Europe

Highlights Duration Strategy: The recent market turmoil was a long overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. Country Allocations: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Feature Repricing "Central Banker Puts" Can Be Painful By a quirk of our scheduling, we have not published a regular Weekly Report since September, during what became a period of more turbulent global financial markets. While we trust that our clients have enjoyed the Special Reports that we have published instead, we are certain that many are asking an obvious question: have the more jittery markets triggered any change in BCA's views on global fixed income? The answer is "no". Just like the sharp "Vol-mageddon" risk asset selloff back in early February, the origin of the recent volatility spike was soaring U.S. Treasury yields driven by a rapid upward revision of Fed rate hike expectations (Chart of the Week). We had been expecting such an adjustment based on our positive assessment of the underlying momentum of both economic growth and inflation in the U.S. This remains a critical underpinning for our below-benchmark call on U.S. duration exposure, and our increased caution on U.S. spread product. Chart of the WeekRisk Assets Struggling As Bond Yields Rise There is more to the story than just the Fed, however. Throughout the course of 2018, we have been warning that global central banks moving away from accommodative monetary policies would be the greatest threat to market stability. This is not only a story of Fed rate hikes. A reduction in the pace of asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), combined with outright contraction of the Fed's swollen balance sheet, has created a backdrop more conducive to volatile spikes - especially if the global economy is losing upward momentum at the same time. The OECD leading economic indicator has been steadily declining throughout 2018, a reflection of the more challenging backdrop for non-U.S. growth. It is no coincidence that, without the support from accelerating liquidity or positive economic momentum, many of last year's best performing investments (Italian government bonds, the Turkish lira, Emerging Market (EM) hard currency corporate debt) have been some of 2018's worst (Chart 2). Investors were willing to ignore the poor structural fundamentals underlying those markets when times were good, but have been much more cautious in 2018 with a less supportive macro environment. Chart 2The Darlings Of 2017 Are The Duds Of 2018 While there have been numerous political headlines that have caused bouts of market turbulence in the past few months - the escalating U.S.-China "tariff war", the Italian fiscal debate with the European Union - the short-term impact of these moves is magnified when global monetary policy is being tightened and global growth is cooling. The reason why central banks have been forced to turn more hawkish (or at least less dovish) is that diminished economic slack has forced their hands. For policymakers with an inflation-targeting mandate, the Phillips curve framework remains the primary analytical framework. When they see low unemployment, they get nervous. When they see low unemployment AND rising inflation, then become hawkish. Three-quarters of OECD countries now have an unemployment rate below the estimate of the full-employment NAIRU - the highest level in a decade - and realized inflation rates are accelerating in the major developed economies (Chart 3). Our own Central Bank Monitors are signaling the need for tighter monetary policy in most countries, while yields at the front-ends of government bond curves are steadily rising. Chart 3Central Bankers Still Believe In The Phillips Curve Looking ahead, we continue to see more upward pressure on global bond yields in the next 6-12 months. Market pricing for the future policy actions of the major central bank did not move much even with the surge in volatility earlier this month. The markets now understand that the "policymaker put" that central bankers have implicitly sold to investors has a much lower strike price when labor markets are tight and inflation is accelerating. It will take much larger selloffs to cause central banks to become less hawkish. We still see the decisions we made in late June, moving to a more cautious recommended stance on overall risk in fixed income portfolios, as appropriate. Staying below-benchmark on overall global duration risk, while underweighting those countries where the central banks are under the greatest pressure to tighten policy, is the most sensible way to allocate a fully-investment government bond portfolio. That means underweighting the U.S. and Canada and overweighting Japan, Australia and the U.K. (Chart 4). In terms of credit, we are maintaining an overall neutral stance, but favoring the U.S. versus European equivalents and a maximum underweight on EM credit. Chart 4Interest Rates Remain Unfazed By More Jittery Markets Bottom Line: The recent market turmoil was a long-overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. The Most Important Charts For Our Most Important Country Duration Views When determining our recommended fixed income country allocation, there are a few critical indicators we are watching to assess if those views should be maintained. We now go over each of those indicators for the most important developed economy bond markets: U.S. (Underweight): Watch TIPS Breakevens & The Employment/Population Ratio U.S. Treasuries have been the one major government bond market this year that has seen a rise in both inflation expectations and real yields. The breakeven inflation rate implied by the spread between 10-year nominal Treasuries and TIPS has gone up from 1.97% to 2.10% since the start of 2018, while the real 10-year TIPS yield has climbed from 0.44% to 1.09% over the same period. The rise in inflation expectations has occurred alongside an acceleration of U.S. economic growth and a generalized rise in inflation pressures. Reliable cyclical leading indicators like the ISM Manufacturing index and the New York Fed's Underlying Inflation Gauge are pointing to an acceleration of U.S. core CPI inflation towards the 2.5-3% range over the next year (Chart 5). This would be enough to push 10-year TIPS breakevens comfortably into the 2.3-2.5% range that we deem consistent with the Fed's price stability target (core PCE inflation at 2%). Chart 5U.S.: Both Real Yields & Inflation Expectations Are Rising Any larger move in inflation expectations would only occur if the Fed were to accommodate it by not continuing to hike rates at the current 25bps/quarter pace. That is unlikely with the strength of the U.S. labor market suggesting that the Fed is behind the curve on rate hikes. The U.S. employment/population ratio for prime age (25-54 years old) workers has almost returned back to the peak levels of the mid-2000s near 80% (bottom panel). The Fed had to push the real funds rate to over 3% during that cycle to get policy to a restrictive setting above the Fed's estimate of the r-star neutral real rate. While it is unlikely that the Fed will need to push the real funds rate to as high a level as in the mid-2000s, the current real rate has not even caught up to the Fed's r-star estimate, which is starting to slowly increase alongside the stronger U.S. economy. That implies a higher nominal funds rate would be needed to push up the real rate to neutral levels, with even more nominal increases needed if inflation continues to accelerate. With only 62bps of rate hikes over the next year currently discounted in the USD Overnight Index Swap (OIS) curve, there is scope for Treasury yields to rise further over the next 6-12 months. Core Europe (Underweight): Watch Realized Inflation Relative to ECB Forecasts In the euro area, the evolution of unemployment, wage growth and core inflation compared to the ECB's positive forecasts will be the critical driver of the future direction of government bond yields. In its latest set of economic projections published last month, the ECB expects the overall euro area unemployment rate to be 8.3% in 2018, 7.8% in 2019 and 7.4% in 2020.1 With the actual unemployment rate falling to 8.1% in August, the realized outcomes are already exceeding the ECB's forecasts (Chart 6). The same can be said for euro area wages, where the growth in compensation per employee (2.45%) is already running above the 2018 ECB projection of 2.2%. The ECB expects no acceleration of wage growth in 2019 (2.2%), but a further ratcheting up in 2020 (2.7%). Chart 6Euro Area: Expect Higher Yields If ECB Forecasts Materialize In a recent Special Report, we identified a leading relationship between wage growth and core HICP inflation in the euro area of around nine months.2 This would suggest that core HICP inflation should rise towards 1.5% within the next six months based on the current acceleration of wage growth (second panel). This would be above the ECB's current projection for 2018 (1.1%), but in line with the 2019 forecast (1.5%). Core inflation is projected to rise to 1.8% in 2020. If unemployment and inflation even just match the ECB's forecasts, there is likely to be a material repricing of core European bond yields through higher inflation expectations. At 1.7%, 10-year EUR CPI swaps are well below the +2% levels that occurred during the past two ECB rate hike cycles in the mid-2000s and 2010-11 (third panel). Both wage and core price inflation in the euro area were around the ECB's current 2019-2020 projections during both of those prior tightening episodes, suggesting that the past may indeed be prologue when it comes to inflation expectations. Given growing U.S.-China trade tensions, and uncertainties over the future path for Chinese economic growth, there is a risk that the ECB's growth and unemployment forecasts are too optimistic. The euro area economy remains highly levered to exports, and to Chinese demand in particular. Furthermore, the ECB continues to provide very dovish forward guidance, with no rate hikes expected until at least September 2019. Yet with a mere 12bps of rate hikes over the next year currently discounted in the EUR OIS curve, there is scope for core European bond yields to rise further over the next 6-12 months if euro area inflation surprises to the upside. Italy (Underweight): Watch Non-Italian Bond Spreads & The Euro The Italian budget battle with the European Union has been a gripping drama for investors in recent months. Italian bond yields have been under steady upward pressure, with the benchmark 10-year yield getting as high as 3.78%. Yet the story remains as much about sluggish Italian growth as it is about Italian fiscal policy. The populist Italian government has pushed for larger deficits, but has toned down the anti-euro language that dominated the election campaign earlier this year. This is why there has been very minimal contagion from higher Italian bond yields into other Peripheral European bond yields or euro area corporate bond spreads, or into the euro itself which remains very firm on a trade-weighted basis (Chart 7). Chart 7Italy: A Story Of Weak Growth, Not Euro Break-Up We continue to view Italian government bonds as a growth-sensitive credit instrument, like corporate bonds. In other words, faster Italian economic growth implies greater tax revenues, smaller budget deficits and a less worrisome trajectory for Italy's debt/GDP ratio. The opposite holds true when Italian economic growth is slowing. This is why there is a reliable directional relationship between Italy-Germany bond yield spreads and the OECD's leading economic indicator (LEI) for Italy (top panel). With the Italy LEI still in a downtrend, we do not yet see a cyclical case for shifting away from an underweight stance on Italian government bonds. Yet if the 10-year Italian yield were to reach 4%, the implied mark-to-market loss would wipe out the capital of Italy's banks, who own large quantities of government bonds. In that scenario, the ECB would likely get involved to stem the crisis, possibly by further delaying rate hikes of ramping up asset purchases. This would especially be likely if there was significant widening of non-Italian credit spreads and a sharply weaker euro. Hence, watch those markets for signs that the Italy fiscal crisis could trigger a monetary policy response. U.K. (Overweight): Watch Real Wage Growth & Business Confidence In the U.K., our non-consensus call to stay overweight Gilts has not been based on any long-run value considerations. Real yields remain depressed and the Bank of England (BoE) has kept monetary policy settings at extremely accommodative levels. The BoE continues to expect that a rise in real wage growth is likely due to the very tight U.K. labor market. This would support consumer spending and eventually require higher interest rates. The only problem is that this is happening very slowly. The annual growth in U.K. wage growth is now up to 3.1%, the fastest rate since 2008. This is above the pace of headline CPI inflation of 2.5%, thus real wages are finally starting to perk up (Chart 8). A continuation of this trend would feed into faster consumer spending and, eventually, trigger BoE rate hikes. Chart 8U.K.: Brexit Uncertainty + Middling Inflation = BoE Doing Little One other big impediment to the BoE turning more hawkish is the uncertainty over the U.K. government's Brexit negotiations with the EU. The extended Brexit drama has weighed on both U.K. business and consumer confidence, both of which have struggled since the 2016 Brexit vote (third panel). With the March 2019 deadline for the U.K. "officially" leaving the EU fast approaching, the odds of no deal being reached in time are increasing. U.K. Prime Minister Theresa May is desperately trying to avoid a no-deal Brexit, but such an outcome would create further instability in U.K. financial markets and close any near-term window of opportunity for the BoE to try and hike rates. For now, we see the depressed confidence from Brexit uncertainty offsetting the bump up in real wage growth, leaving Gilts on a path to continue modestly outperforming as they have throughout 2018 (bottom panel). An announcement of a Brexit deal would be a likely trigger for us to downgrade Gilts to neutral, and perhaps even to underweight given the developing uptrend in real wage growth. Bottom Line: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201809.en.pdf 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?", dated October 5th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Fed remains on a tightening course as the U.S. economy has no spare capacity, yet growth in the rest of the world is suffering as EM financial conditions are tightening. It will take more pain for the Fed to capitulate and pause its 25-basis-points-per-quarter hiking campaign. This clash will heighten currency volatility and, as a result, carry trades will suffer. This means the current rebound in EM currencies is to be sold, and the dollar has more upside. China has not been deemed a currency manipulator, hence the RMB could fall more, creating a deflationary shock for the world. Keep an eye on what might become rocky U.S.-EU trade negotiations. Short CAD/NOK. Short GBP/NZD. Feature A significant increase in volatility across markets has been the defining characteristic of the past two weeks. This tumultuous environment is likely to persist as the Federal Reserve is set to tighten policy, and EM financial conditions deteriorate further. While it is true that enough market turbulence could cause the Fed to blink and temporarily pause its tightening cycle, the U.S. central bank has yet to hit this pain threshold. As a result, we expect carry trades and EM currencies to suffer further, even as we established a few hedges last week. The Battle Between The Fed And Global Growth Has Just Begun The Fed is set to increase interest rates further. For now there is little reason for the institution that sets the global risk-free rate to deviate from its current trajectory of increasing interest rates by 25 basis points per quarter. First, capacity utilization in the U.S. keeps increasing, and in fact, the amount of spare capacity in the U.S. economy is at its lowest level since 1989. This kind of capacity pressure has historically been enough to prompt the Fed to keep increasing rates, as it points toward growing inflationary risks (Chart I-1). Chart I-1No Spare Capacity In The U.S. Second, the labor market is currently at full capacity. This week's release of the JOLTS data not only highlighted that U.S. job openings continue to rise and are now well above the number of unemployed workers, but it also showed that the voluntary quit rate is at a 17-year high. U.S. workers are no longer petrified by fear of not finding a job if they were to jettison their current one. This is symptomatic of an economy running beyond full employment. Additionally, as Chart I-2 illustrates, the number of states where the unemployment rate stands below levels consistent with full employment is near a record high. Historically, this indicator has explained the Fed's policy well. Chart I-2The Labor Market And The Fed Third, and obviously a consequence of the previous two points, various components of the ISM survey are pointing toward an acceleration in U.S. core inflation (Chart I-3). This highlights that with the U.S. at full employment, the rise in inflation is giving free reign to the Fed to further lift interest rates. This development explains why Federal Open Market Committee members are much more willing than previously to display hawkish colors. Chart I-3U.S. Inflation Is In An Uptrend The problem for the currency market is that this hawkish Fed is not emerging in a vacuum. Global growth has begun to slow, and in fact is set to slow more. Korean export growth has been decelerating sharply, which historically has been a harbinger for global profit growth and global industrial production (Chart I-4). Chart I-4U.S. Strength Does Not Equate To Global Strength What lies behind this growth slowdown? In our view, two key shocks explain this vulnerability. First, China is deleveraging. Chart I-5 shows that efforts to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening imposed by Beijing, smaller financial institutions are not building up their working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak. The chart does highlight that deleveraging could take a breather in the coming months, in keeping with the change in official rhetoric. However, this pause is likely to be temporary. Do not expect China to push enough stimulus in its economy to cause a sharp rebound in indebtedness and capex. Xi Jinping has not yet abandoned his shadow bank crackdown, which weighs on overall credit expansion. Chart I-5Chinese Policy Tightening In Action Chinese Deleveraging Is Still Worth Monitoring Second, EM liquidity is deteriorating. Chart I-6 illustrates that global reserves growth has moved into negative territory. Historically, this indicates that our EM Financial Conditions Index (FCI) will continue to tighten. Many factors lie behind this deterioration in the EM FCI, among them: the collapse in performance of carry trades;1 the increase in the dollar and in U.S. interest rates that is causing the cost of servicing foreign currency debt to rise; and EM central banks fighting against currency outflows. Chart I-6Global Liquidity Is Tightening, So Are EM FCI This tightening in the EM FCI has important implications for global growth. As Chart I-7 shows, a tightening EM FCI is associated with a slowdown in BCA's Global Nowcast of industrial activity. As such, the tightening in EM financial conditions suggests that global industrial production can slow further. Since intermediate goods constitute 44% of global trade, this also implies that global exports growth could suffer more in the coming quarters. As a result, Europe, Japan and commodity producers remain at risk. The same can be said of EM Asia, which is the corner of the global economy most levered to global trade and global manufacturing. In fact, our Emerging Markets Strategy colleagues are currently reducing their allocation to Asia within EM portfolios.2 Chart I-7Tighter EM Financial Conditions Equal Lower Growth This deterioration in global growth and global trade is deflationary for the global economy. It is also deflationary for the U.S. economy. As we have highlighted in the past, since the U.S. economy is less levered to global trade and global IP than the rest of the world, weakening global growth tends to lift the greenback. Thus, if global goods prices are declining, such a shock can be compounded in the U.S. by a rising dollar. Does this mean the Fed will be forced to stop hiking rates in response to the growing turmoil engulfing the global economy and global financial markets? The Fed feedback loop suggests that if the dollar rises enough, if U.S. spreads widen enough, and if deflationary pressures build enough in response to these shocks, it will back off, as it did in 2016 (Chart I-8). Chart I-8The Fed Policy Loop However, the key question is that of the Fed's current pain threshold. We posit that 2018 is not 2016. As Ryan Swift argues in the most recent installment of BCA's U.S. Bond Strategy, the stronger the domestic economy is and the deeper domestic U.S. inflationary pressures are, the more the Fed will tolerate weaker global growth and tighter U.S. financial conditions.3 Currently, the U.S. domestic economy is so strong and so inflationary that despite less supportive U.S. financial conditions, our Fed Monitor still points toward more rate hikes in the coming quarters (Chart I-9). This is in sharp contrast to 2016, when the Fed Monitor highlighted the need for easier policy as U.S deflationary pressures were greater than inflationary ones. Chart I-9The BCA Fed Monitor 2018 Is Not 2016 As a result, we think that before the Fed blinks, the situation around the world will have to get worse. This means investors can expect further strength in the dollar and a further increase in borrowing costs around the world. Moreover, since the increase in U.S. bond yields is dominated by real rates, this means that the global cost of capital will continue its ascent - exactly as global growth is easing. This means financial markets could experience additional pain. In fact, Chart I-10 shows that the global shadow rate is a leading indicator of the currency market's volatility. Since the Fed is raising rates and the European Central Bank is tapering its asset purchases, the global shadow rate has scope to rise further. This points toward a continued increase in FX volatility. Higher FX volatility means that carry trades are likely to deteriorate again.4 If carry trades are to suffer more, this also implies that the current rebound in EM currencies is likely to prove temporary. Moreover, since an unwind in carry trades means that liquidity is leaving high interest rate countries, this also means that the EM FCI is set to tighten further, and global IP could suffer more. Chart I-10Higher Vol Ahead Hence, we recommend investors maintain a defensive stance in their FX exposure, favoring the dollar and the yen over the euro and commodity currencies. To be clear, we bought the NZD last week, but this position is a hedge. China is trying to manage the growth slowdown and is attempting to implement targeted stimulus measures. The risk is real that Beijing over-stimulates, which would cause the USD to weaken. The NZD is the best place to protect investors against this risk. Bottom Line: The Fed will continue to tighten policy as the U.S. economy is running well above capacity, creating domestic inflationary pressures. Meanwhile, EM economies are being hit by the combined assault of Chinese deleveraging and tightening financial conditions. This means the Fed is hiking in an environment of sagging global growth. Since it will take more pain for the Fed to back off, the dollar will rise further and carry trades will bear the brunt of the pain as FX volatility will pick up more. Use any rebound in EM currencies to sell them. Do the same with commodity currencies; AUD/JPY has further downside ahead. Breathe A Sigh Of Relief: China Is Not A Currency Manipulator On Wednesday, the U.S. Treasury published its bi-annual Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States report, better known in the market as the "Currency Manipulator Report." Despite the White House's vociferous pronouncements, the Treasury declined to name China a currency manipulator. This does not mean that it will not in the future, but it does mean that China may be willing to let the RMB weaken a bit further in the coming months to alleviate the pain of the trade war with the U.S. After all, a simple way to nullify the impact of tariffs is to let your currency fall. If Washington is not willing to take up this year's depreciation as a pretext for additional tariffs, then Beijing could just let the markets do its bidding and let the RMB weaken. This is dangerous for the global economy and for commodity prices. A weaker RMB means that the purchasing power of Chinese buyers in international markets will decline. This also means that the volume of Chinese purchases of industrial commodities could suffer. As a result, we continue to recommend investors minimize their exposure to the AUD. Moreover, a weaker RMB could cause fears of competitive devaluation across Asia, which means the Asian currency complex remains at risk. The most interesting piece of news from the report was that China only meets one of the three criteria that must be met to be deemed a currency manipulator: a bilateral trade surplus with the U.S. greater than US$20 billion. The Chinese aggregate current account surplus is well below the 3% of GDP threshold used by the U.S. Treasury, and the Chinese monetary authorities are not intervening in a single direction to depress their currency. But as Table I-1 shows, Japan, Germany and Korea already meet two of the Treasury's three criteria, and are thus ostensibly at an even greater risk of being named currency manipulators than China. However, the U.S. has already concluded a new trade deal with Korea that contains a currency component, and is seeking to do the same with Japan. Table I-1Where Does China Stand On The Treasury's Grid? It is true that naming China a currency manipulator will ultimately be a political decision, and on this front, the outlook is not good for China due to the structural decline in U.S.-China relations. But a chat with Matt Gertken of our Geopolitical Strategy Service reminded us that the EU and the U.S. are beginning to negotiate a trade deal, and Germany's large trade surplus could easily become a target. The U.S. and EU did not conclude the TTIP trade deal, so there is no foundation for the upcoming negotiations as there was with Korea, Canada, and Mexico. This raises the risk that the negotiations could be difficult and that the White House could threaten to implement tariffs against Germany under section 232 of the Trade Expansion Act of 1962 as a lever during the negotiations to get a more favorable deal for the U.S. This also means that heated trade negotiations between Europe and the U.S. could become a source of headline risk in the coming months, especially in the New Year - something the market does not need. Ultimately the U.S.'s main beef is with China and the Trump administration will want Europe's assistance in that quarrel. But Trump may still believe he can use tough tactics with the EU along the way. Bottom Line: China is not a currency manipulator. China could use this lack of designation as an opportunity to let the RMB weaken a bit further in the coming months. Moreover, Germany's large trade surpluses and the impending U.S.-EU trade negotiations suggest that the White House could use the lever of tariffs under section 232. This means that the risk of U.S.-EU trade-war headlines hitting the wire in the winter will be meaningful, though not as consequential as the U.S.-China conflict. This will contribute to higher volatility in the FX market. Sell CAD/NOK A potentially profitable opportunity to sell CAD/NOK has emerged. To begin with, CAD/NOK is an expensive cross, trading 10% above its purchasing-power-parity equilibrium (Chart I-11). While valuations are rarely a good timing tool in the FX markets, the technical picture is also interesting as the Loonie is losing its upward momentum against the Nokkie (Chart I-12). Chart I-11CAD/NOK Is Expensive Chart I-12From A Technical Perspective, CAD/NOK Is Vulnerable Economics point to a favorable picture as well. Now that the Norges Bank has joined the Bank of Canada in increasing rates, peak policy divergence is over. When policy divergences were at their apex, CAD/NOK was not able to break out. With Norway's current account standing at 6.6% of GDP versus -3% for Canada, without the help of policy, the CAD is likely to lose an important support versus the NOK. Moreover, there is scope for upgrading interest rate expectations in Norway relative to Canada. As Chart I-13 illustrates, the Canadian credit impulse has fallen relative to that of Norway, and Canada's employment growth is contracting when compared to the Nordic oil producer. This helps explain why Canadian PMIs are near record lows vis-Ã -vis Norway's, and why Canadian relative LEIs are also plunging to levels only recorded twice over the past 20 years. Chart I-13Canada's Economy Is Underperforming Norway's Additionally, CAD/NOK has historically tracked the performance of both exports and retail sales growth in Canada relative to Norway. Both these indicators have sharply diverged from CAD/NOK, and they suggest this cross could experience significant downside over the coming quarters (Chart I-14). This also further reinforces the idea that the Norwegian output gap may now be closing fast, especially relative to Canada. Chart I-14Economic Indicators Point To CAD/NOK Weaknesses In fact, Norwegian core inflation has also gathered steam, rising at a 2.2% rate, in line with Canada's. Meanwhile, Norwegian house prices are proving sturdier than Canadian real estate prices. This combination of similar inflation, improving growth, and outperforming dwelling prices suggests there is scope for investors to upgrade their assessment of the Norges Bank's policy versus that of the BoC. Finally, CAD/NOK is often affected by the spread between the Canadian Oil Benchmark and Brent (Chart I-15). Currently, the WCS/Brent spread is at a record low and may well rebound a bit. However, BCA's Commodity & Energy Strategy service expects Brent prices to rise to US$95/bbl in 2019, with a significant right-tail risk due to supply-curtailment.5 As the bottom panel of Chart I-15 illustrates, the WCS/Brent spread is inversely correlated to aggregate oil prices. Thus, higher Brent prices, especially if caused by supply disruptions, could lead to a continued large discount in the Canadian oil benchmark, and therefore downside risk to CAD/NOK. Chart I-15CAD/NOK Likes Weak Oil Prices This trade is not without risks. CAD/NOK is often positively correlated to the DXY dollar index. This means that this trade is at odds with our USD view. However, in the past five years, CAD/NOK and the DXY have diverged for more than two months more than 10 times. The current domestic fundamentals in Canada relative to Norway suggest that a low-correlation period is likely to emerge. Bottom Line: CAD/NOK is an attractive short. It is expensive and losing momentum exactly as the Canadian economy is falling behind Norway's. As such, investors are likely to upgrade their expectations for the Norges Bank relative to the BoC. This should weigh on CAD/NOK. No Brexit Risk Compensation In GBP; Sell GBP/NZD Six weeks ago, we published a Special Report arguing that while the pound was cheap on a long-term basis, its affordability mostly reflected the expensiveness of the greenback and that actually there was no risk premium embedded in the GBP to compensate investors for Brexit-related uncertainty.6 We argued that because there was a large stock of short bets on the GBP, the pound could rebound on a tactical basis but that such a rebound was likely to prove short-lived as there remained many political hurdles to pass before Brexit uncertainty abated. We thus expected GBP volatility to pick up. Now that the pound has rebounded, where do we stand? The Brexit risk premium remains as absent as it was in early September (Chart I-16). It is also true that the probability of a no-deal Brexit has decreased, which means that long-term investors could benefit from beginning to overweight the pound in their portfolios. However, a political labyrinth remains in front of us, which suggests that GBP volatility is likely to remain elevated, and that the pound could even suffer some tactical downside. Chart I-16No Brexit Risk Premium In GBP We have decided to express this near-term bearish Sterling view by selling GBP/NZD as a way to avoid taking on more dollar risk. First, since November 2016, GBP/NZD has rallied by 20%. Today, long positioning in the pound relative to the Kiwi is toward the top end of the range that has prevailed since 2004 (Chart I-17). This suggests that long bets in the GBP versus the NZD have already been placed. Chart I-17Speculators Are Already Long GBP/NZD Second, the U.K. and New Zealand are two countries where the housing market heavily influences domestic activity. In fact, as Chart I-18 shows, GBP/NZD tends to broadly track U.K. relative to New Zealand house prices. Currently, British residential prices are sharply weakening relative to New Zealand. Previous instances where GBP/NZD strengthened while relative dwelling prices fell were followed by vicious falls in this cross. Chart I-18Relative House Prices Point To A Weaker GBP/NZD... Meanwhile, the U.K. LEI has fallen to its lowest level since 2008 relative to New Zealand's. Moreover, U.K. inflation seems to be rolling over while New Zealand's may be bottoming. This combination suggests that investors expecting more rate hikes from the Bank of England over the coming 12 months but nothing out of the Reserve Bank of New Zealand could be forced to adjust their expectations in a pound-bearish fashion. Finally, over the past four years, GBP/NZD has followed the performance of British relative to Kiwi equities with a roughly one-quarter lag. As Chart I-19 shows, this relationship suggests that GBP/NZD has downside over the remainder of the year. Chart I-19...And So Do Relative Stock Prices Bottom Line: The British pound may be an attractive long-term buy, but the number of political landmines in the Brexit process remains high over the coming four months. As a result, we anticipate volatility in the GBP to remain elevated. Moreover, GBP has had a very nice bull run over the past two months and is now vulnerable to a short-term pullback. In order to avoid taking on more dollar risk, we recommend investors capitalize on the pound's tactical downside by selling GBP/NZD, as economic dynamics point toward a higher kiwi versus the pound. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and the Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, both available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "EMs Are In A Bear Market" dated October 18, 2018, available at ems.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 to $95/bbl" dated September 20, 2018, available at ces.bcaresearch.com 6 Please see Foreign Exchange Strategy Special Report, titled "Assessing the Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The retail sales control group growth outperformed expectations, coming at 0.5%, while retail sales ex autos growth surprised to the downside, coming in at -0.1%. JOLTS job openings outperformed expectations, coming in at 7.136 million. Moreover, both continuing jobless claims and initial jobless claims surprised positively, coming in at 1.640 million and 210 thousand respectively. DXY has risen by roughly 0.6% this week. We continue to believe that the dollar has cyclical upside; as the fed will likely raise rates more than what is currently discounted by the market. Additionally, slowing global growth and positive momentum should also provide a boon for the dollar. Tactically, however, positioning remains stretched, which means that a short correction is likely. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Industrial production yearly growth outperformed expectations, coming in at 0.9%. Moreover, construction output yearly growth also surprised to the upside, coming in at 2.5%. However, core inflation surprised negatively, coming in at 0.9%, while headline inflation was in line with expectations at 2.1%. EUR/USD has fallen by roughly 1% since last week. We expect the euro to have cyclical downside, given that it will be hard for the ECB to raise rates significantly in an environment where emerging markets are suffering. After all, Europe's economy is highly dependent on exports, which means that any hiccup in EM growth reverberates strongly on European inflation dynamics. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Capacity Utilization outperformed expectations, coming in at s positive 2.2%. It also increased relative to last month's reading. Moreover, industrial production yearly growth also surprised positively, coming in at 0.2%. Finally, the Tertiary Industry Index month-on-month growth also surprised to the upside, coming in at 0.5%. USD/JPY has been flat this week. We are neutral on USD/JPY on a cyclical basis, given that the tailwinds of rising rate differentials between U.S. and Japan will likely be counteracted by increased volatility, a positive factor for the yen. Investors who wish to hedge their short exposure to Treasurys can do so by shorting EUR/JPY, given that this cross is positively correlated to U.S. bond yields. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The yearly growth of average earnings including and excluding bonus outperformed expectations, coming in at 2.7% and 3.1% respectively. However, the claimant count change surprised negatively, coming in at 18.5 thousand. Finally, while the core inflation number of 1.9% outperformed expectations slightly, headline inflation underperformed substantially, coming in at 2.4%. GBP/USD has decreased by roughly 1.5% this week. Overall, we are bearish on the pound in the short-term, given that there is very little geopolitical risk price into this currency at the moment. This means that GBP will be very sensitive to any flare up in Brexit negotiations. We look to bet on renewed Brexit tensions by shorting GBP/NZD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The change in employment underperformed expectations, coming in at 5.6 thousand. Moreover, the participation rate also surprised to the downside, coming in at 65.4%. This measure also decreased from last month's number. However, the unemployment rate surprised positively, coming in at 5% and decreasing from the august reading of 5.3%; the labor underutilization measure tracked by the RBA also fell. AUD/USD has been flat this week. Overall, we continue to be bearish on the aussie, as the deleveraging campaign in China will be felt most strongly on China's industrial sector; a sector to which the Australian economy is highly levered, given that its main export is iron ore. Moreover, raising rates in the U.S. will continue to create an environment of volatility, hurting high beta plays like the AUD. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has risen by 0.4% this week. Last week, we bought the kiwi, as a hedge against dollar weakness. While the dollar has gained strength against most other currencies, the NZD has actually appreciated. We are also shorting GBP/NZD this week. This cross has broadly followed relative house price dynamics between U.K. and New Zealand, and the continued relative outperformance of kiwi housing points towards further weakening in GBP/NZD. Moreover, long positioning on this cross remains very high by historical standards, which means that there can significant downside for this cross on a 3 month basis. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has risen by roughly 0.5% this week. This week we are shorting CAD/NOK. This cross is expensive according to our PPP valuations. Moreover, the economic picture is also favorable for the NOK as the policy divergence between Norway and Canada has likely reached its peak. The credit impulse and the growth in employment are both stronger in Norway, while Norway's core inflation is now in line with Canada's. This means that rates in Norway have further upside, given that Canada's hiking cycle is much more advanced than Norway's. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Producer price inflation underperformed expectations, coming in at 2.6%. Moreover, the trade balance also surprised to the downside, coming in at CHF 2.434 million. EUR/CHF has fallen by 0.7% this week, as the EU leaders have expressed their displeasure towards Italy's new fiscal plan. On a structural basis, we continue to be bearish on the franc, as inflationary pressures continue to be too weak in Switzerland for the SNB to move away from its ultra-dovish monetary policy. That being said, political risks in emanating from Europe could prove to be bearish for this cross on a tactical basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by roughly 0.7% this week. The Norwegian krone is our favorite currency within the G10 commodity currencies. Norway is the only commodity currency with a substantial current account surplus. Furthermore, our commodity strategists expect oil to continue to strengthen, even though base metals might suffer in the face of Chinese monetary tightening. This relative outperformance by oil will help oil currencies outperform the NZD and the AUD. We are also shorting CAD/NOK this week, as Norway's economic strength is now matching Canada's. Thus, given that the Norges Bank has kept rates lower the BoC, there is room for rate differentials to move against CAD/NOK now that the Norwegian central bank has begun to lift its policy rate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by roughly 0.7% this week. We are bullish on the Swedish krona on a cyclical basis, as rates in Sweden are too low for the current inflationary backdrop. In our view, the Risksbank will have to make sure sooner rather than later that its monetary policy matches the country's economic reality. We are also bearish on EUR/SEK, as current real rate differentials points to weakness for this cross. Furthermore, easing by Chinese monetary authorities could provide further downside to EUR/SEK. After all the SEK is more sensitive to liquidity conditions than the EUR, which means that when liquidity is plentiful, EUR/SEK suffers. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. 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-9 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 I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Historically, the dollar exhibits positive seasonality in October and November. Technical and valuation indicators suggest that this year will be no exception. Continuing divergence between U.S. and global growth, rising interest rates, and Italian risks point in this direction as well. However, long positioning in the dollar along with the rebound in the China Play Index are creating non-negligible risks to this bullish dollar view. As a result, investors should overweight dollar exposure in their portfolio, but hedge the above risks by buying NZD/USD and selling EUR/JPY. Feature Through most of September, the dollar traded on the heavy side. However, in the last two trading days of the month, the greenback managed to regain some composure. As October and November have historically been strong months for the DXY (Chart I-1), this week we review if this seasonal pattern will once again hold. The balance of evidence suggests that the historical norm is likely to repeat itself, and that the dollar will continue to rally for the next six months or so, though there are a few risks that should be hedged against. Chart I-1Entering A Seasonally Strong Period For The Dollar Technicals: No Obstacle For A Strong Dollar An argument rooted in seasonality is a reasoning based on technical factors. Currently, technical indicators continue to paint a supportive backdrop for the greenback. First, by the beginning of the summer, based on its 13-week rate-of-change measure, the dollar index had reached overbought levels. Faced with this hurdle, the dollar's rally essentially took a pause, with the DXY rising only 0.5% since June 28, compared to its 6.4% rally between April 10 and June 28. However, through this side-move, the dollar's overbought conditions resolved themselves, and now the greenback's 13-week rate of change is back in neutral territory (Chart I-2, top two panels). Normally, a sideways correction tends to be a sign that a currency's underlying support remains strong. On the other hand, the euro's oversold correction is also now complete, but the euro has remained on a slightly more pronounced downward path over the same period (Chart I-2, bottom two panels). Chart I-2Short-Term Overbought Conditions Have Been Cleared Second, the fractal dimension measure for the trade-weighted dollar shows that despite the recent phase of dollar strength that began in September, the dollar's uptrend is not yet ready to exhaust itself (Chart I-3). The fractal dimension is a measure of groupthink promoted by Dhaval Joshi, head of BCA's European Investment Strategy. It compares the short-term and long-term variance of any asset to gauge if long-term and short-term investors are holding the same positions. If they do, risks are high that a paucity of buyers (or sellers in bear markets) may develop, resulting in a trend reversal as all investors are already similarly positioned. This fractal dimension flagged a yellow card for the dollar in June, but it was only followed by the sideways move described above. Now that the dollar is gaining some vigor, the recent pickup in this indicator suggests that this rally can run further. Chart I-3No Groupthink In The Dollar Third, while the dollar needed to digest some short-term overbought conditions, cyclical indicators like the Coppock Oscillator are still nowhere near overbought (Chart I-4, top two panels). By the spring of 2018, the dollar had reached massively oversold territory on a cyclical basis, and it is now in the midst of a powerful rebound. If history is any guide, once the Coppock Oscillator turns, it is likely to move much more than it has so far, indicating that the dollar rally has legs. However, the euro's Coppock Oscillator looks like it still possesses ample downside, as downdrafts never end at the current level of readings (Chart I-4, bottom two panels). Chart I-4Cyclical Oscillators Still Favor The USD Bottom Line: Technical indicators are currently not arguing against the normal seasonal strength in the USD. The short-term overbought conditions present at the beginning of the summer have evaporated, the dollar's trading action does not show meaningful evidences of groupthink, and a key cyclical momentum measure has further upside. Short-Term Valuations: No Obstacle Here Either An additional factor that might prevent the dollar's normal seasonal strength from realizing itself is the current valuation picture. Here again, there is little to worry about. As Chart I-5 illustrates, our Fundamental Intermediate Term Model and our Intermediate-Term Timing Model do not show any mispricing in the USD. The dollar is trading in line with our two augmented interest rate parity valuation metrics - two indicators that have historically been useful in spotting potential periods of USD risk. Chart I-5No Evident Mispricing In The Dollar Economic And Financial Market Developments Still Support The Dollar With no danger for the dollar from a technical and valuation standpoint, economic and financial market developments will likely hold the key to the dollar's outlook. First, economic divergences remains fully at play. As Chart I-6 illustrates, the U.S. economy is handily outperforming the rest of the world as the ISM Manufacturing Index has not been dragged down by the weakness observed outside the U.S. Historically, the gap between the ISM and the world's PMI leads the dollar's gyrations as the greenback is ultimately the factor forcing U.S. and global growth to converge. This time around, the growth gap suggests that the dollar has a few more months of strength ahead of itself. Moreover, Arthur Budaghyan writes in BCA's Emerging Market Strategy service that China's deleveraging campaign will continue to hinder global export growth (Chart I-7) - a sector of the economy with little weight in the U.S. This means that the growth gap between the U.S. and the rest of the world may widen further. Chart I-6Economic Divergences Support The Dollar Chart I-7China Deleveraging Points To Weaker Trade Second, the U.S.'s economic strength may be a problem for a large swath of the global economy. It is often assumed that strong U.S. growth lifts global demand through exports, undoing some of China's negative impact in the process. However, this does not take into account that U.S. rates determine the global cost of capital. The U.S. economy is currently much stronger than the rest of the world, and the U.S. private sector is not as burdened by debt as is the case outside the U.S. (Chart I-8). This makes the U.S. more capable of handling higher interest rates than the rest of the world. As a result, this year, the rise in both 10-year Treasury yields and TIPS yields has been met with pain in assets levered to global growth, like the German DAX and EM stock prices, as well as EM and commodity currencies (Chart I-9). Chart I-8The U.S. Has A More Robust Balance Sheet Chart I-9Higher U.S. Yields Hurt Assets Levered To Global Growth This is in sharp contrast with the U.S. The market and the Federal Reserve are coming to grips with the reality that the U.S. neutral rate is increasing, courtesy of robust household balance sheets, strong capex intentions, rising inflationary pressures and a large dose of fiscal stimulus. Thus, despite the rise in interest rates, the U.S. yield curve has started to steepen anew, even as global asset markets have been suffering (Chart I-10). Fed Chairman Jerome Powell has even given his subtle acquiescence to this move. Indeed, last week he argued that the Fed's policy might still be quite accommodative as the neutral rate may be sitting well above the current level of the fed funds rate. Chart I-10The U.S. Yield Curve Is Steepening Anew Third is the question of Italy. Italian yields continue to rise both in absolute terms and relative to German bunds. Some of this reflects the stress created by higher global real yields, which hurt the outlook for Italian growth and hence point toward a worsening debt load, which requires a higher risk premium in BTPs. But there is more to the widening in Italian spreads. Italy is setting its budget for next year, and is engaging in a war of words with Brussels. The Five Star Movement / Lega Nord Coalition wants to set a 2.4% of GDP deficit for 2019, much more than the previously agreed 0.8% penciled by the previous government this past spring. This is still within the 3% limit of the EU's Growth and Stability pact, but the European Commission and investors are concerned as Italy's public debt-to-GDP is already 133% - and this 2.4% deficit rests on extremely rosy growth assumptions. As a result, markets are punishing Italian bonds. This is a problem because when Italian yields rise, Italian banks suffer. Dhaval Joshi has argued in BCA's European Investment Strategy that a move in BTP yields to 4% could render the whole Italian banking system insolvent, as it would wipe out excess capital of EUR30 billion.1 Since the entire German, French, Spanish, Dutch, Austrian, Belgian, Greek, Irish and Portuguese banking systems still have low capital reserves, their combined EUR 479 billion exposure to Italy is fast becoming a Sword of Damocles. As a result, a war of words between Rome and Brussels - one that could last until December - could cause further tumult in European bank shares, and force the European Central Bank to stay on the defensive longer than it wishes to. This would hurt the euro and by symmetry, help the dollar. Bottom Line: Economic and financial market developments still support the dollar. The outperformance of U.S. growth relative to the rest of the world is likely to continue to be felt in the form of a stronger dollar in the coming months, especially as global exports remains negatively affected by China's deleveraging. Moreover, rising U.S. borrowing costs are so far having a limited impact on U.S. growth, but generating potent headwinds for activity outside the U.S. Finally, Italy is likely to remain a sore spot for Europe over the next two to three months, one that may weigh on the ECB's ability to provide any hawkish guidance this year. Risks To The View The view that the dollar can continue to rally is not without impediments. The first and most obvious one is that speculators have already aggressively bought the dollar (Chart I-11, top panel). This makes the greenback vulnerable to any unexpected improvement in global growth. Chart I-11Risks For The Dollar The second impediment is that a temporary reprieve in the global growth slowdown could well be materializing as we speak. G10 economic surprises have regain some vigor, and the diffusion index of BCA's Global Leading Economic Indicator has been rebounding (Chart I-11, bottom two panels). The third risk is that the China Play Index we introduced 10 weeks ago is rebounding (Chart I-12). This indicator, based on AUD/JPY, Swedish industrial stocks denominated in dollars, iron ore prices, Brazilian stocks and EM high-yield bonds, is very sensitive to Chinese reflation, or at the very least to how investors expect Chinese reflation to evolve going forward. This may reflect the fact that the People's Bank of China has injected liquidity into the banking system by cutting the Reserve Requirement Ratio four times this year, or that local government borrowings have increased. Chart I-12Investors May Be Betting On Chinese Reflation However, these three factors remain risks, not our base case. After all, net speculative positions in the dollar can stay elevated for extended periods, and the Chinese stimulus that is helping the China Play Index and maybe even the G10 surprise index still pales in comparison to the size of the aggregate deleveraging that is causing total social financing to weaken. Another risk to monitor is Fed Chairman Powell. The likelihood that he dials down his hawkish rhetoric on the elevated neutral fed funds rate in the coming weeks is significant. This could cause a temporary setback in Treasury yields and global rates - one that is likely to be welcomed by global risk assets but that may cause temporary indigestion for the dollar. Bottom Line: Three key risks could invalidate our thesis that the dollar strengthens this fall. They are: the large overhang of speculative longs in the greenback, a potential temporary stabilization in global growth, and markets pricing in Chinese stimulus. Additionally, Fed Chairman Powell may walk back some of his hawkish comments from last week, which would impact global bond yields and help global risk assets, but weigh on the dollar. Investment Implications Faced with this outlook, what should investors do? We continue to recommend holding a cyclically bullish dollar stance. Long DXY makes sense at this juncture, with upside toward 102 by Q1 2019, Implying a fall in EUR/USD below 1.10. However, the risks highlighted above are also non-negligible. This means that holding some hedges makes perfect sense. This summer, we recommended selling USD/CAD. As Chart I-13 illustrates, the loonie has been the best performing G10 currency - the only one that managed to eke out a gain against the greenback this summer (top panel of Chart I-13). This means that mean-reversion is not likely to be the CAD's friend going forward. It may thus not be the best instrument anymore to hedge against USD weakness. Instead, Chart I-13 proposes that the three currencies best placed to benefit from any mean reversion if the USD weakens are the SEK, the AUD, and especially the NZD. The NZD is extremely oversold now, which suggests that it could benefit greatly if the dollar were to experience any period of weakness. Moreover, the NZD has traditionally been highly levered to EM asset prices and Asian growth conditions. As a result, if the rebound in the China Play Index ends up hurting the USD, the NZD is likely to be the prime beneficiary. Chart I-13G10 Currency Returns Moreover, the kiwi money markets are currently pricing in a 12% probability of interest rate cuts by the Reserve Bank of New Zealand over the coming four months. While a lack of inflation means that the environment is not propitious for the RBNZ to increase rates, a rate cuts seems farfetched: the Official Cash Rate remains well below the average level of growth experienced over the past three years, whether in nominal or real terms. In other words, monetary policy remains extremely accommodative, despite the fact that the output gap is closed and the unemployment rate stands below full employment (Chart I-14). Chart I-14The RBNZ Will Not Cut Rates Finally, shorting EUR/JPY may well prove to be the best protection if the Fed's leadership guides bond yields lower. As Chart I-15 shows, EUR/JPY performs well when bond yield rise, which explains why this cross has managed to strengthen despite the recent weakness in EM asset prices this year. Hence, if a dollar correction is not driven by global growth converging upward toward the U.S., but instead is driven by the Fed backtracking from its recent hawkish rhetoric, then EUR/JPY will suffer considerably. Chart I-15Short EUR/JPY: A Hedge Against Falling Bond Yields As a result, we recommend investors with long USD exposure hedge their bets by taking on a bit of long NZD/USD exposure and some short EUR/JPY exposure as well. Bottom Line: Since the seasonal and cyclical outlook is favorable to the greenback, it makes sense for investors to maintain a dollar-bullish bias in their portfolio. However, the tactical risks to the dollar created by a potential rebound in non-U.S. growth or a potentially dovish Fed are meaningful. As a result, some hedges should be maintained to mitigate net positive exposure to the dollar. We recommend buying NZD/USD and selling EUR/JPY in order to achieve optimal protection from these risk factors. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Weekly Report, titled "Italy, Bond Vigilantes, And Bubbles", dated October 4, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The unemployment rate surprised positively, coming in at 3.7%. Moreover, initial jobless claims also surprised positively, coming in at 207 thousand. However, while nonfarm payrolls underperformed expectations, coming in at 134 thousand, this miss was compensated by important positive revisions to 270 thousand for August. DXY has risen by roughly 1.4% this week. Overall, we continue to be positive on the dollar, given that inflationary pressures in the U.S. will continue to put upward pressure on interest rates. Moreover, China is tightening monetary conditions, which will continue to act as a drag on global growth. This environment will benefit the green back until at least the beginning of 2019. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Retail sales yearly growth surprised to the upside, coming in at 1.8%. However, core inflation underperformed expectations, coming in at 0.9%. Finally, both the composite and manufacturing Markit PMI, also surprised negatively, coming in at 54.1 and 53.2 respectively. Rising U.S. yields as well as renewed concerns about Italy have lowered EUR/USD by roughly 2% this past couple of weeks. We are negative on the euro on a cyclical basis, given that euro area inflationary dynamics are tightly linked to global economic activity, which will likely be armed by China's monetary tightening. Thus, inflation, and consequently rates, will stay low in the euro area for the time being. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 12.6%. Moreover, the leading economic Index also surprised to the upside, coming in at 104.4. Finally, overall household spending yearly growth also surprised to the upside, coming in at 2.8%. USD/JPY has been falling for the past week and a half. We are negative on the yen on a cyclical basis, given that YCC is likely to stay in place for the foreseeable. After all, Japanese inflation expectations remain moribund. Moreover, the expected negative fiscal shock next year will also weigh on aggregate demand. All of these factors, combined with slowing global growth will continue to widen rate differentials, which will create upside in USD/JPY. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Manufacturing production yearly growth surprised to the upside, coming in at 1.3%. However, Halifax house prices yearly growth underperformed expectations, coming in at 2.5%. Finally, Markit Services PMI underperformed expectations, coming in at 53.9. GBP/USD has been flat since the middle of September. The European Union has been much more conciliatory than anticipated, causing the pound to rally. However, we will continue to watch the negotiations closely, given that very little geopolitical risk is currently priced into the pound at the moment, which means it will continue to be whipshawed with inevitable setbacks in the negotiations. We remain long GBP vol. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has fallen by roughly 2.5% over the past couple of weeks, mostly due to the spike in U.S. real yields and the fall in emerging market assets. We continue to be bearish on the Australian dollar, as the Australian economy is the most sensitive G10 currency to policy tightening in China. Moreover, the Australian economy has a very indebted household sectors, which makes it difficult for the RBA to hike rates in the current environment. Investors who wish to express this bearish view on the AUD can do so by shorting AUD/CAD, as the CAD will likely benefit from rising oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has fallen by nearly 3%. Overall, we are bearish the kiwi, as continued tightening by both the fed and Chinese authorities will keep putting pressure on risk assets like the NZD. Moreover, the momentum in volatility continues to be a negative sign for high yield currencies like NZD. That being said, once volatility momentum becomes negative high carry trades like NZD/CHF will prove to be attractive. Moreover, investors looking to hedge their long dollar positions should look to buy the NZD, as rate expectations in New Zealand have likely hit a bottom. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: While the net change in employment outperformed expectations significantly, coming in at 63.3 thousand, the devil was in the detail; full time employment contracted by 17 thousand jobs. On the other hand, the participation rate also surprised to the upside, coming in at 65.4%. However, housing starts surprised negatively, coming in at 189 thousand. USD/CAD has gone up by roughly 1.2% the past 2 weeks. We are closing our short USD/CAD trade this week, as we think the tactical upside for the CAD is now limited. Investors looking to hedge their long dollar exposure should instead look to buy the kiwi. That being said we continue to be positive on the Canadian dollar against the Australian dollar, as oil will further outperform base metals. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Headline inflation underperformed expectations, coming in at 1%. Moreover, the SVMW Purchasing manager's Index also surprised negatively, coming in at 59.7. Finally, real retail sales yearly growth also underperformed expectations, coming in at 0.3%. EUR/CHF has risen by roughly 1.7% this past two weeks. Overall, we are bearish on the franc on a long-term basis, as inflationary forces are too tepid in Switzerland for the SNB to move away from its ultra-dovish monetary policy. Moreover, the strength in the franc over the past few months will likely drive prices down, adding further fuel to the SNB's easy money campaign. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Headline and core inflation both outperformed expectations, coming in at 3.4% and 1.9% respectively. Moreover, manufacturing output growth also surprised to the upside, coming in at -0.1%. However, register unemployment surprised negatively, ticking up to 2.3%. USD/NOK has risen by roughly 1% the past couple of weeks, in spite of rising oil prices. We have long argued that USD/NOK is more sensitive to real rate differentials than to oil prices. Given that we expect real U.S. rates to have additional upside, we continue to be bullish on this cross. That being said, the NOK could outperform other commodity currencies like the AUD and the NZD, as the relative performance of oil in the commodity space will provide a cyclical lift to the NOK against these currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2%. Moreover, consumer confidence also surprised to the upside, coming in at 103.6. However, manufacturing PMI underperformed expectations, coming in at 55.2. USD/SEK has risen by roughly 2.7% the past couple of weeks. Overall, we are bullish on the krona on a long term basis, as monetary policy is too easy in Sweden given Sweden's current inflationary backdrop, which means that the path of least resistance for rates is up. Nevertheless, the policy tightening by Chinese authorities could continue to weigh on global growth. This means that the SEK could have some downside on a 3 to 6 month horizon. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights This Special Report was written with our colleagues in BCA Research's Geopolitical Strategy, led by Marko Papic. In it, we explore the evolution of Russia's role in European natural gas markets vis-a-vis the fast-growing U.S. natural gas production and Liquefied Natural Gas (LNG) export capabilities. So what? Rise of U.S. LNG exports to Europe will benefit gas producers and LNG merchants with access to U.S. supplies. Russia will grow ever-more dependent on China, while retaining a market share in Europe. Why? Exports of U.S. LNG to Europe are set to surge over the next decade. Russia will not be completely displaced, as American LNG fills the gap in European natural gas production. But U.S. LNG will lead to the end of oil-indexing of long-term natural gas contracts, hurting Russian state coffers on the margin... ... And forcing Russia further into the arms of China. Also... A tighter Trans-Atlantic partnership - soon to involve a deep energy relationship - and a budding Sino-Russian alliance will further divide the world into two camps, producing a Bifurcated Capitalism that may define this century. Feature Russia's obituaries have been written and re-written many times since the end of the Cold War. And yet, Moscow continues to play an outsized role in global affairs that is belied by quantitative measures of its power (Chart 1). Chart 1From Bipolarity To Multipolarity How so? The fall of the Soviet Union was precipitated by the country's sclerotic managed economy, its failure to escape the middle income trap, and its disastrous military campaign in Afghanistan. But before it died, the Soviet Union sowed the seeds for its resurrection. The $100-130 billion (in 2018 USD) spent on building a natural gas pipeline infrastructure into Western Europe was the elixir that revived Russian power. Just as Russia emerged from its lost decade in the 1990s, it caught a break. Western Europe's natural gas demand rose. At the same time, China's epic industrialization created a once-in-a-century commodity bull market (Chart 2). With demand for its resources buoyed on both sides of the Eurasian landmass, Russia once again saw revenue fill its coffers (Chart 3). With material wealth came the ability to rebuild its hard power and put up a fight against an expansionary Western alliance encroaching on its sphere of influence. Chart 2Chinese Industrialization... Chart 3...Filled Russian Coffers Is there an existential risk to Russia's business model looming in the form of surging U.S. liquefied natural gas (LNG) export capability (Chart 4)? Not yet. Thanks to a massive drop in European domestic production, U.S. LNG exports will fill a growing supply gap, but will not replace Russia's natural gas exports in the medium term. All the same, the once-lucrative European market no longer holds as much promise as it once did with the arrival of the U.S. LNG supplies. Chart 4U.S. LNG Exports Will Surge In order for Russian natural gas exports to Europe to be permanently displaced, Europe would have to build out new LNG capacity beyond 2020, restart domestic production by incentivizing shale development, or turn to alternative energy sources with large base-load potential, such as nuclear power. None of these are on the horizon. With ~15% of its government revenue sourced from natural gas sales, Russia is as much of a one-trick pony as there is in macroeconomics. While we do not foresee that pony heading off to the glue factory, Russia will face some considerable risks in the future, starting with the shift away from the rigid oil-indexed contracts it favors (which lock the price of natural gas to that of oil). As such, the risk to Russia is not that it loses market share in Europe's energy market, but that this market share yields much smaller income in the future, as gas-on-gas pricing competition increases. The U.S. Shale Revolution Goes Global Our commodity team has presented a compelling case for why investors should expect an increase in U.S. LNG exports beyond the current EIA forecast.1 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so as not to curtail oil production, will drive a large part of the expected growth in LNG exports. Our commodity team expects that a major LNG export center will be developed in south Texas, in Corpus Christi, over the next five years, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.2 At the same time, global LNG demand is expected to rise at an impressive 1.7% annual rate to 2040 (Chart 5). A few key markets will lead this trend (Chart 6). Based on BCA Commodity & Energy Strategy calculations, world LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7). The majority of the new capacity (53%) will come from the U.S., while 18% will come from Australia and 15% from Russia. Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally Chart 7LNG Export Capacity Growth The pickup in Australian export capacity is already impressive. While being a relatively small natural gas producer - the eighth largest, accounting for 3% of world output - it has already become the second largest LNG exporting country in the world with over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019. Most of Australia's LNG trade lies with Asia, given its geography. The U.S., whose LNG export terminals will be located in the Gulf of Mexico, only has 3 Bcf/d of liquefaction capacity today. Most of its LNG exports also go to Asia (Table 1), but that may change as the current capacity expansion will see exports rise to just over 9 Bcf/d in 2020.3 Furthermore, American gas will compete with surging Australian LNG exports and a build-up of Russian pipeline export capacity to China, which is set to start delivering gas to the country in 2019. Table 1U.S. LNG Exports By Country Europe, on the other hand, has massive regasification capacity slack and thus requires only minimal capex to begin importing large volumes of U.S. LNG. Europe has 23 Bcf/d regasification capacity, with a very low utilization rate of just 27%. This means that it has ~ 16 Bcf/d capacity available, more than enough to absorb all of expectant U.S. ~ 6-7 Bcf/d exports in the next couple of years.4 Bottom Line: The U.S. shale revolution is going global, with U.S. LNG exports set to surge over the next 5-10 years. While some of that capacity will find its way to Asia, those markets will also be flooded with Australian LNG and Russian piped natural gas. Europe, on the other hand, is filing just a quarter of its LNG import capacity, making a Trans-Atlantic gas alliance a match made in heaven. From Cold War To Gas War? If half of the currently proposed, pre-FID, LNG export projects were built in the U.S., American capacity would grow to potentially ~26 Bcf/d by 2030. Europe would need only one or two extra LNG import terminals to build over the next two decades to absorb this volume, as its current capacity is able to import nearly every molecule coming out of North America (Chart 8). Chart 8Europe Has Plenty Of Regasification Capacity Will this new U.S. LNG displace Europe's imports of Russian natural gas? The short answer is no. By 2030, Europe's supply-gap (i.e. domestic supply minus domestic consumption) is estimated to reach 36 Bcf/d. The U.S. could cover a large part of this gap if only half of the proposed pre-FID projects are constructed. However, if Europe's demand remains stable over this period, Europe will still import roughly 20 Bcf/d of Russian natural gas, which in 2017 amounted to 35% of Europe's natural gas consumption. If the U.S. fills 100% of the increase in Europe's supply-gap, it means new Russian natural gas production (the IEA and BP expect Russian production to keep increasing until 2030) will not be sent to Europe. Hence, even if it does not displace old Russian exports, it will limit Russia's ability to export its new natural gas. Europe's demand for natural gas is not likely to be stable. Despite sclerotic growth and generally weak population growth, European governments have tried to incentivize natural gas consumption due to its low emission of CO2 (Table 2). As such, investors should expect further displacement of coal and nuclear power generation in favor of natural gas. Table 2Natgas Emits Less CO2 Thus, U.S. exports will simply replace Europe's domestic production, which is facing considerable declines. The U.K. North Sea production will decrease 5% annually due to the lack of capex and the large number of fields reaching a mature state. Meanwhile, the Netherlands is phasing-out its Groningen field by 2030. Finally, Norwegian gas production is likely to stagnate after reaching record levels in 2017. The second reason that Europe will not be able to sever its relationship with Russia is that its LNG import terminals are largely located in countries that are not massively dependent on Russian imports (Map 1). The two major LNG terminals serving Central and Eastern Europe are the Swinoujscie terminal in Poland - finished in 2015 - and the Adria project in Croatia, to be completed in 2020. Map 1European Natural Gas Geography The Polish LNG terminal will do little to alleviate the dependency of countries further East - Belarus, Ukraine, Bulgaria, Hungary, and Slovakia - from Russia as it currently satisfies only one third of Poland's natural gas needs, and is projected to reach 50% by 2022 once the expansion is completed. This could significantly cut Russian exports to Poland, but not completely end them.5 The Croatian LNG terminal will likely make a very small dent in the overall reliance of the Balkans on Russian natural gas, as once it satisfied Croatian demand, little will be left over for the rest of the region. Beyond these two terminals, Europe will have to invest in pipeline infrastructure in order to reverse the flow of pipelines currently taking gas from the East to the West. At some point in the distant future, we could see a scenario where American natural gas flows even through Cold War era, Soviet-built pipelines deep into Central and Eastern Europe. But given the steep declines in West European natural gas production, this day will come after 2030. Bottom Line: Dreams of displacing Russian natural gas in Europe with American are overstated. European imports of U.S. LNG are likely to skyrocket, but that will merely replace the massive decline in West European and North Sea production. What does that mean for geopolitics? It means that Russia will continue to have a role to play in Europe, but its share of European imports will decline. As such, Europe will have options. If it builds more LNG import terminals, it could expand those options beyond American LNG imports. However, Russian geopolitical influence will not be displaced completely. Russian Coffers Will Take A Hit Although Russian natural gas will continue to course through Europe's veins, its state coffers are nonetheless going to take a hit. European governments are actively diversifying away from Russia via U.S. LNG imports, and buyers generally are shortening the tenor of contracts as they seek more flexible pricing.6 The growth in the global LNG market, fueled by surging U.S. production, will ultimately allow Asian and European markets to diversify away from oil-indexed pricing - which tends to be priced higher than gas-on-gas pricing - and expand access to U.S. supplies.7 The EU has co-financed or committed to co-finance LNG infrastructure projects valued at ~ 640mm euros to secure U.S. LNG. Ultimately, as more and more U.S. LNG moves toward Europe, markets will move toward short- and long-term contracts priced in USD/MMBtu (indexed to Henry Hub, LA, prices), much like Brent crude oil priced in USD/bbl. European markets have already seen this shift, as illustrated in Chart 9. Chart 9European Gas-On-Gas Pricing Is Rising The totality of U.S. export prices is determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. These contracts are without the restrictions found in many oil-indexed contracts. In the U.S., the presence of a deep futures market delivering natural gas to Henry Hub, LA, allows flexible long-term financing and short- and long-term contracting that can be hedged by buyers and sellers. According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply. While in Europe the share of LNG spot and short-term deals is small relative to the overall market, it is growing (Chart 10). With U.S. LNG volumes becoming increasingly available in Europe, market participants will be inclined to turn to the LNG spot market to buy or sell outside contracted volumes. This will deepen the development of European natgas markets: in any fully developed market, spot trading is followed by forward contracting, then futures trading using contracts settling against a spot price.8 Chart 10Expect More LNG Spot Trading Russia is a low-cost gas producer in Europe and will be committed to maintaining its market in Europe. However, with U.S. LNG export capacity potentially reaching ~14 Bcf/d by 2025, from ~3 Bcf/d today, it is entirely likely that Russia will find itself in a price war defending existing market share in Europe at lower prices. Its preferred way of doing business, via oil price indexed contracts, will be challenged overnight by a surge in U.S. LNG imports. Bottom line: The EU and its member states are actively diversifying gas supply sources away from Russia via U.S. LNG purchases. This will lower the marginal price of all gas bought and sold in Europe, all else equal, resulting in lower margins for all sellers of gas and better prices for consumers. Ultimately, the European natural gas market will resemble every other fully developed commodity market, operating on razor-thin margins. This means whatever rents were available in this market will be dissipated as competition increases. Investment And Geopolitical Implications The immediate investment implication of these developments is that gas producers and LNG merchants with access to U.S. shale-gas supplies, processing trading, and risk-management capabilities should be favored in this evolving market. Beyond the short term, however, we expect several ongoing geopolitical developments to be ossified by the flood of American LNG steaming towards European shores: Sino-Russian alliance deepens: As Russian natural gas exports to Europe stagnate, its pipeline infrastructure build-out will increase its exports to China to 3.8 Bcf/d by 2019. China will become the growth market for Russian energy producers, deepening the move between the two former Cold War foes to stabilize their relationship. Although it may seem obvious that Russia would retain leverage in such a relationship - given that it can "turn off the lights" to Beijing at whim - we actually think that Beijing will hold all the cards.9 Europe will have an incentive to keep diversifying its natural gas supplies. Meanwhile, Chinese demand is likely to keep growing. As such, China will become Russia's main option for revenue growth. And as the old adage goes, the customer is always right. Trans-Atlantic alliance deepens: Despite the fears that the "Trump Doctrine" would lead to American isolationism - fears that we shared in 2017 - the growing U.S.-European LNG connection will ensure that the Trans-Atlantic alliance - forged 70 years ago in blood - will be saved via brisk energy trade.10 A growing European energy deficit with the U.S. will also resolve - or at least alleviate - the main source of marital problems in the relationship: Europe's trade surplus. Bifurcation of capitalism: A key theme of BCA's Geopolitical Strategy is that the age of globalization will yield to the world's segmentation into spheres of influence.11 A deepening Trans-Atlantic alliance, when combined with a budding Sino-Russian relationship, will lead to a Bifurcated Capitalism system where the Trans-Atlantic West faces off against the Eurasian East. What would such a Bifurcated Capitalism mean for investors? Time will tell. But it may mean that thirty years of global capitalism (1985 to roughly today) may give way to something more common in human history: a world dissected into spheres of influence where flows of capital, goods, and people within spheres are relatively smooth and unencumbered, yet flows between the spheres are heavily impeded. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Pavel Bilyk, Research Associate Commodity & Energy Strategy pavelb@bcaresearch.com 1 Please see "U.S. Set To Disrupt Global LNG Market," published by BCA Research's Commodity & Energy Strategy October 4, 2018. It is available at ces.bcaresearch.com. 2 Please see "The Price of Permian Gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 3 Following a two-year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized. Therefore, final decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. 4 Cheniere Energy, the largest U.S. LNG exporter, expects ~ 50% of its exports to go to Europe, according to S&P Global Platts. Please see "US LNG vs Pipeline Gas: European Market Share War?" published April 2017 by Platts. 5 Additionally, if the Baltic Pipe Project, moving gas from Norway to Poland, reaches FID in 2019, this would help Poland diversify its energy supply from Russia, as the country would cover close to all its domestic demand via its production + LNG and new pipeline imports. 6 Please see "US and Russia step up fight to supply Europe's gas," published by the Financial Times August 3, 2017. See also "Russia's gas still a potent weapon," also published by the FT, re the so-called collateral damage suffered by Europe when Russia cut off gas supplies to Ukraine in January 2009. 7 For the EU, supply diversification is a particularly important goal. On July 25, 2018, the European Commission and the U.S. issued a joint statement, in which the EU agreed to import more LNG from the U.S. "to diversify and render its energy supply more secure. The EU and the U.S. will therefore work to facilitate trade in liquefied natural gas," according to a press release issued August 9, 2018, by the Commission. Re Japan's diversification strategy, please see "Feature: US LNG sources fit with Japan's desire for route diversity: minister," published by S&P Global Platts September 27, 2018. 8 Please see Darrell Duffie, Futures Markets (1988), Prentice-Hall; and Jeffrey C. Williams, The Economic Function of Futures Markets (1986), Cambridge University Press. Longer-term deals already are being signed under flexible Henry Hub futures-based indexing terms in the U.S. This is occurring because the U.S. LNG market is able to tap into futures liquidity that supports hedging by natgas producers and consumers. Please see "Vitol-Cheniere Pact Shows Long-Term LNG Deals Aren't Dead," published by bloomberg.com September 17, 2018. 9 Please see BCA Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com.