. On balance, we no longer believe that euro area and Japanese equities will outperform the U.S. in local currency terms. Overweight the U.S. market on an unhedged basis. Chart I-13Oil Production Outlook Chart I-14Composite Equity Valuation Indicators Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins. Mark McClellan Senior Vice President The Bank Credit Analyst June 28, 2018 Next Report: July 26, 2018 1 Please see Geopolitical Strategy Special Reports, "The South China Sea: Smooth Sailing?," March 28, 2017 and "Taiwan Is A Potential Black Swan," March 30, 2018, available at gps.bcaresearch.com. 2 Please see The Bank Credit Analyst Overview, dated December 2016, Box I-1. 3 Please see Geopolitical Strategy Special Report, "Mediterranean Europe: Contagion Risk Or Bear Trap?," June 13, 2018, available at gps.bcaresearch.com. 4 Please see The Bank Credit Analyst, March 2018 and June 2018, available at bca.bcaresearch.com. 5 The breakeven spread is the amount of spread widening that would have to occur over 12 months for corporates to underperform Treasurys. We focus on the breakeven spread to adjust for changes in the average duration of the index over time. II. U.S. Fiscal Policy: An Unprecedented Macro Experiment Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart II-1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart II-1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart II-2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart II-2Lots Of Fiscal Stimulus In 2018 And 2019 Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart II-3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart II-3Comparing To The Reagan Era The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart II-3). Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb Chart II-4The Withering Support Ratio The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart II-4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts II-5 and II-6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart II-5Entitlements Will Explode ##br##Mandatory Spending Chart II-6All Discretionary Spending ##br##To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart II-7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart II-7An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart II-8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart II-8U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart II-9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart II-9U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart II-10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart II-10The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? Chart II-11Entitlements Are Popular* The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart II-11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart II-12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart II-12What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart II-12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart II-13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart II-14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. Chart II-13U.S. Budget Deficit Stands Out Chart II-14International Debt Comparison The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box II-1. None of the factors in Box II-1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. BOX II-1 Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IO Us. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart II-15Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart II-15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart II-16).5 Chart II-16Structural Drivers Of The U.S. Dollar Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com. 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in June. Forward earnings estimates continue to climb at an impressive pace. The U.S. net revisions ratio pulled back a little, but remains well above the zero line. Moreover, positive earnings surprises continue to trounce negative surprises. That said, the earnings upgrades are partly due to the Trump tax cuts, which are still being reflected in analysts' estimates. Second, some of our indicators are warning that there are clouds on the horizon. Our Monetary Indicator has fallen to levels that are low by historical standards, which is a negative sign for risk assets. This partly reflects the slowdown in growth in the monetary aggregates (see the Overview section). Our Equity Technical Indicator is threatening to dip below the zero line, which would be a clear 'sell' signal. Our Equity Valuation Indicator is flirting with our threshold of overvaluation, at +1 standard deviations. This is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Our Willingness-to-Pay (WTP) indicator for the U.S. has rolled over, although this hasn't yet occurred for Japan and the Eurozone. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This indicator suggests that flows into the U.S. stock market are waning. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in June. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. The dollar is expensive on a PPP basis, but is not yet overbought. The long-term outlook for the dollar is down, but it has more upside in the next 6-12 months. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Oil markets are on tenterhooks, as unplanned outages; continued losses in Venezuela's output; pipeline bottlenecks in the U.S. shales; and a higher likelihood of sharper losses of Iranian exports are priced into global benchmarks. In our updated base-case balances model, we expect core OPEC 2.0 to front-load their just-agreed production increase, with ~ 800k b/d added to the market in 2H18, and just over 210k b/d in 1H19.1 This will lift the core's total output ~ 1.1mm b/d by the end of 1H19 vs. 1H18. This is offset by losses in the rest of OPEC 2.0 of ~ 530k b/d in 2H18, and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels (Chart of the Week). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our base case is augmented with three scenarios: i) Venezuela production collapses; ii) a reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks; and iii) both of these occurring simultaneously in the Oct/18 - Sep/19 interval. Our revised Brent ensemble forecast for 2H18 now stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to average $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months (Chart 2). Chart of the WeekOPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses Chart 2Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Highlights Energy: Overweight. We remain long call spreads along the Brent forward curve, given our belief upside risks will dominate oil markets. These positions are up 34.1% on average over the past four months they've been open. We expect backwardation to increase as OECD storage falls, supporting our long S&P GSCI trade, which is up 13.8%. Base Metals: Neutral. In a tit-for-tat response to U.S. tariffs on steel and aluminum, the EU imposed import duties on U.S. products this past Friday. Canada plans to impose tariffs beginning July 1, while Mexico has already implemented duties on U.S. exports. Risks that ongoing trade disputes could escalate into a trade war are weighing on the metals complex. Copper retraced its early June jump, despite ongoing contract renegotiations at Chile's Escondida mine. Precious Metals: Neutral. Gold traded down to the low $1,250/oz level as a stronger broad trade-weighted USD and rising real rates pressure the market. Ags/Softs: Underweight. In effort to diversify its source of imports amid the ongoing trade row with the U.S., China announced the removal of import tariffs on animal feed from five Asian countries earlier this week.2 Ag prices have fallen since the beginning of June amid fears escalating trade fights will bear down on U.S. farmers. Nevertheless, May trade data show China's ag imports have remained robust. Feature In recent weeks, markets have been buffeted by reports of a 350k b/d unplanned outage in Canada; 400k b/d of losses in Libya; continued force majeures in Nigeria's Bonny system; and indications Venezuela's production decline is accelerating: The country's U.S. refiner Citgo was left to fend for itself on the open market, in the wake of the failure of state-run supplier PDVSA to deliver crude. On top of that, markets appear to be pricing in as much as 1mm b/d of lost Iranian exports, on the back of increased pressure from the Trump Administration in the U.S., which is leaning on American allies to take Iranian imports to zero. In our modeling, we continue to expect 500k b/d will be lost to export markets, as a result of the re-imposition of sanctions by the U.S., but are watching the situation closely. The Kingdom of Saudi Arabia (KSA) is attempting to get out ahead of an almost-certain tightening of the global market. In what appears to be hastily arranged leaks, the Kingdom signaled it already has undertaken a two-month production ramp - lifting its output to record levels this month and next: 10.8mm b/d in June, 11mm b/d in July. This is up from ~ 10mm b/d earlier this year, per over-compliance by KSA on its OPEC 2.0 quota of 10.54mm b/d. Russia, the other putative leader of OPEC 2.0, is signaling it will be able to contribute ~ 200k b/d over 2H18, vs production of ~ 11.2mm b/d at present.3 OPEC 2.0 Front-Loads Output Hike Lacking detail from OPEC 2.0, we are front-loading the coalition's just-agreed production increase in our updated base-case balances model, with ~ 800k b/d added to the market in 2H18, and just over 210k b/d in 1H19. This lifts core OPEC 2.0's output ~ 1.1mm b/d compared to 1H18 levels. Core OPEC 2.0's increased production will be offset by continued losses in the rest of the coalition amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. Globally, we expect global supply to rise ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively. Our base case is augmented with three scenarios: i) Venezuela production collapses to 250k b/d from current levels of ~ 1.3mm b/d, which allows it to support domestic refined product demand and nothing more; ii) a reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks; and iii) both of these occurring simultaneously in the Oct/18 - Sep/19 interval. In our simulations, a Venezuela collapse would be met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the temporary lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. On the demand side, we are keeping annual growth at ~ 1.7mm b/d in 2018 and 2019. For all the agita in the market at present - largely a function of increasingly acrimonious trade frictions between the U.S. and its allies and China - fundamentals remain well supported. Indeed, one of our key gauges, EM trade import volumes, remains well supported (Chart 3). EM import volumes are closely aligned with income levels - as income grows, import volumes grow. Likewise, as EM incomes grow, demand for commodities - particularly oil and copper - grows. Chart 3Growing EM Incomes Support Import Volumes,##BR##And Oil Demand Chart 4Balances Remain##BR##In Deficit As always, EM demand growth paces global growth, rising at a rate of ~ 1.3mm b/d over the 2018 - 19 interval. In 2018, we expect consumption to average just over 100mm b/d globally, while next year we're expecting demand to come in at 102mm b/d. Even with OPEC 2.0's production hike, the contingencies we're modeling - in Venezuela and the U.S. shales - along with weak net growth in overall production volumes for the better part of the next 18 months, leaves global balances in deficit (Chart 4 and Table 1). This continues to force OECD inventories lower over the next 18 months (Chart 5). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 5Physical Deficits Draw Inventories Lower Our revised Brent ensemble forecast for 2H18 now stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months (Chart 2). OPEC 2.0 Likely Taps Spare Capacity At this point it appears OPEC 2.0 could be forced to revisit its just-concluded deal to lift production, particularly if, as appears increasingly likely, Venezuela's production collapses, and the market loses its 1mm b/d or so of exports. The country reportedly is falling behind in meeting commitments to its customers, which deprives it of the cash to pay for additives needed to run its heavy oil as a charging stock in refineries. Venezuela's state-owned Citgo refinery operating in the U.S. reportedly is being forced to source crude away from Venezuela, as the barrels it relied on in the past no longer are shipping on schedule. Chart 6Unplanned Outages Are Back Unplanned outages are once again picking up, following a relatively tranquil period (Chart 6). We expect continued volatility in crude oil markets over the next 18 months, particularly if unplanned outages continue to rise, and OPEC 2.0 is forced to cover another event(s) similar to the most recent loss of production in Libya, where civil unrest took ~ 400k b/d off the market, and Canada (~ 350k b/d), where a power failure at Syncrude Canada's oil sands facility in Alberta shut down production. Chart 7Global Spare Capacity Stretched Thin On this score, the market is extremely vulnerable - the U.S. EIA estimates OPEC's spare capacity presently is ~ 1.8mm b/d, most of which is found in KSA. By next year, the EIA expects spare capacity to be slightly over 1mm b/d (Chart 7). Estimated 2018 spare capacity translates into 1.8% of global consumption this year, and a little over 1.0% next year, given our demand estimates of 100mm and 102mm b/d this year and next. By way of comparison, in 2007, spare capacity stood at 2.4% of global demand - 2.1mm b/d vs. 86.4mm b/d. This was the period when WTI prices were headed to $150/bbl, and OPEC was meeting demand out of spare capacity. EM Consumers Exposed China and India pressed OPEC 2.0 leadership to raise production, because, along with other large EM economies, they implemented fuel-subsidy reforms, which expose their consumers to higher fuels costs. This is a key difference in the current cycle vs history: Many more consumers are directly exposed to higher prices. Recent academic research suggests higher prices resulting from strong demand are not destabilizing to economic growth if they reflect rising consumer incomes. However, rising prices due to supply shocks are destabilizing to economic growth, and typically are followed by recession. Higher oil prices resulting from a supply shock - e.g., if Venezuela were to go off line for a long enough period of time - would force OPEC 2.0 and the U.S. shales to replace more than 3mm b/d of lost production. At this point, it is not clear they can do this in short order. Indeed, given the inelasticity of oil demand, it is likely demand destruction - via higher prices - would be required to balance supply and demand globally. Higher prices required to equilibrate markets almost surely would reduce EM oil demand - the dominant source of growth in our models - and derail the global economic recovery, if households' budgets are hit too hard by higher oil prices. Bottom Line: In our revised ensemble forecast for 2H18, we expect Brent crude prices to average $70/bbl, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to average $77/bbl next year. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Higher volatility is expected. We remain long call spreads along the forward curve, and expect backwardation to steepen, which will support our long S&P GSCI recommendation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. This past week it agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. 2 Please see "China drops tariffs on animal feed from Asian countries as U.S. dispute escalates," dated June 26, 2018, available at reuters.com. 3 Please see "Oil rises on supply losses, U.S. push to isolate Iran," published by reuters.com June 27, 2018, for reporting on KSA's intention to go to 11mm b/d. The number reported by Reuters for KSA's June production is slightly less than 800k b/d over the 10.03mm b/d production level for May KSA self-reported in this month's OPEC Monthly Oil Market Report. See also "OPEC, Russia Agree to Raise Production," published June 24, 2018, by egyptoil-gas.com. 11mm b/d would be record production for KSA. 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

Special Report

Highlights China's crude oil inventories - both strategic and commercial - have skyrocketed in recent years. This has entirely offset the decline in OECD commercial crude oil inventories. China's crude oil import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017. Chinese crude oil inventories will rise much more slowly and a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. Chinese crude oil final consumption growth is tempering alongside slowing growth in almost all major petroleum products demand. Both transportation and industrial consumption growth of petroleum products is showing considerable weakness. The investment implication is that Chinese oil demand and especially imports of crude oil will likely be much less supportive of oil prices in the coming two years than they have been in recent years.1 Feature The common narrative in the global investment community of late attributes the oil price rally since 2016 to the decline in OECD crude oil inventories. Yet, the OECD countries do not include China and many other developing nations. This report looks to shed light on China's impact on the oil market with respect to demand, output and inventories. The most revealing part of our assessment is that China's crude oil inventories have skyrocketed in recent years, which in turn have offset the decline in OECD commercial crude oil inventories. The top panel of Chart I-1 illustrates that when China's crude oil inventories are added to the OECD measure, the aggregate of global crude inventories is currently still near a record high. Chinese crude oil inventories have surged from 470 million barrels in 2014 to more than 1 billion barrels presently (Chart I-1, bottom panel). In brief, China has been importing much more oil than it has been consuming since the middle of 2014, when crude prices began to collapse (Chart I-2). In other words, the massive inventory accumulation has been a major force behind the double-digit growth in China's crude imports. Chart I-1Be Aware Of High Chinese Crude Oil Inventories Chart I-2China: Importing More Oil Than Consuming The key question for investors is: Will China maintain strong crude oil imports growth going forward? Having examined China's demand, output, and inventory dynamics, we conclude that the recent deceleration in Chinese crude oil import growth (to 5-6%) has been driven by legitimate fundamentals. Crude import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017 (Chart I-3).2 Chart I-3Chinese Oil Imports Growth: ##br##No More Double Digits This suggests that China will be much less supportive of global oil prices in the coming year or two than it has been in recent years, a fact that may also weigh more generally on global investor sentiment towards China. A Clearer Picture Of Global Oil Inventories In Chart I-1, our calculation showed a massive buildup of China's crude oil inventories over the past three years, reaching a record high of 1,030 million barrels as of May 2018. Below we answer four questions about China's inventories: Why are China's oil inventories significant for investors? How did we calculate a timely monthly oil inventory estimate for China? How can investors judge the validity of our approach? What is the outlook for strategic and commercial inventory accumulation over the coming year? Why are China's oil inventories significant for investors? The following suggest that without China's oil inventory build-up, oil prices would not have rallied as much as they have over the past two years. In other words, China has been a major force pushing oil prices higher: Mainly due to the significant inventory buildup, the increase in Chinese oil imports has been bigger than the increase in global oil production in both 2016 and 2017, which are clearly different from previous years (Chart I-4, top panel). The 490 million-barrel increase in Chinese crude oil inventories over 2015-2017 alone mopped up 35% global oil production increase. While OECD commercial crude oil reserves have declined 275 million barrels from their July 2016 peak to May 2018, Chinese crude inventories have actually risen by 380 million barrels over the same period. As of May 2018, Chinese crude oil inventory levels had already risen to 36% of OECD total commercial crude oil inventories (Chart I-4, bottom panel). How did we calculate a timely monthly oil inventory estimate for China? Our Chinese crude oil inventory proxy was constructed based on the crude oil flow diagram shown in Chart I-5. Chart I-4China Has Been A Major Force For Oil Price Rally Chart I-5How We Derived Our Chinese Crude Oil Inventory Proxy? Total crude oil supply in China equals to the sum of crude oil net imports and domestic crude oil production. The crude oil available for demand is either for final consumption without any transformation, which in general only accounts for about 1-2% of total supply, or used in refineries to be transformed into petroleum products. The latter typically accounts for over 90% of total supply. The remaining unused crude oil is stored as either Strategic Petroleum Reserves (SPR) or Commercial Petroleum Reserves (CPR). Therefore, by deducting the crude oil consumed in the refining process from the total supply of crude oil, we derived the flow of inventory - the level of changes of inventory.3 By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. Here we assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low compared to current levels. Hence, any error in this calculation is reasonably minute. Chart I-2 on page 2 clearly shows that crude oil supply growth is much faster than the growth of domestic crude oil consumption, resulting in rising domestic crude oil inventories. In the meantime, Chart I-6 illustrates that most of the increase in China's crude oil imports have indeed been due to the massive build-up in domestic crude oil inventories - not growth in final demand. Chart I-6Significant Inventory Buildup Has Driven Up ##br##Chinese Crude Oil Imports Regarding the data, there is a technical question to clarify: Does the NBS data of crude oil consumed in the refining process cover all Chinese refineries? We believe so. The data always cover both state-owned refineries and large and medium non-state-owned refineries. The only question is whether the crude oil used in small refineries - which have capacity of 2 million tons per year or lower - are accounted for in the NBS data on the amount crude oil refined. According to NBS, the data is collected from refineries with annual main business income of RMB20 million and above. In China, all refineries have much higher revenue than RMB20 million. Even for a small refinery with capacity of 2 million tons per year, its annual main business income is considerably above this threshold. For example, at the end of 2013, there were 49 local refining enterprises in Shandong province, with total main business income of RMB 336 billion. This means on average one refining company in Shandong can generate about RMB 7 billion - significantly higher than the RMB20 million threshold. Investors should note that Shandong province has the most local refineries and owns the largest local refining capacity in China among all provinces. Since 2015 the government has also implemented supply reforms in the oil refinery sector, having shut down or upgraded outdated refining facilities with capacity of 2 million tons per year or lower. Therefore, the amount of crude oil used in the small refineries that is not captured by NBS statistics, if any, is insignificant. In addition, increasingly stringent environmental policies, intensifying domestic competition and rising requirements for higher-quality petroleum products have all forced many small refineries out of business. In brief, our level of conviction in our crude oil inventory estimate for China is high. How can investors judge the validity of our approach? Official Chinese oil inventory data does exist: the NBS publishes a yearly series of annual changes in domestic crude oil inventories. But the significance of our inventory estimate is that it is available with far greater frequency and timeliness than the official data, and a simple comparison of our proxy with the official data for crude oil inventories shows similar size and variations (Chart I-7). Hence, our inventory calculation provides investors with a timely monthly estimate of Chinese oil inventories that is consistent with official data. Chart I-7Validity Check: Our Inventory ##br##Proxy Vs. NBS Data What is the outlook for strategic and commercial inventory accumulation over the coming year? As of this past May, China had 290 million barrels of SPR and 740 million barrels of CPR. Looking forward, the pace of SPR accumulation will be significantly slower than the previous several years. Back in 2004, the government planned three phases of SPR construction. The first phase has long been completed, and was filled in before 2010. The completion of construction of the second phase of SPR was delayed from 2015 to last year. So far, the government has released little information about the third phase of SPR construction. Total capacity from the first two phases is 40 million tons: 12 million tons from the first phase and 28 million tons from the second phase. The NBS last December released Chinese crude oil SPR inventory data, which was at 37.73 million tons (277 million barrels) as of June 2017. We believe the second phase of the SPR was completed in the past 10 months, and that there is not much free SPR space left at the moment. The third phase has the same capacity (28 million tons, or about 200 million barrels) as the second phase. Given that in both first and second phases it has taken more than two years to select and construct the SPR sites, the fill of the third phase of the SPR will unlikely occur within the next two years. The CPR has been rising much faster than the SPR due to low oil prices and the government's policy of allowing local refineries to import crude oil starting in 2015. In the past three years, CPR accumulation accounted for about 80% of China's total crude oil inventory increase. This makes sense, as commercial crude oil users have much larger physical reserve space than the SPR. Also, both commercial users and the government would have taken advantage of previously low oil prices to import as much as they could during the past several years. This is in line with China's strategy of building commodities inventories when prices drop. Back in 2009-2010, when oil prices were low, China also significantly boosted its purchases of crude oil overseas to build up domestic crude oil inventories. As China will continue with its domestic refinery capacity expansion, we still expect further accumulation in the country's CPR, albeit at a much slower pace. That said, a brief period of modest de-stocking in commercial inventories of crude oil cannot be ruled out either. Current Chinese crude oil inventories (CPR and SPR combined) are no longer low (Chart I-8). They are equivalent to 123 days of crude oil net imports - much higher than the 90 days the IEA requires OECD countries to hold. Chart I-8Chinese Crude Oil Inventories: No Longer Low With Brent oil prices rising above $75 per barrel and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. Tightening credit supply also will hinder companies' ability and willingness to finance more inventory accumulation. This might cause even a brief period of de-stocking in commercial inventories of crude oil. Bottom Line: After a massive buildup over the past three years, further inventory accumulation for both the SPR and CPR will slow considerably and in fact a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. As a result, Chinese oil imports will converge to the pace of final demand growth. Tempering Final Oil Demand Growth In addition to our view that Chinese oil inventory accumulation will slow significantly and even could halt for several months, China's final oil demand growth is also trending lower (Chart I-9). As China's economic structure has been shifting from exports and investments to consumer spending, its energy intensity has declined. Petroleum products consumption within industry (mining, manufacturing and electricity generation) posted the biggest decline on record in the past decade, while consumption in transport service and residential posted the largest gains (Chart I-10, top panel). In 2016, the transport service and residential sectors (car driving and cooking and heating) together accounted for 83% of the increase in Chinese total petroleum products consumption (Chart I-10, bottom panel). Chart I-9Slowing China's Oil Consumption Growth Chart I-10Drivers Of Chinese Oil Consumption Growth In terms of types of petroleum products, this economic shift has translated into higher growth in gasoline, kerosene and LPG consumption, and lower growth in diesel fuel and fuel oil consumption. Gasoline and kerosene are mainly consumed as fuel for passenger cars and airplanes, respectively. LPG is also widely used for residential heating and cooking fuel. By comparison, diesel fuel and fuel oil are more used in the industrial process, even though diesel is also a major fuel for commercial trucks and special vehicles. As a result, gasoline, kerosene and LPG have experienced a rising share of total Chinese petroleum consumption, while diesel and fuel oil and other products have drifted lower (Chart I-11). Looking forward, we still expect positive growth in Chinese petroleum products consumption, but expect it to fall from 4-5% to 3-4% over the next two years. Chinese car sales growth will remain weak at 1-2% in the coming years as rising car ownership, advanced public transportation and high frequency of traffic jams temper car sales growth (Chart I-12). Chart I-11Chinese Oil Products As Share Of Total ##br##Oil Consumption: Gains And Losses Chart I-12Weak Car Sales Growth Some government policies are discouraging residents from owning a car. For example, Beijing car buyers are required to obtain a license plate through a random draw before they can actually drive their car. The odds of obtaining a plate in Beijing as of this past February stood at an astonishingly low 1 in 1,907 - twice as low as the end of last year (1 in 800) and the lowest since the license plate lottery was introduced in January 2011. In Shanghai and Shenzhen, it costs more than $14,000 to get a new car license plate, and the success rate of bidding keeps declining. Meanwhile, the authorities' priority is to move to ecologically friendly vehicles. The government has been using sale tax discounts to promote sales of small-engine cars with engines up to 1.6L from 2008 to 2017. As a result, among existing cars and new car sales, passenger cars with capacity under 1.6L account for over 55% of total cars (Chart I-13). The government also encourages new energy vehicle (NEV) sales through direct cash subsidies, tax subsidies and easier access to a new car plate. With the government's support, we expect NEV sales growth to remain high (Chart I-14). NEV sales reached 770 thousand units last year, and accumulated sales will rise to 5 million units by 2020. Chart I-13Government Promotes ##br##Ecologically Friendly Vehicles Chart I-14Strong Growth of New Energy ##br##Vehicle Sales Will Continue In addition, the government is aiming to improve the average passenger car's fuel efficiency from 6.7L/100KM to 5L/100KM in 2020 and further to 4L/100KM in 2025. This means a 25% reduction in fuel consumption for driving 100KM over the next two years, and another 20% reduction from 2020 to 2025. Fuel efficiency improvement has been limited in the past several years as gas-guzzling SUVs have dominated sales. The government could increase its policy enforcement to facilitate the improvement in fuel efficiency over the next 12-18 months as we move closer to 2020. China has also started promoting ethanol consumption in transportation fuel to substitute gasoline to some extent. The industrial sector will continue to slow, which will lead to lower diesel and fuel oil demand. Bottom Line: Chinese organic oil demand growth is on a weakening path. Improving Chinese Crude Oil Production After accounting for inventory accumulation and underlying demand growth, production is the final aspect to consider when analyzing China's impact on the market for oil. The big contraction in Chinese crude oil production - a 6.9% drop in 2016 and a 4.1% decline last year - has contributed to 33% and 22% of Chinese net imports growth in 2016 and 2017, respectively (Chart I-15). Chart I-15Chinese Crude Oil Production ##br##Will Likely Improve Aging fields and oil prices below break-even production costs are the main culprits behind shrinking output. We expect Chinese crude oil output to recover over the next 12-18 months. As China has a crude oil production target of a minimum of 200 million tons in 2020, the country has to boost its output by 4.4% over the next two years. Odds are high that Chinese crude oil output may at least stop falling this year. Petro China has produced 1.38 million tons of crude oil in Xinjiang in the past two years and plans to raise its output from the region to 6 million tons, in accordance with the country's 13th five-year development plan (2016-2020). Rising oil prices may help recover some production losses. In 2016, some high-cost and low-efficiency production in the Shengli oilfield was shut down. In that year, the Xinjiang oilfield also cut 700 thousand tons of production. Oil majors such as PetroChina and CNOOC are ramping up their upstream exploration efforts. Bottom Line: Chinese crude oil output is likely to recover over the next 12-18 months. Investment Conclusions The major investment implication from the above analysis is that Chinese oil demand and imports will be much less supportive for global oil prices in the coming two years than they have been in recent years. Chart I-16Crude Oil: Still Near-Record ##br##High Speculative Positions From the perspective of BCA's China Investment Strategy service, this reality may weigh on global investor sentiment towards China given the prominence that many market participants place on China's commodity demand when judging its contribution to global economic activity. BCA's China team downgraded Chinese ex-tech stocks versus their global peers to neutral from overweight in yesterday's Special Alert,4 and our conclusions in this report support that recommendation. From the perspective of BCA's Emerging Markets Strategy service, the "China factor" has probably not been well discounted in the current price of oil, as both net speculative positions and open interest in crude oil recently rose to their highest levels since at least 2000 (Chart I-16). Hence, the Emerging Markets Strategy team believes the risk-reward for oil prices is poor. In comparison, a lot of positive news that has already occurred and is widely known by investors - i.e. OPEC production rationing, U.S. newly re-imposed sanctions on Iran and a further decline in Venezuelan crude oil output - has likely already been fully discounted in current oil prices. In addition, emerging market (EM) ex-China crude oil demand is facing strong headwinds, given that oil prices in many emerging countries in local currency terms have risen substantially and in some cases to new highs (Chart I-17A and Chart I-17B ). Besides, as many of these countries have removed fuel subsidies, local prices will continue to move in tandem with world oil prices. Chart I-17AOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds Chart I-17BOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds The combination of both high local currency oil prices and fuel subsidies removals entails that consumers in many developing countries are already feeling the pain from higher oil prices, and their demand will slow. EM ex-China accounts for 45.3% of global oil consumption. Hence, weakness in EM demand from EM ex-China will not be inconsequential for oil prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 This view differs from BCA's Commodities and Energy Strategy team's view on oil that is bullish. 2 Our research suggests that China's net exports of petroleum products will likely continue to rise strongly and require even more crude oil imports. However, the increase of Chinese crude oil imports for rising net petroleum products will not affect total global crude oil demand as its final oil products will just be consumed outside of China. Hence, it is about shifts in market share of refineries not oil final demand. 3 This is also adjusted for final consumption of crude oil without refining. This use of crude oil account for only 1-2% of total crude oil supply (output plus net imports). 4 Please see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral," dated June 20, 2018, available on cis.bcaresearch.com

Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights In line with our House view, we expect the broad USD trade-weighted index (TWIB) to continue to appreciate over the next six to 12 months, as U.S. growth outpaces that of other DMs, and the Fed's pace of rate hikes outpaces that of other systemically important central banks. Ordinarily, this would be bad news for the overall commodities complex. However, most commodity prices disconnected from the U.S. dollar in 2015 - 16. This disconnect produced a not-often-seen positive correlation between commodities and the USD, which remained in place into 2017. Fundamentals are keeping oil and base metals correlations weaker vs. the USD. Precious metals and ags are most vulnerable to a stronger USD. Highlights Energy: Overweight. Cracks in Nigeria's Bonny pipeline system will further delay loadings already curtailed by a force majeure declaration, according to local sources. Elsewhere, the Kingdom of Saudi Arabia (KSA) apparently boosted production ahead of the regularly scheduled OPEC meeting in Vienna on June 22, as mounting losses in Venezuela and U.S. sanctions against Iran loom.1 KSA and Russia are pushing for higher production from OPEC 2.0 ahead of the Vienna meeting. Base Metals: Neutral. Although union negotiators took a conciliatory tone in discussions, contract terms between it and BHP Billiton in Chile's Escondida mine still have not been resolved. Among other things, the union proposed a salary increase of 5% and a $34,000 one-off bonus for workers.2 Precious Metals: Neutral. Gold prices held close to $1,300/oz going into this week FOMC meeting. Ags/Softs: Underweight: The USDA revised down its ending-stocks estimates for corn and soybeans for the 2017/18 and the 2018/19 crop years in its latest WASDE, which was released earlier this week. Feature Chart of the WeekUSD TWIB Vs. Chief Commodity Indices Broadly speaking, commodity prices are negatively correlated with the USD TWIB. The principal indices we follow - the CRB, Bloomberg and S&P GSCI index - all are cointegrated with the USD, i.e., they share a long-term trend, wherein commodity prices rise as the USD falls, and vice versa (Chart of the Week). Ordinarily, we would expect the near-term appreciation of the U.S. dollar to weigh on broad commodity indices' performance. These are not ordinary times. Surprisingly, what holds for these aggregate indices does not hold for individual commodity groups within the indices. We've ranked each commodity by industry group, and found that over the long term - and this is critical - oil and base metals are most sensitive to changes in the USD TWIB, while precious metals and ags are less sensitive. A 1% change in the U.S. dollar index leads to a change in the energy sub-index of the CRB of almost 5%, while a 1% change in the TWIB leads to a change of just under 4% for the base metals sub-index of the CRB. For the precious metals sub-index of the CRB, we would expect to see prices change by just under 3% for every 1% change in the dollar index, while for the ags sub-index of the CRB, broadly speaking, we could expect a change of just under 2.5%.3 USD's Complicated Relationship With Commodities To understand what's driving the broad indices and their component sub-indexes, we ran Granger-causality tests to get a better picture of what's driving what.4 On average, the U.S. dollar drives the broad indices, from a Granger-causality perspective. However, it does not drive the individual commodity sub-indexes in the same manner (Table 1). Table 1USD Vs. Commodities: What's Driving What? We found an interesting relationship between copper and oil: Copper's relationship with oil is stronger than its relationship with the USD - likely because both commodities respond to the same demand factors (e.g., global industrial growth), and that mining and refining copper are energy-intensive processes. We still see a long-term underlying common relationship with the U.S. dollar, but copper is more strongly tied to oil. Bottom Line: We ranked the four main commodity groups with respect to their historical sensitivity to the USD using two distinct metrics. Over the long haul, we found the order from most to least sensitive is (1) Energy, (2) Base Metals, (3) Precious Metals, (4) Ags. USD And Commodities Out Of Whack While most commodity indices exhibit strong and stable negative correlations with the U.S. dollar, many of these relationships were pushed out of their long-term equilibria in 2016, and, importantly, have remained out of whack for an unusually long period (Chart 2).5 In fact, we found most individual commodities and commodity groups haven't converged back to their long-term equilibrium correlation levels with the USD TWIB, and their respective divergences are once again moving higher (Chart 3). Chart 2CRB Sub-Indices Out Of Whack With USD Chart 3Short-Term Correlations Remain In Disequilibrium As we've shown in previous research, commodity prices can remain in disequilibrium with the dollar when important fundamental (supply - demand) shocks dominate price formation.6 Table 2 shows which commodity groups are most out-of-equilibrium since 2016 relative to their long-term historical correlation. Energy, especially oil, and base metals groups are at the top of this list. Despite the fact that both of these groups are the most sensitive to the USD, based on our long-term analysis discussed above, the fact that they remain in disequilibria with the USD suggests the increase in the U.S. dollar we expect over the next 6 months will have a limited impact on these commodities. This leaves ags and, notably, precious metals, most vulnerable to the USD appreciation foreseen in our House view. Table 3 shows how the sensitivities of the different commodity groups vs. the USD TWIB have changed from 2015 to now versus the 2000 to 2015 period preceding it.7 Moreover, we see that in the shorter period between 2015 and now, the base metals and oil sensitivities (in red) are not significant. Economically, this means prices have disconnected from the USD during this period, owing to the overwhelming influence of supply-demand fundamentals on the price-formation process. Table 2Rank Of Rolling Correlation Divergences##BR##In 6-Month Vs. 5-Year Rolling Correlations Table 3Fundamentals Overwhelm##BR##USD's Influence Since 2015 The most plausible explanation for this is base metals and oil markets experienced fundamental shocks over the period - especially since 2016, e.g. OPEC launching a market-share war in 2014 and surging production, followed by the OPEC 2.0 production cuts still in force in the market. In theory, and absent important fundamental (supply-demand) shocks in base metals and energy markets (e.g., a strike at major copper mines or an unexpected outcome at the OPEC 2.0 meeting next week), these correlations should converge back to the long-term equilibrium. However, the speed of convergence is unknown. As long as we observe a disequilibrium in the short-term correlations, we can assume that the disequilibrium will be maintained over the short term. The short-term correlation movements show most of the commodity groups were converging toward equilibrium in recent months, but have since reversed course, particularly oil (Chart 4 and Table 2). Chart 4Short- Vs. Long-Term Correlations Divergence We believe the historic correlation levels between base metals and oil prices and the USD TWIB gradually will be restored. However, a number of factors will have to be monitored in order to determine the timing and the level around which the correlations will stabilize - i.e., close to the 2008 - 2013 levels or to those of the 2000 - 2007 period (Chart 5). We found that the EM/DM business cycle - i.e., the relative performance of EM to DM economies - as well as the shape of the oil forward curve generally can act as mediating factors in restoring the correlations of the USD TWIB and commodity prices.8 The stronger EM economies are relative to DM economies, or the more in contango the oil forward curve is, the more negative the correlations between commodities, especially oil and base metals, and the USD TWIB. Obviously, should the opposite occur, we would expect the weaker correlations to persist, although this might not constitute a complete disequilibrium. The mediating factors we mentioned can diminish or enhance the USD - Commodity correlations, but that does not mean they completely break them down. Chart 5Oil Vs. USD TWIB Correlation Remains Out Of Whack Bottom Line: Commodity prices disconnected from the U.S. dollar in 2015 - 16, which led to a rare environment in which the correlations between the USD TWIB and commodities became positive. Surprisingly, this disconnect remained in place for an extended period, which led us to revise our USD-elasticity ranking of commodity groups. As long as the fundamental shocks in the energy and base metals groups continue to dominate price formation in these markets, precious metals and ags will remain the most vulnerable groups to U.S. dollar appreciation. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "More delays to Nigerian Bonny Light as crude pipeline closes," published by Naija247 in Nigeria on June 11, 2018, and "Saudis Start to Ramp Up Oil Output, Ahead of OPEC Meeting," published by The Wall Street Journal, June 8, 2018. See also BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding to Higher Output; Volatility Set To Rise ... Again," published on March 31, 2018. Available at ces.bcaresearch.com. OPEC 2.0 is the name we coined for the oil-producer coalition led by The Kingdom of Saudi Arabia (KSA) and Russia. 2 Please see "Escondida Union to Copper Investors: Bet on Quick Wage Deal," published by bloomberg.com, June 7, 2018, and "BHP responds to contract proposal from union at Chile's Escondida mine," published by uk.reuters.com on 11 June 2018. 3 These elasticities are the average coefficients for each commodity group we calculated using two different cointegrating regressions - Dynamic Ordinary Least Square and Panel - covering Jan 2000 to now. 4 Granger-causality measures the extent to which changes in one variable cause (or allow one to predict) changes in another variable. This is based on the work of the 2003 Nobel laureate, Clive Granger, who began publishing on this in 1969. Please see "Investigating Causal Relations by Econometric Models and Cross-spectral Methods," Econometrica, Vol. 37, No. 3 (Aug., 1969), pp. 424-438. 5 We make sure the correlations we estimate use cointegrated random variables, which means the empirical results we get provide consistent estimates of actual population correlations. Please see Johansen, Soren (2007), "Correlation, regression, and cointegration of nonstationary economic time series," published by the Center for Research in Econometric Analysis of Time Series at the Aarhus School of Business, University of Aarhus. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "OPEC 2.0 Vs. The Fed," dated February 08, 2018, available at ces.bcaresearch.com. 7 These sensitivities are coefficients in cointegrating regressions, which, given the construction of the regressions, are elasticities. 8 Using threshold regressions, we found the USD impact on BM and energy prices is, on average, weaker when DM stock prices outperform that of EM and when the oil forward curve is backwardated. These two variables act as mediators to the USD-Commodity relationship, and can be used to project the strength of the relationship. 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 Neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Although the U.S. economy is increasingly service-oriented, financial markets have become more bound to the manufacturing economy in the past 30 years. The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. Feature U.S. risk assets are rebounding amid solid economic news and rising hopes that another Eurozone financial crisis has been averted. Still, investors remain concerned about rising rates, protectionist trade policies, and the health of emerging market economies. In addition, market participants continue to scan the U.S. economic data in both the manufacturing and service sectors looking for signs that the late-cycle phase of the expansion is ending and that a recession is nigh. The NASDAQ and small cap U.S. stocks rallied past their February peaks last week, but the S&P 500 remains 3.7% below its early 2018 heights. Moreover, BCA's stock-to-bond ratio continues in an uptrend and we expect stocks to beat bonds in the next year. However, neither U.S. high-yield spreads nor the VIX have returned to their January lows. 10-year Treasury yields are 53 bps higher and the dollar is up by 5%. West Texas Intermediate oil prices peaked at $72.26/bbl on May 21. We discuss BCA's latest view on oil later in this report. U.S. economic growth remains solid. May's reading (58.6) on the ISM non-manufacturing index released last week is consistent with 3.5% real GDP growth. Moreover, the May sounding (58.7) on manufacturing indicates that the U.S. economy is growing near 5%. We discuss the signal from both the ISM's manufacturing and non-manufacturing indicators in the next section. In any case, U.S. economic activity in 1H 2018 will easily surpass the FOMC's view of both potential GDP growth (1.8%) and its estimate for actual growth in 2018 (2.7%) (Chart 1). The Fed will provide a new set of dot plots and economic forecasts this week. BCA expects the Fed to bump up rates this week and then gradually during the next year. The Fed and the market's view of the path of rates in the next 12 months is aligned (Chart 2). However, BCA's stance is that inflation will accelerate in 2019, which would elicit a more aggressive response from the central bank starting in the second half of 2019. Our view is that the Fed will stick to its gradual path unless economic growth is much weaker than expected or inflation spikes higher. Moreover, because inflation is at the Fed's 2% target and the economy is at full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Still, a wider trade war is a risk to U.S. and global growth, and we address this issue in the service sector below. Chart 11H GDP Tracking Well Above##BR##Potential & Fed's Forecast Chart 2Fed And Market Aligned##BR##On Rate Path In Next 12 Months On The Same Page The ISM surveys - manufacturing and non-manufacturing - are aligned. The top panel of Chart 3 shows that both metrics have climbed since their troughs in late 2015 (manufacturing) and early 2016 (non-manufacturing). These lows occurred amid EM-related economic and market turbulence. The 2015 nadir in the manufacturing series was more pronounced, thus the rise outpaced the non-manufacturing indicator (panel 2). U.S. financial markets, and the stock market more specifically, are sensitive to the performance of the manufacturing sector. The service sector accounts for 62% of U.S. economic activity and 86% of private-sector employment (Chart 4). Charts 5 and 6 show the relationship between the year-over-year change in BCA's stock-to-bond ratio and the level of manufacturing (Chart 5) versus non-manufacturing (Chart 6) composites. The relationship (r-squared 0.56) between our stock-to-bond ratio and the manufacturing sector is more robust that the r-squared (0.43) between the stock-to-bond ratio and the non-manufacturing sector. Chart 3Manufacturing And Non-Manufacturing ISM Are Aligned, But That's Not Always The Case Chart 4U.S. Economy Is 60% Services... Although the U.S. economy is increasingly service-oriented, Charts 7 and 8 show that the financial markets have become more bound to the manufacturing economy in the past 30 years. Between 1958 and 1988, the r-squared between our stock-to-bond ratio and manufacturing data was 0.19 (Chart 7). That increased to 0.34 from 1988 to 2018 (Chart 8). Chart 5Tighter Relationship Between##BR##Stock-To-Bond Ratio And Manufacturing ISM... Chart 6... Than With##BR##Non Manufacturing ISM Chart 7ISM Manufacturing Vs.##BR##Stock-To-Bond Ratio 1958-1988... Chart 8... And##BR##1988-2018 Chart 9 shows that there have been six other periods when the manufacturing index recovered more quickly than non-manufacturing. Five of the intervals were associated with EM stress.1 Moreover, as is currently the case, the economy was at or below full employment in four of the six occasions when manufacturing outpaced the service sector. Furthermore, the Fed initiated rate hikes in four of the seven episodes, including the current one (Appendix Chart 1). EM stocks tend to outpace U.S. equities as the non-manufacturing index rises faster than the manufacturing index. In addition, when the U.S. manufacturing sector is accelerating relative to the service sector, China's growth prospects (as measured by the LI Keqiang Index) improve. Chart 9Performance Of EM Assets When Manufacturing ISM Outpaces Service Sector ISM The peak in our Relative ISM composite index is consistent with BCA's view that the economic expansion that began in 2009 is nearing an end. Our Relative ISM Composite dipped prior to the 2001 recession, but began to rise as the 2007-2009 downturn commenced. Both the manufacturing and non-manufacturing indices collapsed at the same pace prior to the 2007-2009 recession, because the breakdown of the banking system related to the housing crisis weighed on the non-manufacturing data. Unfortunately, the ISM non-manufacturing data only begins in 1997. However, using the goods and service-sector GDP as proxies for the ISM metrics, we find that the manufacturing sector tends to underperform the service sector in the late stages of an expansion (Chart 10). Our earlier work2 details the performance of U.S. financial assets in a late-cycle environment. Chart 10Manufacturing Sector Tends To Underperform The Service Sector In Late Cycle Environments Bottom Line: Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Service Sector: An Update Even with the increasingly dominant role of the service sector (Chart 4 again), the majority of high frequency economic data measures activity in the manufacturing sector. However, the Quarterly Services Survey (QSS) initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the service sector which includes small- and medium-sized companies3 and produces timely revenue figures on a quarterly basis. The dataset is used primarily by the BEA to paint a more accurate picture of national accounts, notably personal consumption and the intellectual property segment of private-fixed investment. The survey is also essential for FOMC policymakers because it is very useful to track economic performance. Moreover, the QSS is an important source of revisions to real GDP because over 40% of the quarterly estimates of personal consumption expenditures (PCE) for services is based on the QSS. The "key services statistics" include information services, health care services, professional, scientific and technical services, administrative and support, and waste management and remediation services. The QSS for Q1 2018 found that total revenues for selected services fell by 1.2% over the previous quarter but rose 5.2% over the last four quarters (in nominal terms and only non-seasonally adjusted data available). Nominal GDP climbed 4.7% year-over-year in Q1 (Chart 11). Several areas of the service economy saw sales growth in Q1 outpace nominal GDP. Sales were strongest in finance and insurance (+7.8%) followed by information (+7%). Real estate and rental leasing sales increased by 4.7% in the past year while revenue in health care & social assistance rose +3.4%. Together, sales in finance & insurance and health care & social assistance make up about 50% of total revenues. Chart 11Many Areas Of Service Sector##BR##Advancing Faster Than Nominal GDP Chart 12Sales Growth In The Service Sector##BR##Is Broad Based However, revenue growth in several categories decelerated in Q1 and grew more slowly than nominal GDP. Arts, entertainment and recreation, administration support and waste management, and other services are in this category. Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see a similar revision to real consumer spending for services for the third estimate of Q1 real GDP in late June (Chart 12). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2018. This above-trend growth will continue to put downward pressure on the unemployment rate and push inflation higher, setting the stage for a more aggressive Fed next year and a recession in 2020. The Wrong Trade War? The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market (Chart 13). President Trump campaigned on his ability to create high-paying manufacturing jobs and he has focused his attention on the goods side of the U.S. trade deficit. Nonetheless, his America First rhetoric threatens jobs in the high-paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side (Chart 14). U.S. imported goods exceeded exports by $807 billion in 2017. Service exports reached an all-time high of $798 billion in 2017 - $255 billion more than imports - up from $249 billion in 2016. It is too soon to tell if the smaller surplus in services is related to Trump's protectionist trade rhetoric. Exports of services have increased by 6% a year on average since 2000, which is nearly twice as fast as nominal GDP. Service exports expanded by just 4% in 2017 versus 2016, which is below the pace of nominal GDP (4.7%) The trade surplus in services subtracted 0.08% from real GDP in Q1 2018, but added 0.05% in 2017. Moreover, the trade surplus in services has consistently added to GDP growth over the past few decades, although the trade surplus in services is swamped by the large drag on GDP due to the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is faster than in industries where the U.S. runs a deficit. In addition, median wages ($30.07 as of April 2018) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24.94) where there is a trade deficit. Moreover, wages in the trade-oriented service sector have escalated quicker than in the goods-producing sector in the past year (Chart 15). Chart 13The U.S. Runs Trade##BR##Surplus In Services... Chart 14...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods Chart 15Wages In Export-Led Service Industries##BR##21% Higher Than In Goods Sector Furthermore, exports in the U.S. service sector tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast for a modest increase this year (Chart 16). That said, the Trump administration's trade policies threaten to reduce the U.S.'s global dominance in services. Chart 16Services Exports Compete On Quality, Not Price Table 1 shows that the U.S. has the largest trade surplus in travel ($82 billion surplus in 2016), intellectual property ($80 billion), financial services ($73 billion) and other business services ($43 billion), which includes legal, accounting, consulting and architectural services. The U.S. also runs a surplus in maintenance and repair services. Table 1Key Components Of U.S. Trade Surplus In Services Trump's trade and immigration policies put this trade surplus at risk. In 2016, foreigners spent $82 billion more to vacation in, travel to, and be educated in the U.S. than what U.S. citizens spent on those services overseas. Moreover, a recent U.N. report4 noted that "Global flows of foreign direct investment fell by 23 per cent in 2017. Cross-border investment in developed and transition economies dropped sharply, while growth was near zero in developing economies." If foreign governments continue to react to Trump's directives on trade and immigration, then the U.S. trade advantage in financial services ($73 billion), software services ($29 billion), TV and film rights ($12 billion), architectural services ($5 billion) and advertising ($10 billion) will also be at risk. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth via increased manufacturing output and a smaller goods trade deficit. However, many U.S. trading partners have already announced tariffs on U.S. goods which will put the brakes on growth. Even so, any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the midterm elections in November.5 On a related note, an increase in onshore oil production in the past 10 years reduced the U.S's large trade deficit in petroleum and petroleum products. BCA's energy strategists recently updated their oil price and production forecasts for this year and next. Still Bullish On Oil BCA's Commodity & Energy Strategy service remains bullish on oil, although two key elements of the outlook makes forecasting particularly difficult.6 Our base case forecast has been bullish for some time, based on our assumption that OPEC 2.0 would retain its previous output cuts, at least through the end of 2018. Venezuela's production has contracted sharply and we penciled in a further modest decline. Iranian exports will also shrink due to the re-imposition of U.S. sanctions. The only substantial growth on the production side is expected to come from U.S. shale producers. The supply/demand backdrop pointed toward higher prices with world demand projected to remain robust. We estimated that Brent could reach $90/bbl early next year. Chart 17Ensemble Forecast Accounts For##BR##Collapse In Venezuela's Exports However, some major oil consumers, including the U.S., are starting to complain. The U.S. has asked the OPEC 2.0 countries to increase output, which may remove further upward pressure on prices. OPEC 2.0's leadership has signaled that it will consider reversing the production cuts during the second half of this year. This could add an extra 870 b/d of production. The other major unknown is how much further Venezuelan production will slide. Our oil strategists have run alternative scenarios to gauge the risks to the base case. The optimistic case sees OPEC 2.0 retaining production cuts and Venezuelan production dipping by another 1m b/d. The pessimistic case sees OPEC 2.0 reversing the production cuts, while Venezuelan production erodes modestly compared with the base and optimistic cases. Chart 17 shows that Brent hits $100/bbl in 2019 in the optimistic case, but drops to $60 in the pessimistic scenario. The ensemble forecast, shown in red in Chart 17, is a weighted average of the three scenarios. It shows that the price of oil will be roughly flat over the next 18 months. Bottom Line: Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com Appendix Appendix Chart 1Fed Policy And Labor Market Slack When Manufacturing ISM Outpaces Service Sector ISM 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 3 https://www.census.gov/services/qss/about_the_survey.html 4 http://unctad.org/en/PublicationsLibrary/wir2018_overview_en.pdf 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com.

Special Report

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Our Commodity & Energy Strategy (CES) desk is using a new ensemble forecast, which takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl, and WTI to $70/bbl from $72/bbl. For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and WTI goes to $67/bbl from $72/bbl. CES expects higher volatility, as well. Feature Following the roll-out of our oil-price ensemble model last week, we are publishing a Special Report written by our colleague Marko Papic, who runs BCA's Geopolitical Strategy (GPS) service. This report explores the more nuanced aspects of the U.S. - Iran sanctions conflict, and why the contest for Iraq is important for investors. We also summarize our latest forecast. We trust you will find this analysis informative, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Chart 2BCA's Updated Ensemble Forecast:##BR##Brent Averages /bbl in 2H18 Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 CES's updated ensemble forecast takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl previously, and its WTI forecast to $70/bbl from $72/bbl (Chart 2). For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and its WTI expectation goes to $67/bbl from $72/bbl. CES expects higher volatility, as well, as markets continue to process sometimes-conflicting news flows. This means spike to and through $80/bbl for Brent are more likely than markets currently anticipate. Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.4 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).5 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.6 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."7 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).8 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.9 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Chart 4Geopolitical Crises And Global Peak Supply Losses Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). Map 3The Collapse Of A Would-Be Caliphate How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.10 Chart 5Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.11 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. Chart 6Great Power Competition The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission. In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix on page 24). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Diagram 1South China Sea As Traffic Roundabout Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.14 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.15 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Chart 8Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. Box 1: Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1a Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.16 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##BR##Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##BR##Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have 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 achieved (Chart 11). 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 12). Furthermore, 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 1.2 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 13). Chart 11Primary OPEC 2.0 Members Are Producing##BR##1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary##BR##OPEC 2.0 Chart 13Venezuela Is##BR##A Bigger Risk 2H18, 2019 Oil Forecasts BCA's Commodity & Energy Strategy updated its forecast last week, after the leaders of OPEC 2.0 indicated member states would be considering putting as much as 1mm b/d back on the market, following the price run-up accurately called from the beginning of this year. KSA and Russian are not being explicit about what they intend to do. In the background are the U.S.'s renewed Iran sanctions discussed above, which could remove ~ 500k b/d from the export markets by the end of 1H19, and the increasingly likely collapse of Venezuela's exports, which could remove ~ 1mm b/d. Against this, we have production in the U.S. shales increasing this year and next by ~ 1.3 - 1.4mm b/d to offset these potential losses, but even there we're seeing problems getting the shale oil out of the U.S.17 That's why CES went to an ensemble forecast, and will keep it in place as the market continues to process these conflicting signals (Chart 14). While some production will be restored to the market this year, it will be a drawn-out process, given CES's view OPEC 2.0 does not want to undo the hard work it took to drain OECD oil inventories (Chart 15). CES's Brent forecast was lowered $2/bbl in 2H18 and $7/bbl in 2019 to $76/bbl and to $73/bbl, respectively. CES's WTI forecast for 2H18 also was lowered $2/bbl to $70/bbl, while our 2019 forecast is now at $67/bbl, down $5/bbl vs. our previous forecast. Chart 14Factors In BCA's Ensemble Forecast Chart 15Balances Will Loosen If Supply Increases CES continues to expect continued strength on the demand side, with global oil consumption growing 1.7mm b/d. This will be driven by steady income growth in EM economies. One of the principal gauges CES uses to assess EM demand - import volumes - continues to move higher on a year-on-year basis, signaling incomes continue to expand (Chart 16). EM growth accounts for 1.3 of the 1.7mm b/d of growth we're expecting in 2018 and 2019. In forthcoming research, CES will be looking more deeply into the evolution of demand and the threat - if any - higher prices pose for EM growth. As was noted in last week's CES publication,17 consumers in many states no longer are shielded from high oil prices, as they were in the past: Governments around the world used the collapse in prices beginning in 2014 to remove/reduce fuel subsidies. This changes the dynamics of EM oil demand considerably, even if governments feel compelled to step into markets and order suppliers to not pass through the entire price increase. OPEC 2.0's leaders - KSA and Russia - appear united in their view of what is required to keep oil markets balanced over the long haul, so as not to disincentivize consumers from purchasing cars and trucks and the motor fuel required to run them. But over the short term, their goals differ. KSA is looking to IPO Saudi Aramco - next year, according to the latest reports - and this sale would most definitely benefit from higher prices. Indeed, KSA's oil minister Khalid al-Falih appeared to be comfortable with prices pushing toward $80/bbl recently. Russia's energy minister, Alexander Novak, has said in the past he favors an oil price somewhere between $50 and $60/bbl. CES continues to believe the dominant price risks remain on the upside - at 28.31% and 12.12%, markets continue to underestimate the probability Brent prices will trade above $80 and $90/bbl this year and next (Chart 17). Chart 16Strong EM Commodity Demand Expected,##BR##As Incomes And Imports Continue To Grow Chart 17Oil Markets Continue To Underestimate##BR##Upside Price Risks In 2H18 And 2019 Bottom Line: A renewal of U.S. - Iran tensions throws up real risks that are not being fully priced by the oil markets at present. They raise the probability global oil supplies out of the Middle East will be directly threatened, and that tensions in Iran and Iraq will flare into proxy wars. Such an outcome would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Lastly, rising tensions could exacerbate sectarian conflict in the Middle East as a whole, particularly along the Sunni - Shia divide, which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 5 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 6 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 7 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 8 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 9 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 10 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 11 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 12 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 13 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 14 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 17 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again," published May 31, 2018.It is available at ces.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) 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