Geopolitics

Special Report

Highlights So What? Go long Brent / short S&P 500. The risk of a recession in 2019 is underappreciated. Why? The likelihood is increasing of a geopolitically-induced supply-side shock that pushes crude prices above $100 per barrel in the coming 6-12 months. Oil supply disruptions in Iran, Iraq, and Venezuela represent the primary source of risk. Historically, the combination of Fed rates hike and an oil price spike has preceded 8 out of the last 9 recessions. Also... A recession in 2019, ahead of the 2020 election, would set the stage for a confrontation between Trump and the Fed, adding fuel to market volatility. Feature Geopolitical tensions are brewing from the Strait of Hormuz to the Strait of Malacca. As we go to press, news is breaking that a Chinese naval vessel almost collided with the USS Decatur as the latter conducted "freedom of navigation" operations within 12 nautical miles of Gaven and Johnson reefs in the Spratly Islands. Given the trade tensions between China and the U.S., this alleged maneuver by the Chinese vessel suggests that Beijing is not backing off from a confrontation. Our view remains that Sino-American trade tensions can get a lot worse before they get better. The latest incident, which builds on a series of negative gestures recently in the South China Sea, suggests that both sides are combining longstanding geopolitical tensions with the trade war. This will likely encourage brinkmanship and further degrade U.S.-China relations. Yet China-U.S. tensions are not the only concern for investors in 2019. Another crisis is brewing in the Middle East, with the potential to significantly increase oil prices over the next 12 months. U.S. households may have to deal with a double-whammy next year: higher costs of imported goods as the U.S.-China trade war rages on and a significant increase in gasoline prices. In this report, we discuss this dire outlook. The Folly Of Recession Forecasting In mid-2017, BCA Research published two reports, one titled "Beware The 2019 Trump Recession" and another titled "The Timing Of The Next Recession."1 Both argued that if the Federal Reserve kept raising rates in line with the FOMC dots, then monetary policy would move into restrictive territory by early 2019 and increase the likelihood of recession thereafter. We subsequently adjusted the timing of our recession forecast to 2020 or beyond, based on a more positive assessment of the U.S. economy. In this report, we explore a risk to the BCA House View on the timing of the next recession. As BCA's long-time Chief Economist Martin Barnes has said, predicting recessions is a mug's game. There have been eight recessions in the past 60 years (excluding the brief 1980-81 downturn) and the Fed failed to forecast all of them (Table 1). Table 1Fed Economic Forecasts Versus Outcomes The Atlanta Fed produces a recession indicator index which is designed to highlight the odds of recession based on trends in recent GDP data. At the moment, the indicator is at a historically sanguine 2.4%. Unfortunately, low readings are not a reliable cause for optimism. The 1974-75, 1981-82, and 2007-09 recessions were all severe and the Atlanta Fed's recession indicator had a low reading of 10%, 1.6%, and 7.7%, respectively - just as the recession was about to begin (Chart 1). Chart 1The Market Is Not Expecting A Recession The 1974-75 recession is instructive, given the numerous parallels with the current environment: Energy Geopolitics: The 1973 oil crisis caused a massive spike in crude prices. This point is especially pertinent since the 1973 oil embargo is widely viewed as an important contributor to the 1974-75 recession. Real short rates had risen and the yield curve had inverted long before oil prices spiked, so recession was almost inevitable even without the oil price move. But the oil spike made the recession much deeper than otherwise. Protectionism: President Nixon imposed a 10% across-the-board tariff on all imports into the U.S. in 1971 to try to force trade partners to devalue the U.S. dollar. Dislocation: Competition from newly industrialized countries - Japan and the East Asian tigers in particular - laid waste to the steel industry in the developed world. Polarization: President Nixon polarized the nation with both his policies and behavior, leading to his resignation in 1974. Given the exogenous and geopolitical nature of oil supply shocks, today's recession indicators are missing a critical potential headwind to the economy. A geopolitically induced oil-price shock could create more pain than the economy is able to handle. Why An Oil Price Shock? America's renewed foray into the politics of the Middle East will unravel the tenuous equilibrium that was just recently established between Iran and its regional rivals. The U.S.-Iran détente that produced the signing of the 2015 Joint Comprehensive Plan of Action (JCPA) created conditions for a precarious balance of power between Israel and Saudi Arabia on one side, and Iran and its allies on the other side. This equilibrium led to a meaningful change in Tehran's behavior, particularly on the following fronts: The Strait of Hormuz: Tehran ceased to rhetorically threaten the Strait as soon as negotiations began with the U.S. (Chart 2). Since then, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities remain unchanged.2 Iraq: Iran directly participated in the anti-U.S. insurgency in Iraq. Tehran changed tack after 2013 and cooperated closely with the U.S. in the fight against the Islamic State. In 2014, Iran acquiesced to the removal of the deeply sectarian, and pro-Iranian, Prime Minister Nouri al-Maliki. Bahrain and the Saudi Eastern Province: Iran's material and rhetorical support was instrumental in the Shia uprisings in Bahrain and Saudi Arabia's Eastern Province in 2011 (Map 1). Saudi Arabia had to resort to military force to quell both. Since the détente with the U.S. in 2015, Iranian support for Shia uprisings in these critical areas of the Persian Gulf has stopped. Chart 2Geopolitical Crises And Global Peak Supply Losses Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Put simply, the 2015 nuclear deal traded American acquiescence toward Iranian nuclear development in exchange for Iran's cooperation on a number of strategically vital regional issues. By unraveling that détente, President Trump is upending the balance of power in the Middle East and increasing the probability that Iran retaliates. Since penning our latest net assessment of the U.S.-Iran tensions in May, Iran has already retaliated.3 Our checklist for "kinetic" conflict has now risen from zero to at least 15%, if not higher (Table 2). We expect the probability to rise once the U.S. starts implementing the oil embargo in November. This will dovetail our Iran-U.S. decision tree, which sets the subjective probability of kinetic action by the U.S. against Iran at a baseline of 20% (Diagram 1). Table 2Will The U.S. Attack Iran? Diagram 1Iran-U.S. Tensions Decision Tree Bottom Line: The premier geopolitical risk to investors in 2019 is that President Trump's maximum pressure tactic on Iran spills over into Iraq, causing a loss of supply from the world's fifth-largest crude producer.4 We expect the U.S. oil embargo against Iran to remove between 1 million and 1.5 million barrels per day from the market. In addition, the loss of Iraqi production due to sabotage could be anywhere between 500,000 and 3.5 million barrels per day. Added to this total is the potential loss of Venezuelan exports due to the deteriorating situation there. When our commodity team combines all of these factors, they generate a worst-case scenario where the price of crude rises to $110 per barrel in 2019 or higher (Chart 3). And this scenario assumes that EMs do not reinstitute energy subsidies (and therefore their consumption falls faster than if they do reinstitute them). Chart 3Worst-Case Scenario Propels Oil Price Toward 0/Barrel The Ayatollah Recession We believe that the midterm election is a dud from an investment perspective, no matter the outcome. However, the election does matter as a hurdle that, once cleared, will allow President Trump to renew his "maximum pressure" tactic against China, Iran, and perhaps domestic tech corporations.5 Iran is a critical risk in this strategy. If President Trump applies maximum pressure on Iran, then a reduction in crude exports from Iran, Iranian retaliation in Iraq, and the simultaneous loss of Venezuelan supplies could combine to increase the likelihood of U.S. recession in 2019. Readers might recall that no sitting president has gotten re-elected during a recession. Why would Trump pursue a policy that risks his re-election chances in 2020? Surely he would deviate from his maximum pressure tactic if faced with the prospect of a recession. However, it is folly to assume that policymakers are perfectly rational, or fully informed. American presidents are some of the most unconstrained policymakers in the world, given both the hard power of the United States and the constitutional lack of constraints on the president when it comes to national security. Trump may believe, for instance, that the 660 million barrels of crude in America's Strategic Petroleum Reserve can offset the impact of sanctions against Iran.6 Or he may believe that he can force OPEC to supply enough oil to offset the Iranian losses. The problem for President Trump is that Iran is not led by idiots. Iranian policymakers understand that the best way to reduce American pressure is to induce an oil price spike in the summer of 2019 that hurts President Trump's re-election chances, forcing him to back off. As such, sabotaging Iraqi oil exports, which mainly transit through the port of Basra - a city highly vulnerable to Shia-on-Shia violence that is already a risk to the country's stability - would be an obvious target. An oil price spike would serve as a negotiating tool against the U.S., and the additional revenue would help replace what Iran loses due to the embargo. Tehran and Washington will therefore play a game of chicken throughout 2019, and there is a fair probability that neither side will swerve. President Trump may be making the same mistake as many predecessors have made, assuming that the Iranian regime is teetering at a precipice and that a mere nudge will force the leadership to negotiate. Oil price shocks and recessions have a historical connection. In a recent report, our commodity strategists highlighted that a spike in oil prices preceded 10 out of the past 11 recessions in the U.S. since 1945 (Table 3). Admittedly, not all spikes were followed by recession. The combination of an oil price spike and Fed rate hikes has produced a recession 8 out of 9 times.7 If oil prices rose to $100 per barrel in the coming 6-12 months, there will be several negative macro consequences. In particular, gasoline prices will rise back toward $4 per gallon (Chart 4). Retail gasoline prices have already increased by more than 50% since they bottomed in February 2016. So how much more upside can the U.S. private sector take? Table 3History Of Oil Supply Shocks Chart 4A Source Of Pressure For Consumers The Household Sector Consumer confidence is currently near all-time highs, which tends to signal that the path of least resistance is flat or down (Chart 5). Household gasoline consumption has already declined in response to higher oil prices since the middle of 2017. Given that gasoline demand is relatively inelastic, consumers may already be near their minimum consumption level. Chart 5Nearing All-Time Highs Instead, households will experience a decline in their disposable income. This will come on the back of both higher gasoline prices and an increase in the prices of other goods and services, as the oil spike spills across sectors. U.S. households - and most likely those in other markets - are stretched to the limit already. A recent Fed survey found that 40% of U.S. households do not have the funds needed to meet an unexpected $400 cost in any given month.8 Such an unexpected expense would require them to either sell possessions, borrow, or cut back on other purchases. Chart 6Most Americans Cannot Cut Saving To Spend Left with few other options, households would react to their lower disposable income by reducing demand for other goods and services. This dent in consumer spending would bring down aggregate demand, leading to slower employment growth and even less income and spending. Households could save less to maintain their current purchasing levels, given the recent rise in the savings rate (Chart 6). But this is unlikely. Although the household savings rate has increased in recent years, we have previously argued that a material part of the increase was driven by small business-owner profits. These owners have much higher levels of income than the median consumer. For Americans living paycheck-to-paycheck, it would be difficult to reduce a savings rate that is already close to, or below, zero. Higher oil prices will also hurt growth in Europe and Japan, economies that are already struggling to gain economic momentum after grappling with a weaker growth impulse from China. In addition, EM economies that took the opportunity to reform their oil subsidies amid lower oil prices post-2014 will have to grapple with a much larger shock to consumers than usual. The Corporate Sector In theory, what consumers lose from rising oil prices, producers of crude can gain in stronger revenue. This is especially important in the U.S. as domestic energy production has increased significantly over the past 10 years. Nonetheless, the oil and gas extraction sector accounts for just 1.1% of GDP and 0.1% of total employment. The marginal propensity to spend out of every dollar of income is lower for producers than consumers. Moreover, if consumer confidence fell and consumer spending weakened, non-energy capex would decline as businesses reassessed household demand and held off from making investment decisions. Small business confidence is at record highs, and as with consumer confidence, vulnerable to downward revisions (Chart 7). Chart 7Dizzying Heights Chart 8Only One Way To Go (Down) Profit margins remain at a highly elevated level and also have only one way to go (Chart 8). If high oil prices should combine with rising borrowing costs and upward pressure on wages (which could develop in this macro environment) the result would be a triple hit to margins (Chart 9). Of course, rising wages would give consumers some offset to higher oil prices, so the question will be the net effect of all variables. And if the dollar bull market continues, as our FX team believes it will, the combination of higher oil prices and a strong USD would hurt U.S. companies with international exposure. The debt load held by the U.S. corporate sector would turn this bad dream into a nightmare. Many American companies have spent the past 10 years increasing leverage to buy back equity (Chart 10). Companies with high debt would need to revise down their profit expectations, with potentially devastating consequences. Elevated debt levels also increase the likelihood of financial market stress if bond investors get worried and spreads begin to widen significantly. Chart 9Rising Pressures On Earnings? Chart 10Large Corporate Debts According to all measures, U.S. stocks are at or near their all-time valuation peaks. Investors have also priced in a significant amount of optimism for profit growth (Chart 11). These expectations would be subject to quick revision if our oil shock scenario plays out. In other words, investor expectations for profit margins are not sufficiently factoring the triple hit of higher oil prices, higher interest rates, and higher wages. Chart 11The Market Has High Hopes An additional geopolitical risk on the horizon for 2019 is the creeping "stroke of pen" risk from potential regulation of technology enterprises. This is unrelated to an oil price spike (other than that it would be an effect of U.S. policy) but could nonetheless combine with rising energy prices to sour investors' mood.9 Bottom Line: An oil price spike above $100 would produce negative consequences for the U.S. household and corporate sectors. Given the supply-side nature of the price shock, it would not be accompanied by the usual decline in USD, and could therefore hurt the foreign profits of U.S. corporations as well. If investors must also deal with mounting regulatory pressures on FAANG stocks, they could face a perfect storm. Given the high probability of such an oil price shock, why isn't a 2019 recession BCA's House View, rather than merely a risk to it? Because it is difficult to say how high oil prices need to rise to cause a recession. For example, 1973 both marked a permanent move up in oil prices and saw oil prices triple. In 2019 terms, that would mean an oil price above $200, a far less probable scenario than $100-$110. Nevertheless, the combination of elevated oil prices and the price impact on consumer goods of the U.S.-China trade war could combine to create a nightmare scenario for consumers. But it is impossible to gauge the level of both required to push the U.S. into a recession. Second, there are many ways in which today's macro environment is different from that in 1974. In the 1970s the inventory cycle was a key factor in the business cycle, with excesses building up ahead of recessions, forcing output cutbacks as demand weakened. That is no longer the case in today's world of just-in-time inventory management. Also, inflation was a much bigger problem back then, requiring tougher Fed action. On the other hand, debt burdens were much lower. Investment Implications To be clear, none of the usual recession indicators that BCA Research uses are flashing red at this time. The point of this analysis is to illustrate a credible, exogenous scenario that cannot be revealed through the usual data-driven recession forecasting methods. What happens if a recession does occur ahead of the 2020 election? How would President Trump react to a recession induced by his foreign policy adventurism in the Middle East? By doing what every other president would do: finding someone else to blame. In this case, we would put high odds on the Federal Reserve becoming the target of President Trump's fury. Ahead of 2020, the Fed and its independence may very well become an election issue.10 This could spell serious trouble for the Fed, which is at a massive disadvantage when it comes to explaining to voters why central bank independence is so important. The Fed had great difficulty managing public opinion regarding its extraordinary measures to combat the Great Recession - its attempts at public outreach largely failed. Compare the number of Trump's Twitter followers to that of the Fed's (Chart 12). Chart 12The Fed's PR Abilities Are Limited Though most of our clients and colleagues will probably disagree, we do not see central bank independence as a static quality. It was bestowed upon central banks by politicians following widespread inflation fears throughout the 1970s and 1980s, although in the U.S. the current tradition goes back to the 1951 Treasury Accord that restored the independence of the Fed. Our colleague Martin Barnes penned a report on the politicization of monetary policy in 2013.11 His conclusion is that political meddling in monetary affairs is less pernicious than economic performance. The Fed will incur Trump's ire, in other words, but it will be its failure to generate economic growth that causes a break in independence. We are not so sure. The next recession is likely to be a mild one for Main Street given the lack of real economic bubbles. But given the slow recovery in real wages over the past decade and the general angst of the populace towards governing elites, even a mild recession that merely reminds voters of 2008-2009 could produce deep anxiety and significant public reactions. Further, the idea of "independent," non-politically accountable institutions is going out of style. President Trump - and other policymakers in the developed world - have specifically targeted the "so-called experts" and "institutions." President Trump has attacked America's foreign policy architecture, NATO, the WTO, and a slew of supposedly outdated norms and practices for being "out of touch" with the electorate. This policy has served him well thus far. If our nightmare scenario of an oil price-induced recession plays out, the immediate implication for investors will be a sharp downturn in risk assets. As such, we are recommending that investors hedge their portfolios with a long Brent / short S&P 500 trade. Alternatively we would recommend going long U.S. energy / short technology stocks. A longer-term, and perhaps even more pernicious implication, would be the end of the era of central bank independence and a full politicization of the economy. Laissez-faire capitalist system would give way to dirigisme. In the process, the U.S. dollar and Treasuries would be doomed. Jim Mylonas, Global Strategist Daily Insights & BCA Academy jim@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 3 Please see BCA Research Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018 and "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com. 6 The Strategic Petroleum Reserve currently covers 100 days of net crude imports, or 200 days of net petroleum imports, and can be tapped for reasons of political timing as well as international emergencies. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," dated September 13, 2018, available at bcaresearch.com. 8 Please see the U.S. Federal Reserve, "Report on the Economic Well-Being of U.S. Households in 2017," May 2018, available at federalreserve.gov. 9 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com. 10 Please see BCA Daily Insights, "Politics And Monetary Policy," dated August 22, 2018, and "The Battle Of The Press Conferences: Trump Versus Powell," dated September 27, 2018, available at dailyinsights.bcaresearch.com. 11 Please see BCA Special Report, "The Politicization Of Monetary Policy: Should We Care?" dated April 15, 2013, available at bca.bcaresearch.com. Geopolitical Calendar

Special Report

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Chart 3A Tight Race The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Chart 7Net Approvals Advantage Bolsonaro However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Chart 8Haddad Is Ahead##br## In These Polls To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Table 2Voter Profile Of Each Candidate As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Chart 10BBrazil's Parliament Is Fractious No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Diagram 1The J-Curve Of Structural Reform On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Chart 17A New##br## Paradigm Shift? Chart 18Sovereign Credit Spreads Will##br## Continue Widening We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Highlights The risk of unplanned oil-production outages is rising. One or more such events will severely test OPEC 2.0's spare capacity in a supply-constrained market (Chart of the Week).1 As things now stand, OPEC 2.0 spare capacity - if it is available - and a likely U.S. SPR release of 500k b/d in 1Q19 will not cover expected production losses, if markets are hit with another unplanned outage from Libya or Iraq.2 Demand destruction via higher prices will have to balance markets. Oil markets are tightening (Chart 2). Falling supply and stable demand will produce a 1mm b/d physical deficit into 1H19, forcing continued OECD inventory draws (Chart 3). The dominant scenario in our forecast includes a supply shock arising from lost Iranian and Venezuelan exports, which triggers price-induced demand destruction. We raised the odds of Brent prices hitting $100/bbl by 1Q19, and our 2019 forecast to $95/bbl on the back of these factors. Unplanned outages would lift prices higher. Energy: Overweight. The long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls we recommended last week are up an average 33.8%, as of Tuesday's close. Base Metals: Neutral. Our foreign-exchange strategists expect the USD to correct further. This will be bullish for copper, which is up ~ 10% since Sept. 11. Precious Metals: Neutral. The USD correction will support gold in the short term. Technically, gold appears to be forming a pennant, which could be short-term bullish. Ags/Softs: Underweight. Corn prices are benefiting from strong exports, according to USDA data. Accumulated exports for the current crop year are up 27% vs last year in the week ending Sept. 13. Chart of the WeekUnplanned Oil-Production Outage Risks Up, OPEC 2.0's Spare Capacity Down Chart 2Physical Oil Deficit Returns##BR##To Oil Market Next Year Chart 3Fundamentals Support##BR##Strong Prices Feature Oil markets are approaching a moment of truth. OPEC 2.0's spare capacity likely will be put to the test in 1Q19, as Iranian export volumes continue to fall, and other threats to production - Venezuelan losses, and increasing sectarian tension in Iraq and Libya - come to the fore. As the Chart of the Week demonstrates, spare capacity in the traditional OPEC states is low and falling: The U.S. EIA's most recent estimate of OPEC spare capacity is 1.7mm b/d this year and 1.3mm next year, well below the 2.3mm b/d average of 2008 - 2017. For its part, Russia - the other putative leader of OPEC 2.0 - likely only has ~ 200k b/d of spare capacity to ramp. On a relative basis, OPEC spare capacity is even more stretched: This year, the EIA expects it to average 1.7% of global demand. By next year, it is expected to fall to 1.3%, or ~ 1.3mm b/d. This will be lower than the spare capacity reported for 2008 (1.6%), when OPEC (mostly KSA) found itself struggling to meet surging EM demand, and well below the 2.6% average for 2008 - 2017. Spare capacity is very close to levels last seen in 2016, when low prices resulted in supply destruction. In the wake of the oil-price rout of 2014 - 16, capex collapsed as did maintenance spending needed to keep production steady y/y. This can be seen in the relentless decline in OPEC production ex GCC and the stagnation in other states unable to grow output (Chart 4 and Chart 5). Indeed, as prices hit their nadir in 1Q16, sovereign wealth funds (SWFs) in OPEC and non-OPEC states were being liquidated to cover gaping holes in producers' fiscal accounts. This partly explains the growing incidence of unplanned outages, and our contention OPEC spare-capacity claims are highly suspect (Chart of the Week). Chart 4OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5Outside Of A Very Few Regions, Oil Production Has Struggled U.S. Remains Adamant On Shutting Down Iran's Exports The Trump administration's goal is to reduce Iranian oil exports to zero via the sanctions it will impose beginning November 4 from ~ 2.5mm b/d back in April, when the U.S. sanctions were announced. However, as the EIA data indicates, achieving this goal would leave markets seriously short oil. Indeed, the Washington-based Center for International Strategic Studies (CSIS) noted in late August, "realistically, there is simply not enough readily available spare oil production capacity in the world to replace the loss of all Iranian barrels (some 2.4 mm b/d), coupled with the potential for further reductions in Venezuela, Libya, Nigeria, and elsewhere."3 Our modeling includes 1.25mm b/d of lost Iranian and Venezuelan exports, continued y/y losses in non-core OPEC (Chart 4), constrained U.S. production growth, and stagnate supply growth outside a handful of states able to lift their output (Chart 5). We do not believe OPEC 2.0 spare capacity is sufficient to cover these losses and one or two additional unplanned outages in Iraq or Libya, or anywhere for that matter. In addition, a 500k b/d release of U.S. SPR after the price goes above $90/bbl in 1Q19 will contain the supply shock we expect slightly, but will not completely reverse it. We have long believed KSA's ability to maintain production above 10.5mm b/d for an extended period is suspect, despite its claims it can ramp to its capacity of 12mm b/d.4 We are carrying KSA's current production at 10.4mm b/d in our balances estimates, roughly the level it self-reported to OPEC last month. To be clear, we are not saying KSA's production cannot be increased - perhaps to 10.7mm b/d - but we are dubious it can get to its claimed 12mm b/d capacity, or that it can sustain 10.7mm b/d indefinitely. It is important to note any short-term increase in OPEC 2.0's production will come out of spare capacity available to meet unplanned outages, or deeper-than-expected Venezuelan losses next year. Lastly, unplanned outages in a market already stretched by tighter supply will accelerate the rate of demand destruction via higher prices. This also would accelerate the arrival of a U.S. recession brought about by an oil-price shock, all else equal.5 Iran's Hand Is Strengthening You'd never know it from the declarations of President Trump and U.S. Treasury Secretary Steve Mnuchin - both of whom are adamant in their professed desire to see Iranian oil exports fall to zero - but the U.S. has been attempting to engage Iran in treaty discussions to limit the country's ballistic-missile capabilities and nuclear-development program.6 Not surprisingly, Iranian officials have shown no interest in such discussions. This is a remarkable turn of events, but not unexpected. At some point, it likely became apparent to the Trump administration the global oil markets are on a trajectory for significantly higher prices, as our analysis and forecasts indicate. It also likely is apparent to administration officials that oil prices - and gasoline prices, in particular, which matter most to U.S. voters - will be surging just as the 2020 presidential campaign gets underway next summer. Along with our colleague Marko Papic, who runs BCA's Geopolitical Strategy, we believe that, from a game-theoretic perspective, the approach from the U.S. actually strengthens Iran's hand. Given its history with the previous round of sanctions, and the economic hardships they imposed, the government in Iran likely believes it can ride out 12 to 18 months of renewed sanctions. It is not unrealistic to entertain the possibility Iranian politicians take the bet that sharply higher gasoline prices in the U.S. by 2H19 will give Democrats in U.S. presidential and congressional races - which kick off next summer - a powerful issue with which to campaign against President Trump and the GOP. Bottom Line: There is a non-trivial chance that OPEC 2.0 spare capacity will prove insufficient to cover the losses in Iranian and Venezuelan exports we foresee in the very near term. Should this prove to be the case, the odds that Brent crude oil prices exceed our $95/bbl forecast for next year are high. We believe Iran's political hand could be strengthened, if it rebuffs overtures by the Trump administration to negotiate a treaty to replace the executive agreement with former U.S. president Obama that limited its nuclear program. We recommended getting long Brent call spreads last week to position for the higher prices we are forecasting for next year. Specifically, we recommended getting long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls. As of Tuesday's close, these positions were up 33.8% on average vs their opening levels last Thursday. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Upside Risks Dominate BCA's Oil Price Forecast," published by BCA Research's Commodity & Energy Strategy October 26, 2017, and "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. Both are available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed in November 2016, following the price collapse brought on by OPEC's market-share war launched in November 2014. Please see last week's Commodity & Energy Strategy lead article, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. In that article we note that, in addition to the highly visible export losses in Iran due to U.S. sanctions and continued deterioration in Venezuelan production, the EIA reduced its estimate of U.S. production growth by 201k b/d in 2019, and the IEA reduced its estimate of Brazilian output this year by 260k b/d. 3 Please see "Whither the Oil Market? Headlines and Tariffs and Bears, Oh My..." published by csis.org August 29, 2018. We are closely following a just-proposed workaround to U.S. sanctions on Iranian oil exports made by the High Representative of the EU, Federica Mogherini, at the UN General Assembly meeting in New York on Tuesday. Ms. Mogherini proposed setting up a special-purpose vehicle that would allow importers in the EU, China and Russia to continue purchasing Iranian oil crude. The SPV would transact in euros, yuan, and roubles, so as to avoid processing transactions through the Society for Worldwide Interbank Financial Telecommunication SWIFT system in Brussels. The SWIFT system is dominated by USD transactions, and the U.S. Treasury has high visibility into transactions made using the system, given USD-denominated transaction like oil purchases and sales must ultimately be cleared through a U.S. bank or intermediary. Iran already takes yuan for its oil, and this mechanism would allow it to purchase goods and services denominated in these currencies. If technical details of the proposed system can be worked out, the SPV could facilitate increased Iranian exports under the U.S. sanctions regime. This would cause us to lower our estimate of lost exports from that country from our baseline assumption of 1.25mm b/d. Please see "Why India Will Struggle to Join Iran's Sanctions Busters," published by bloomberg.com on September 26, 2018. 4 We are not the only ones dubious of KSA's ability to ramp production. Please see "Can Saudi Arabia pump much more oil," published by reuters.com July 1, 2018. 5 In our House view, a recession in the U.S. does not arrive until 2H20. We have argued an oil-supply shock, particularly during a Fed tightening cycle, typically presages a recession in the 6 - 18 months following the shock. Please see Commodity & Energy Strategy lead article, "Odds of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. 6 Please see "U.S. seeking to negotiate a treaty with Iran," published September 19, 2018, by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks Table 1A Divided Government Is Marginally Negative For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year Chart 15Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! Chart 17Our Senate Model Is Generous To The Democrats We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? Chart 19The Sun-Belt: No Place To Hide For The GOP? Chart 20Trump Is Not Nixon (Yet) Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated Chart 23Conservatives Distrust Tech Companies How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Chart 4... Even Those That Produce Gridlock What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Chart 5B...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Chart 9Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling Chart 15Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Chart 20 Geopolitical Calendar

Special Report

Highlights Cable is cheap on a PPP basis. However, the discount does not reflect a geopolitical risk premium; it reflects the dollar's general expensiveness. In fact, when the British productivity picture is taken into account, the trade-weighted pound's discount appears rather modest. Our model specifically designed to capture the geopolitical risk premia in GBP/USD and EUR/GBP shows that investors are currently pricing in a very rosy political outlook in the U.K., and near certainty that a soft Brexit will materialize. We are not willing to bet that the path toward a soft Brexit will be easy. As a result, we would expect that if the GBP experiences any rebounds, they will prove short-lived, especially as the outlook for global growth outside the U.S. remains murky. Feature This fall will be a tumultuous time for the pound, as the Brexit process goes into full swing ahead of March 2019. While there remain many possible paths that the U.K.'s relationship with the rest of the EU could ultimately take, ranging from a complete reset of the relationship (i.e. a hard Brexit) to no Brexit at all, another unknown needs to be tackled: Is the GBP priced to adequately compensate investors for such heightened uncertainty? In this week's piece, we develop a simple model to try to ascertain whether geopolitical risk premium is currently present in the pound. We conclude that even though the pound seems cheap enough to compensate investors for the high degree of uncertainty surrounding the U.K.'s long-term economic outlook, this picture is deceiving. As a result, BCA remains concerned about the pound's cyclical outlook, especially against the euro. Is The Pound That Cheap? At first glance, it seems obvious that the pound is very cheap. Cable currently trades at a prodigious 20% discount to it purchasing power parity (PPP) estimate (Chart I-1). Such bargain-basement levels must be a reflection of the economic risks surrounding Brexit. Well, perhaps not. First, the pound may be trading at a large discount against the dollar, but the euro also trades well below its PPP fair value. In fact, when using PPP models, it is hard to dissociate the cheapness of the pound from the expensiveness of the U.S. dollar against its trading partners (Chart I-2). Thus, PPP models are not enough to gauge whether or not the pound is adequately compensating investors for inherent geopolitical risk. Chart I-1Is The Pound Cheap... Chart I-2U.S. Dollar And PPP ...Or Is The Dollar Expensive? Second, when one uses a slightly more sophisticated valuation approach, the discount of the pound seems much more muted than when one looks at PPP alone. Based on our proprietary long-term fair value model, the trade-weighted pound exhibits a much more muted discount of only 3% - well within the historical norm (Chart I-3). Chart I-3Pound: A Much Smaller Discount On A Trade-Weighted Basis What explains this disconnect is the U.K.'s poor productivity performance. In the world of exchange rate determination, there is a phenomenon called the Penn effect. It is an empirical observation - one not fully understood under a theoretical lens1 - which shows that countries with higher levels of productivity growth than their trading partners tend to experience an appreciation in their real exchange rates. As Chart I-4 illustrates, the U.K. is on the wrong side of this phenomenon, as its relative productivity has been falling in comparison to its trading partners. This factor has played an important role in dragging down the pound's fair value. This poor productivity performance has also had another pernicious effect: unit labor costs in the U.K. have risen much more sharply than in the majority of its important trading partners (Chart I-5). This hurts the pound's competitiveness and suggests that a simple PPP model based purely on producer prices might be missing the mark for the true fair value of the British currency - further supporting the message of our proprietary long-term valuation model. Chart I-4Negative Penn Effect For The Pound Chart I-5The U.K. Is Uncompetitive Even when these adjustments are taken into account, our model might still be missing the mark due to a very significant problem: All fair value models for the pound are now based on a potentially unrepresentative sample, one where the U.K. was part of the EU. Thus, another exercise is needed to evaluate the pound's geopolitical risk premium. Bottom Line: Based on simple PPP models, cable looks cheap and therefore may already embed a large geopolitical risk premium. However, this conclusion is misleading. A large share of the pound's undervaluation is not GBP-specific and instead simply mirrors the USD's premium to its fair value. Additionally, the U.K.'s poor productivity performance relative to its trading partners already provides an economic justification for a cheap pound. Thus, we need a different exercise to zero in on the degree of geopolitical discount present in the pound. Zeroing In On The Geopolitical Risk In order to assess the degree of political risk priced into the pound, one needs to isolate this risk. The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the Footsie, consumer confidence or business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart I-6). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart I-6ATraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Chart I-6BTraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) We therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. Moreover, we wanted to keep the model simple, as simplicity permits us to better understand the pound's deviation from its predicted value. Practically, we settled on the following specification: for GBP/USD, we regressed the pair versus the dollar index and the British leading economic indicator. For EUR/GBP, we regressed the cross against the trade-weighted euro and the U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps us isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlooks for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risks. To make sure the exercise was robust, we then tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations, respectively. The results of the models are shown in Chart I-7, and they are startling. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from our fundamental-based model), today the pound's pricing shows an absence of geopolitical risk premium, both against the dollar and against the euro. This corroborates the message from the uncertainty index computed by Baker Bloom and Davis, which shows a very low level of economic policy uncertainty based on language in the press (Chart I-8). Chart I-7ALittle Risk Premium In The Pound (I) Chart I-7BLittle Risk Premium In The Pound (II) This is particularly salient when compared to the euro, where the geopolitical risk premium is currently exaggerated. As Chart I-9 illustrates, the probability of a euro area breakup in the next five years priced into the bond market is at its highest level since the heyday of the euro area crisis in 2011 and 2012. However, this risk is currently overstated as investors have been frightened by the recent Italian elections. Yet, after a tumultuous beginning, the populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels. Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. Italians realize that life outside the euro area will not be a land of milk and honey. Chart I-8British Political Uncertainty Has Collapsed Chart I-9Investors Are Worries About The Euro Area Instead, the pound's cheapness reflects the weakness in the British LEI. This is a consequence of the deterioration in global economic activity. As Chart I-10 shows, the trade-weighted pound has been more sensitive to EM gyrations than the euro or the dollar. This is because total trade represents a stunning 40% of U.K. GDP, versus 37% for the euro area or 28% for the U.S. The U.K. is therefore highly sensitive to global economic conditions. Moreover, the tightening in global liquidity conditions that has contributed to the deterioration of the global growth outlook is itself particularly negative for the pound. The U.K. runs a current account deficit of 4% of GDP, and as FDI inflows into Great Britain have collapsed, the U.K. now runs a basic balance-of-payments deficit (Chart I-11). As such, it is highly dependent on global liquidity flows to finance its current account deficit. As a result, the recent weakness in the pound is more a function of global economic conditions than Brexit itself. Chart I-10The Pound Has Fallen Because of EM Risks... Chart I-11...And As Global Liquidity Has Tightened Bottom Line: After developing a more precise method for evaluating the size of the geopolitical risk premium embedded in the pound, we arrived at an interesting conclusion: There is currently no evidence of a risk premium at all. Instead, the pound's weakness reflects the expensiveness of the dollar, weakening global growth and deteriorating global liquidity conditions. In fact, it is the euro that currently suffers from an exaggerated geopolitical risk premium, as euro area bonds currently incorporate too-large of a break-up risk premium. Investment Implications Taking into account the thin risk premium embedded in the pound against both the dollar and the euro, the GBP does not have much maneuvering room through the fall season. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart I-12). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart I-13). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within Conservative MPs. This also raises the risk that Jeremy Corbyn, whose popularity is rising, could end up as British Prime Minister (Chart I-14). Both of these outcomes are worrisome. The pound is currently pricing in neither the risk of a hard Brexit, nor the risk of the U.K. being controlled by the most leftist government of any G10 nation since the election of Francois Mitterrand in France in 1981. Chart I-12More Undecided Voters Than ##br##Net Brexit Detractors Chart I-13A Risk To ##br##U.K. Stability... Chart I-14...Especially With Mitterand 2.0 ##br##Lurking In The Shadows Moreover, while Germany and EU chief negotiator Michel Barnier seem amenable to keeping the window of negotiations open for the ultimate form of Brexit during the transition period, it remains to be seen what kind of concessions London is willing to make on the free movement of people required to be granted access to the common market in goods. Additionally, the Northern Ireland border remains an unresolved issue. These factors increase the chances that negotiations with the EU will remain difficult. Hence, the implementation of the Chequers White Paper is far from certain, yet the pound currently seems to be priced for an absolute soft Brexit. With the global economic outlook already justifying a lower pound, especially versus the dollar, it therefore seems that the pound today is too risky an investment. It is true that positioning and sentiment in cable are currently very depressed, raising the risk of a short-term rebound (Chart I-15), especially if the EU meeting in Salzburg in two weeks shows an acquiescent EU. However, this will not remove Britain's domestic political problems. Hence, we would be inclined to fade any such rebound. Finally, it is unlikely that the Bank of England will be of much help to the pound either. The British LEI continues to slow, which not only drags the fair value of the pound lower, but also limits how fast the BoE can raise interest rates. Moreover, while British inflation surged as imported goods prices skyrocketed after the GBP plummeted in 2016, domestic prices have remained well behaved (Chart I-16). Thus, as the pass-through to inflation of the previous pound weakness dissipates, British inflation will decelerate further, limiting the upside for interest rates in the process. This combination is only made more binding for the BoE as the government is expected to exert some drag on growth as the British fiscal thrust will subtract 0.4%, 0.2%, and 0.2% to growth in 2018, 2019, and 2020, respectively (Chart I-17). Chart I-15There Is Room For A ##br##Countertrend GBP Rally Chart I-16Little Domestic ##br##Price Pressures Chart I-17Fiscal Drag ##br##Not Over On a six- to nine-month basis, it makes most sense to short the pound against the dollar and the yen, as slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. However, on a longer-term basis, we would expect the break-up risk premium in the euro area to dissipate, which will boost the cheap euro in the process. This means that on investment horizons beyond one year, being long EUR/GBP still makes sense. Bottom Line: Since this year's pound weakness did not represent a swelling of the GBP's geopolitical risk premium but instead has been a reflection of poor global growth and liquidity, any hiccups in British politics could inflict considerable pain on cable. While the EU negotiations may progress positively, domestic British politics remain a big source of risk that investors are not being compensated to take on. As such, we are inclined to fade any rally in the pound. While the pound could weaken most against the dollar and the yen through the fall months, the longer-term outlook looks riskier against the euro. To be clear, the confidence interval around these views remains wide, as the British political situation remains very fluid. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 The Balassa-Samuelson effect has been cited as a potential explanation for this observation, but it still does not fully satisfy many theorists. Appendix Chart II-1Out-Of-Sample Testing Of Model (I) Chart II-2Out-Of-Sample Testing Of Model (II) Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Iraq remains vital for the security of the Middle East and global oil supply; Sectarian tensions in Iraq have peaked, but risk of Shia-on-Shia violence is rising, which could imperil the all-important export facilities in Basra; With the Islamic State defeated, Iran's military support is no longer needed; This opens a window of opportunity for Saudi Arabia and its Gulf Cooperation Council (GCC) allies to make diplomatic inroads in the country; Stability and security are positive for investments in Iraq's energy sector, but official targets are overly ambitious. BCA's Commodity & Energy Strategy expects oil prices to push higher ahead of the likely loss of 2 million bbl/day of exports on the back of U.S.-imposed sanctions against Iran and the all-but-certain collapse of Venezuela's economy. Feature "Divisiveness is not good for the people ... the policy of exclusion and the policy of marginalization must end in Iraq ... All Iraqis should live under one roof and for one goal." Muqtada Al Sadr, April 2012 "Competition between parties and election candidates must center on economic, educational, and social service programs that can be realistically implemented; to be avoided are narcissism [and] inflammatory sectarian and nationalist rhetoric" Ayatollah Al Sistani, May 4, 2018 "Say no to sectarianism, no to corruption, no to division of shares, no to terrorism and no to occupation" Muqtada Al Sadr's call for a peaceful million man "Day of Rage," September 2018 Moqtada Al Sadr's Sairuun party's unlikely victory in Iraq's May elections came as a surprise. The former leader of the Mahdi Army - a militia that terrorized U.S. forces - has reinvented himself into a champion of reform and a counterweight against foreign influence in the country, particularly Iranian. His political success is due to his ability to recognize that Iraq is at a crossroads. Attitudes and priorities are shifting on several levels: Iraq is turning away from sectarian politics after a decade and a half of internal strife. The security threat from the Islamic State has been eliminated, with nationalism replacing sectarianism. Iran-Saudi tensions are ramping up again at the same time that the U.S. is putting pressure on Iran by reimposing a global oil embargo. Iraq, a buffer state between Iran and Saudi Arabia, will become a battlefield between the two regional powers, but the battlefield may be shifting from the military theatre to the economic one. These junctures provide both opportunities to transition the country to a new stage, as well as challenges in cleansing the system of its old demons. The composition of Iraq's new government matters. It will ultimately determine whether these impulses will pave the way for a stronger, more unified country, or whether Iraq will remain consumed with internal battles. Unity is required for Baghdad to boost its oil output in the way it hopes. The Iraqi economy's relationship with oil markets is two-sided. Not only is its income dependent on oil, but global oil markets are also reliant on Iraqi supplies at a time when global spare capacity is razor-thin. Given that Iraq is currently the fifth-largest crude oil producer in the world - the second-largest within OPEC - and accounts for 5% of global crude oil supply, Iraq's production ambitions are important for global oil markets (Chart 1). Chart 1Iraqi Upstream Production Matters As such, when Baghdad announced its ambitions to raise capacity to 6.5 million bbl/day by 2022, the energy markets were paying attention. If this capacity increase translates to a rise in actual production, additional Iraqi oil by the end of the four-year period would roughly equal 2 million bbl/day. This is equivalent to BCA's Commodity and Energy Strategy's expectation of a loss of exports from the two main risks to energy markets today: the Iranian oil embargo and the internal strife in Venezuela (Chart 2).1 (Of course, the Iraqi production would not come in time to prevent the run-up in prices that we expect as a result of the latter two risks, given that they are immediate risks whereas Iraq will take four years to ramp up.) Chart 2Losses From Venezuela and Iran Will Push Prices Higher The doubling of Iraq's production over the past decade occurred despite constant sabotage of its oilfields, pumping stations, and pipelines by insurgents. It would seem that the restoration of security offers an optimistic outlook for Iraq's production plan, especially given Iraq's naturally competitive conditions (Table 1). But there is no certainty in Baghdad's ability to reach these targets. Iraqi output is now operating near full capacity (Chart 3). The past decade and a half have wreaked havoc on its infrastructure and discouraged investments needed to develop its fertile oilfields. Table 1Operating Costs Are Competitive Chart 3Not Much Idle Capacity In this report, we assess whether political conditions will support stability in Iraq. The alternative scenario, one where Iraq becomes a physical battlefield between Iran and Saudi Arabia, would not only snuff out any hope of an oil export boom, but could also become yet another risk to global oil supply. Political Will Is Not Enough To Boost Oil Output An expansion of oil production capacity would bring much needed revenue to aid in Iraq's rebuilding efforts. Iraq's economy is highly dependent on the energy sector, even relative to other major oil-producing Middle Eastern peers (Chart 4). The rebound in oil prices over the past couple of years has therefore helped support Iraq's budget, with a surplus expected this year for the first time since 2012 (Chart 5). Extra revenue has, in turn, helped grease the wheels of stability and reconciliation in the country. Chart 4Addicted to Petrodollars Chart 5Higher Prices Will Help Flip the Deficit However, political will is not a sufficient condition. Rather, the success of the plan to expand capacity is contingent on Baghdad overcoming several key constraints: While the threat from Islamic State has for the most part subsided, security and the potential for sabotage remain risks to Iraq's current oil infrastructure. Ongoing disputes over the status of Kurds in northern Iraq - risks that contains almost 20% of proven reserves - raise the potential for conflict. Additionally, oil infrastructure may become vulnerable to sabotage from Iran, or Iranian-backed militants, if there is a souring of relationships (see more on that below). Discontent among Iraqis in the southern oil-rich region also raises the probability of disruptions. Over the weekend, protesters upset with corruption and poor services gathered near the Nahr Bin Omar oilfield. Clashes between Basna protesters and security forces have already led to six deaths over the past three days. Iraq's current network of pipelines, pumping stations, and storage facilities - many of which are damaged beyond repair - are not capable of handling greater volumes. An expansion of the export capacity is required for Iraq to be able to benefit from future increases in production. Such an expansion will require FDI, which in turn will require stability and a political climate conducive to large-scale, long-term investments. There are currently two main functioning oil export hubs - the northern network of pipelines, and the southern shipping route (Map 1). Map 1Iraq's Oil Infrastructure On Shaky Ground In northern Iraq, the Iraq-Ceyhan pipeline is connected to Kurdish lines at the city of Fishkabur and carries northern oil to the Turkish port (Table 2). Table 2Defunct Pipelines Leave Room For Improvement Northern exports account for ~15% of Iraq's total crude exports (Chart 6). While the Fishkabur-Ceyhan pipeline has a nameplate capacity of 1.5 million bbl/day, usable capacity is reportedly significantly lower, constraining Iraq's northern exports. Chart 6Southern Crude Accounts For Bulk Of Iraqi Exports Although the Kurdistan Regional Government (KRG) has its own network of pipelines transporting crude from fields in the Khurmala Dome and Tawke fields to Ceyhan via Fishkabur, the main infrastructure on the Baghdad-controlled side - the Kirkuk-Fishkabur pipeline - has been targeted by insurgents and has slowly been losing capacity. Its pre-2003 0.9 million bbl/day capacity was reduced to 0.25 million bbl/ day in 2013. Finally, it was closed down in March 2014 rendering it inoperable. Exports from Kirkuk have been on hold following Iraq's takeover of the oilfield in October 2017, as the Iraqi government does not have the infrastructure to bypass Kurdish pipelines. As a result, exports through Ceyhan have collapsed to almost half their pre-October levels.2 The closure of the Kirkuk pipeline undercuts Iraq's ambitions to increase Kirkuk's oil production to 1 million bbl/day. This has been partially mitigated by an agreement for Iraq to truck 0.03-0.06 million bbl/day of Kirkuk oil to Iran in exchange for oil in the south. Ultimately, the vulnerability of northern exports highlights the need for more reliable transportation channels. As such, the Iraqi government announced plans late last year to build a new pipeline from Baiji to Fishkabur, replacing the defunct Kirkuk pipeline in transporting oil to Ceyhan. Furthermore, the idea of using KRG pipelines to export Kirkuk's oil was floated during meetings between current Prime Minister Haider al-Abadi and former President of the Kurdish Regional Government (KRG) Masoud Barzani, and thus could be a possibility going forward. A positive outcome would require a thaw in Iraqi-Kurdish relations and ultimately hinges on the outcome of government formation in Baghdad. Thus, the northern infrastructure - which currently has a nameplate export capacity of 1.5 million bbl/day - underlines the vulnerability of Iraq's exports, not only to sabotage, but also to internal strife. Export capacity from southern Iraq, which accounts for 85% of oil exports, will also require expansion. Pipelines between the oilfields, storage facilities, and export terminals on the Persian Gulf are also susceptible to damage. However, authorities have been expanding export capacity there. The authorities currently operate five single point moorings, bringing total export capacity from the Persian Gulf to 4.6 million bbl/day. The Iraqi Pipeline to Saudi Arabia (IPSA), which could support export capacity from the south, runs through the Arabian Peninsula to the Red Sea. However, it has not been operating since the first Gulf War, and the Saudis have converted their section of the pipeline to transport natural gas. Talks of a revival of this line have recently surfaced. An improvement in Saudi-Iraqi relations would certainly be a positive sign for southern export capacity, providing another outlet for any potential supply increase. Currently there are no operating export pipelines going westward.3 The Kirkuk-Baniyas pipelines were damaged in 2003, and while Iraq and Syria agreed to replace these pipelines with two new ones in 2010, no progress has been made yet. Given instability in Syria, this is unlikely to happen anytime soon. However, there is a plan in place to create a new line between Basra and Aqaba in Jordan with an export capacity of 1 million bbl/day. This would allow Iraq to transport just under a quarter of its total exports via the Red Sea, rather than the Persian Gulf. In terms of internal transportation, the Iraq Strategic Pipeline is a pair of bi-directional lines that run vertically between the country's most important oil-producing regions. However, it has been damaged and currently operates only northward, from Basra to Karbala. Since there are no operational pipelines to the north under Iraqi control, it is currently of limited use. In other words, the oil is stuck in Iraq. Increases in water injection facilities are also required to maintain pressures in the reservoir and boost oil production. Natural gas, which Iraq currently flares, could technically be used as an alternative to water injection. Iraq is working towards reducing gas flaring and hopes to use the captured gas for electricity. The Common Seawater Supply Project (CSSP) aims to treat and transport 5-7.5 million bbl/day of seawater from the Persian Gulf to oil production facilities. 1.5 bbl of water injected are required to produce 1 bbl of oil in the major southern oilfields. However, since the termination of talks with Exxon Mobil Corp on the construction of the facility in June (after two years of negotiations!) there has been no progress on this project. It will likely be awarded to another company, but the lack of clarity regarding CSSP's completion date adds uncertainty to Iraq's expansion plans. Electricity shortages also put expansion plans in peril. Iraq needs significant upgrades to its electricity grid. Given that the oil and gas industry is the top industrial customer of electricity, a stable connection is required to boost output. The World Bank reports that in 2011, an average of 40 outages occurred each month, affecting 77% of firms in Iraq. Bottom Line: Export capacity of Iraq's northern pipeline to Ceyhan currently stands at 1.5 million bbl/day, while its southern ports allow for 4.6 million bbl/day to be shipped through the Persian Gulf. These figures are generous. Usable capacity is reportedly much lower. Iraq has plans to increase its western export capacity to 1 million bbl/day through a new pipeline to Aqaba. Nevertheless, this infrastructure is vulnerable to sabotage by residual insurgents, as well as to Iraq-Kurdish and Iraq-Iran disputes. Iraq's Shifting Interests... Policymakers in Baghdad face the challenge of ensuring sufficient water and electricity not only for the country's oilfields but also for the population. Electricity shortages triggered the recent protests in Basra. Demonstrators have been calling for improved access to these essentials, along with job opportunities and a crackdown on corruption. Furthermore, there is increased evidence that Iraqis have become disillusioned with the political elite and are losing confidence in the political "establishment," such as it is (Chart 7). Transparency International rates Iraq as "highly corrupt" and ranked it 169 out of the 180 countries in its 2017 Corruption Perceptions Index. It stands out even among its highly corrupt Middle Eastern peers (Chart 8). Chart 7Iraqis Lack Confidence In Their Leaders Chart 8Corruption Is Rampant Iraqis fear that even as their country exploits its oil, they will remain destitute. Although the southern region contains three-quarters of Iraq's oil reserves (Table 3), it has the highest poverty rate (Chart 9). Table 3Southern Oilfields Are Iraq's Crown Jewel... Chart 9...Yet Poverty Is Widespread There Anti-establishment sentiment is rising, as reflected in the most recent parliamentary elections in May 2018. Voter turnout was reported at 44%, down from 60% in the previous two elections. The success of Moqtada Al Sadr's Sairuun coalition in winning the majority of seats highlights this shift in allegiance (Box 1). While Iraq's demographic makeup remains heterogeneous, voters are no longer instinctively looking for sectarian parties to represent them. Rather, they want policymakers to resolve basic needs like electricity, water, and corruption. Protesters in Basra are therefore not chanting sectarian slogans, but rather demanding basic services and jobs (Chart 10). Box 1 Ma'a Salama Sectarianism? In surprising results from the May parliamentary elections, the Sairuun coalition - an unlikely combination of communists, leftists, and centrist groups, led by firebrand Shia cleric Moqtada Al Sadr - attained the largest number of votes (Table 4). Nevertheless, it was not able to garner enough seats to secure an outright majority necessary to form the government on its own. Instead, alliances are now being forged as parties scramble to establish the largest coalition group. Of the 329 seats in Iraq's Council of Representatives, just over half are represented by the main Shia parties. The challenge for them this time around is that the five main Shia blocs, which were previously united, have split into two opposing camps. Table 4Politicians Are Picking Up On Shifting Trends The Sadr-backed Sairuun coalition, along with (1) Prime Minister Abadi's Nasr al Iraq, (2) the conservative Hikma bloc, and (3) the Ayad Allawi, centrist Wataniyya bloc have already announced a preliminary agreement to form a coalition as well as a commitment to take an anti-sectarian approach. Several smaller Sunni, Christian, Turkmen, and Yazidi parties have pledged that they would support the non-sectarian, nationalist, bloc of parties. This brings their seats to 187. At the other end are the pro-Iranian Fateh and Dawlet al Qanun blocs, which recently announced that they had formed the largest bloc. The two main Kurdish parties are not included in either alliance. Together they hold 43 seats, giving them the power to be the tie-breakers. They have drafted a list of demands and stated their willingness to join whichever bloc is able to guarantee their fulfillment. Given Maliki's previously divisive rule, we assign a greater probability to the scenario in which they join the core coalition headed by Sadr, as several Sunnis have already done so. The danger of a nationalist, cross-sectarian movement is that it would signal the rebirth of an independent Iraq, which is not necessarily in the interest of its two powerful neighbors, Saudi Arabia and Iran. Iran, in particular, would feel its dominant position weaken and might want to instigate sectarian conflict in order to arrest the nationalist, Sadr-led movement. This would definitely matter to global investors as a Shia-on-Shia conflict in Iraq would geographically take place around Basra, the main shipment route for 85% of the country's oil exports. Chart 10Iraqis Want Better Services Prime Minister al-Abadi has also become more responsive to people's needs. He recently sacked the electricity minister and promised to fund electricity and water projects. Furthermore, amid demands for employment opportunities in the oil sector and accusations of corruption, the Iraqi cabinet recently announced a regulation requiring that at least 50% of foreign oil company employees be Iraqi citizens. Given that the voice of discontent in Iraq is getting louder, we expect the government to uphold these promises. Pacifying protesters will increase stability, reduce risks of violence and disruptions, and build support for the government. Nevertheless, many voters still see the prime minister as part of the corrupt political elite. Bottom Line: Iraqis are demanding their basic rights, and this is taking the form of increased pro¬tests, especially in the south where key oilfields are located. The schism among the main Shia parties along the nationalist/Iran axis suggests that Iraq has evolved beyond the purely sectarian political system. This is a positive in the long term as it means that the country can focus on material issues that matter to Iraqis. However, in the short term, the Iran-aligned Shia groups could spur violence, especially if they realize that the sectarian model of politics is waning. ...And Shifting Allegiance? Apart from the shift in focus toward issues-based politics, the election also highlights a pivot in allegiance away from Iran. Sadr's Sairuun bloc is critical of Iranian interference, and while it was initially open to joining forces with Amiri's Iran-backed Fateh coalition, it ultimately allied with the more secular Shia parties. Iran's recent role in Iraq has been mainly through military aid. It proved vital in driving the Islamic State militants out of Iraq - training, equipping, and funding Iraqi militias who fought against the terrorist group. Iran-backed militias united in 2014 to form the Popular Mobilization Forces (PMF) and eventually defeated Islamic State. The PMF, estimated to be between 100,000-150,000 strong, was officially recognized as part of the Iraqi army earlier this year. However, the loyalty of the Shia militias to Baghdad remains unclear. Furthermore, when Washington expressed reluctance in arming Iraq with U.S. military equipment to fight terrorist groups in early 2014, Iran stepped up and signed a deal to sell arms and ammunition worth $195 million (Table 5). Iran also sent its own troops to support in fights against insurgencies - dispatching 2,000 troops to Central Iraq in June 2014. This military collaboration culminated in the signing of a July 23, 2017 agreement between Iran and Iraq for military cooperation in the fight against terrorism and extremism. Table 5Iran's Military Support Was Needed In The Past... Yet with the curbing of Islamic State, Iraq is preparing to begin a new chapter - rebuilding its war-torn cities. In doing so, its needs will shift from military support to financial support, potentially shifting its allegiance from Iran to Saudi Arabia. Furthermore, Iran's current economic situation - especially with the anticipated impact of U.S. sanctions - will leave fewer funds available for it to direct towards Iraq. The electricity crisis earlier this summer symbolizes the shifting dynamic. Iran, which has been supplying southern Iraq with electricity, announced it would no longer provide Iraq with power, citing its dissatisfaction with the accumulation of unpaid bills. Iran itself is experiencing electricity shortages and is no longer willing or able to sacrifice for Iraq, which it fears is drifting outside its sphere of control. Iran eventually took back this move and restarted its electricity exports. However, this occurred only after the Iraqi government sent a delegation to Saudi Arabia to negotiate an agreement to supply electricity to southern Iraq. The Saudis also offered to build a solar power plant to provide electricity to Iraq at a quarter of the Iranian price. Baghdad therefore used the crisis to signal to Tehran that it has other options, including a closer economic relationship with Iran's chief rival, Saudi Arabia. This emerging rift was also apparent during the International Conference for Iraq's Reconstruction, hosted in Kuwait, where Iraq hoped to secure $88 billion worth of funds. There, Iraq obtained $30 billion in pledges toward rebuilding its economy (Chart 11). While Iraq's Arab neighbors jointly pledged over $10 billion, Iran - despite being present at the conference - failed to guarantee any funds. Later it offered Iraq a $3 billion credit line. Chart 11...But Now Iraq Needs Monetary Support Iran is not only limited by the dire state of its economy. Protests in Iran earlier this year partly focused on Tehran's foreign policy expenses, i.e. its support of various loyal regimes around the region. This "loyalty" costs money that Iranians believe could be better spent on their domestic needs. As such, Iranian policymakers will be wary of committing more funding to Iraq, as it could be seen as wasteful by restless voters at home. What's more, Iraq's Arab GCC neighbors have both the willingness and the ability to ally with Iraq and, in turn, to curb Iran's influence in the region. Bottom Line: Stronger ties with its Arab neighbors - and the accompanying funds - are what Iraq needs right now. Iraq requires another $58 billion towards its reconstruction efforts. Its southern neighbors can help it get there. Whether this will transpire hinges on Iran's ability to infiltrate Iraq's political elite. Given that Iraqi people have become disillusioned with many of these leaders, Iran will likely face a bigger challenge this time around. Investment Implications: Short-Term Pain For Long-Term Gain Since 2011, BCA's Geopolitical Strategy has stressed the emerging Saudi-Iranian proxy war as the main regional dynamic.4 With the U.S. "deleveraging" out of the Middle East, the field is open for regional power dynamics. The result is a "security dilemma," in which Saudi and Iranian attempts to improve their defenses appear offensive to the other side, resulting in a vicious cycle of distrust. The Trump administration has deepened the tensions by ending the Obama administration détente with Iran. Lower oil revenue will limit Iran's ability to influence the Middle East through its proxies, including in Iraq. Iran may decide that Iraq is lost. At that point, it may conclude that if it cannot own Iraq, it must break it. Recently, Reuters reported that Iran has moved short-range ballistic missiles into Iraq in order to threaten Saudi Arabia and Israel, in case it needs to retaliate against a U.S. attack against its nuclear facilities.5 While the report was strongly denied by Iran, it suggests that Tehran could be trying to sow discord in Iraq, or even that its operatives are working with impunity in Iraq. Iran's pain is ultimately Saudi Arabia's gain. An Iranian economy battered by the imposition of sanctions will give way to increased Saudi influence in Iraq. The oil-rich GCC countries certainly have the coffers to incentivize such a switch. In offering to fill the funding gaps of its less fortunate neighbors, Saudi Arabia has already won the allegiance of other strategic regional partners such as Egypt, Pakistan, and Sudan. In 2016, amid economic turmoil in Egypt, Saudi Arabia signed agreements worth over $40 billion to support Egypt (Table 6). This does not include financing from other GCC allies. The UAE and Kuwait also support Egypt's economy in a significant fashion. Table 6Saudi Arabia Is No Stranger To Purchasing Allies Similar financial backing in Iraq would go a long way towards filling the $58 billion funding gap for its reconstruction. The quid pro quo would be the backing of Saudi Arabia's regional political agenda, which includes curbing Iranian influence. Not only would such investment accelerate the eventual increase in Iraqi oil production. It would also curb Iran's ability to retaliate through the region, both by removing an important ally and by cutting off Syria and Lebanese Hezbollah geographically from Tehran. Domestic Iraqi politics are therefore critical for global investors. If Iraq forms a nationalist, non-sectarian government over the next several months, it will degrade Iran's ability to influence the country. At that point, Iran may either lash out against the new Baghdad government and try to create domestic strife through its proxies - the battle-hardened Shia militias - or it may be pressed into negotiations with the U.S., lest it lose more allies in the region. If Iran choses to lash out against Iraq, we suspect that it will do so through attacks and sabotage against Iraqi infrastructure. This could present an additional tailwind to oil prices over the next several months. Any additional risk premium on the cost of a barrel of oil would be a boon for Iran as it deals with a loss of exports due to sanctions. Such a campaign of sabotage, however, would ensure that Baghdad firmly moves outside the Iranian sphere in the long term, which could open up the potential for Saudi Arabia and its GCC allies to invest in the country. In the short term, therefore, there is further risk to global oil supply as the shifting political dynamics in Iraq will put the country squarely in the middle of the ongoing Saudi-Iranian proxy war, right where it has always been. In the long term, we believe that Iranian influence in Iraq has peaked and will wane going forward. This opens up the opportunity for Baghdad to rely on Saudi Arabia and GCC countries for funding. This could be a boon for global oil supply over the next decade. Of course, much will hinge on whether Saudi Arabia is willing to finance the development of Iraqi oil fields. Oil produced in those fields would compete directly for market access with Saudi's own production. If Saudi Arabia decides to look out for its own, short-term, economic interests, then Iraq may be limited in terms of funding its development, or even be thrust back into Iran's orbit. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Special Report, "Re Oil Demand: Fed Policy Trumps Tariffs," August 30, 2018, available at ces.bcaresearch.com. 2 Prior to the takeover, Kirkuk oil was being transported to Fishkabur via KRG pipelines, which the Iraqi government can no longer access. 3 The Kirkuk-Haifa line has been defunct since 1948. 4 Please see BCA Emerging Markets Strategy and Commodity & Energy Strategy Special Report, "Riyadh's Oil Gambit," dated October 11, 2011, available at ces.bcaresearch.com. 5 Please see John Irish and Ahmed Rasheed, "Exclusive: Iran moves missiles to Iraq in warning to enemies," Reuters, dated August 31, 2018, available at reuters.com.

Special Report

Highlights Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The U.S. Treasury has authority to intervene unilaterally in foreign exchange markets. However, conditions for effective interventions to weaken the dollar exist neither within nor outside the U.S. For the time being, central banks in Europe, Japan, and China will not cooperate with the U.S. to depreciate the dollar. The Federal Reserve will effectively team up with the U.S. Treasury to depreciate the greenback only if economic conditions in the U.S. warrant a weaker currency. This is not currently the case. In this context, the dollar will continue to appreciate, but its rally will be accompanied by substantially higher volatility as the U.S. administration aggressively "talks down" the dollar. To capitalize on this theme, traders should consider going long dollar volatility. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM. Feature Chart I-1U.S. Core Inflation Will Rise Further Economics and politics are set for a major clash in foreign exchange markets. Economic fundamentals and crosscurrents worldwide herald U.S. dollar appreciation. Yet, U.S. President Donald Trump wholeheartedly opposes any dollar strength. The higher the greenback rises, the more forceful Trump's jawboning about the exchange rate and interest rates will become. If the dollar does not halt its advance and overshoots, the odds are material that at a certain point the U.S. Treasury will initiate currency market interventions itself. It would do so by selling dollars and buying foreign assets. What will be the outcome of this battle between economics and politics in financial markets? The conclusion of this report is that for government-led currency market interventions to be effective in reversing the dollar's uptrend, the U.S. administration will have to convince the Federal Reserve to cease rate hikes and balance sheet contraction. Without the Fed recalibrating policy to be more consistent with a weaker dollar, the U.S. Treasury may not succeed in weakening the greenback on a sustainable basis. Given core consumer price inflation in the U.S. will likely surprise to the upside (Chart I-1), the Fed will not be willing to halt its tightening campaign. Hence, it will take time for the U.S. administration to wrestle and convince the Fed to accommodate currency interventions in efforts to weaken the greenback. In the meantime, the dollar will likely continue its volatile ascent. The Dollar Will Rally If Left To Market Forces Based on economic fundamentals, the path of least resistance for the greenback is up - for now. U.S. growth and inflation warrant higher interest rates, and the Fed is willing to continue moving short rates higher. In contrast, the unfolding EM/China slowdown is not only negative for their own respective currencies but is also harmful for commodities currencies in the advanced economies. Besides, the German and Japanese economies are much more vulnerable to a slowdown in EM/China than the U.S. (Chart I-2). Consistently, Chart I-3 illustrates that outperformance by the equal-weighted U.S. stock index versus its global peers in local currency terms - a measure of relative domestic demand - still points to a stronger U.S. dollar. On the whole, the growth and interest rate differentials between the U.S. and the rest of the world will likely continue to move in favor of the former and extend the dollar rally. Chart I-2Germany and Japan Are Much More Exposed ##br##To EM/China Than To The U.S. Chart I-3Relative Share Prices Point ##br##To A Firmer Dollar The dollar is typically a counter-cyclical currency. It depreciates when global trade is improving and appreciates when the global business cycle is slowing (the dollar is shown inverted on this chart) (Chart I-4). Odds are that global trade will continue to decelerate due to the slowdown in EM/China and trade protectionism - even if U.S. domestic demand growth remains robust. Furthermore, U.S. trade protectionism is positive for the dollar. The basis is that exporters to the U.S. could opt for weaker currencies to offset the negative impact of tariffs on their local currency revenues. Financial markets are often self-regulating, and they move to rebalance the global economy and amend economic excesses. A stronger dollar is the right medicine for the global economy for now. A firmer dollar is required to rebalance growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. In addition, a stronger greenback will compel unraveling of excesses within the developing economies. While it will cause growth retrenchment and will be painful for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. U.S. dollar liquidity is tightening, supporting the greenback (the latter is shown inverted on this chart) (Chart I-5). Continued shrinkage of the Fed's balance sheet entails tighter U.S. dollar liquidity going forward. With respect to currency market technicals, the broad trade-weighted U.S. dollar is not yet overbought, and trader sentiment on the U.S. currency is not extremely bullish (Chart I-6). Hence, conditions for an ultimate cyclical top in the dollar do not yet exist. Chart I-4The Global Business Cycle and The Dollar Chart I-5Upside Risks To The Dollar Chart I-6The Dollar: Market Technicals Finally, the U.S. dollar is not expensive. Our favored currency valuation measure - the real effective exchange rate-based on unit labor costs - currently suggests that the greenback is only slightly above its fair value (Chart I-7). This measure is superior to the real effective exchange rate based on consumer and producer prices because it considers both wages and productivity. Ultimately, competitiveness is not a function of wages (or prices) but wages adjusted for productivity.1 Besides, labor costs typically constitute the largest share of business costs. Hence, the unit labor cost-based real effective exchange rate is the best measure of currency competitiveness. This currency valuation yardstick does not corroborate the widely circulating narrative in the investment community that the U.S. currency is very expensive. The greenback is also not expensive according to the real broad trade-weighted dollar index. The latter is only slightly above its historical mean, and well below its previous highs (Chart I-8). Chart I-7AThe Dollar Is Not Expensive Chart I-7BThese Currencies Are Expensive Chart I-8Trade-Weighted Dollar in Real Terms To be sure, we are not implying the dollar is cheap. It is not. Rather, our point is that the greenback is not yet expensive. When valuations are not extreme, they usually do not prevent a rally or selloff. Odds are that the dollar could become more expensive in this cycle before topping out. Bottom Line: Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The Main Risk To The Dollar Is Trump Chart I-9U.S. Monetary Conditions Are ##br##About To Become Tight Will the U.S. administration invoke the "nuclear" option - currency market interventions - to eclipse the dollar's fundamentals and reverse the greenback's rally? President Trump fiercely opposes a stronger dollar. He prefers a structurally weaker currency to bring back manufacturing jobs to the U.S. Besides, from a cyclical perspective, President Trump has been explicit that higher U.S. interest rates and a stronger dollar are negating his economic stimulus. Trump's worry is that tightening monetary conditions, if they persist, will depress growth by late 2019 when the next presidential election season begins in earnest (Chart I-9). President Trump is a genuine economic populist and is ready to cross boundaries that many presidents refused to. This leaves us little doubt that the U.S. administration will escalate its calls both for a weaker currency and a halt in Fed tightening. The U.S. Treasury is in charge of foreign exchange policy, and it can intervene in currency markets. The Fed can, but is not obliged by law, to supplement the Treasury's interventions in foreign exchange markets. In theory, the U.S. Treasury has a special fund (the Exchange Stabilization Fund) and could opt for unilateral currency market interventions even if the Fed does not cooperate. In such a case, a pertinent question is: What are the essential conditions for currency interventions to succeed in reversing the dollar's uptrend? Conditions For Effective Currency Interventions There have been two major interventions conducted by the U.S. authorities to depreciate the dollar: the 1971 Smithsonian Agreement and the 1985 Plaza Accord. BCA's Geopolitical Strategy service has discussed the political and trade backdrops of these interventions in past reports, and we will not detail them here.2 There was also the Louvre Accord in 1987, but it was aimed at propping up the U.S. dollar, not weakening it. All of these interventions were successful and achieved their objective (Chart I-10). We list below the stipulations that secured the success of these interventions and examine whether conditions for effective interventions are present today. Chart I-10The Smithsonian And Plaza Accords Were Successful Currency interventions accompanied by congruent monetary and fiscal policies tend to be more successful. The previous currency interventions conducted by the U.S. Treasury would not have been successful without the Fed simultaneously adjusting monetary policy. Not only did the Fed join the U.S. Treasury's efforts to depreciate the greenback following the Smithsonian Agreement and the Plaza Accord, but it also altered its monetary policy stance - it pursued a policy of lower-than-otherwise called for real interest rates. Academic literature on this issue is straightforward. Bordo (2010) contends the following about the efficacy of currency interventions: "If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it ... Most of the movements in exchange rates over the Plaza and Louvre period seem attributable to policy changes, not intervention."3 Given current economic conditions in the U.S. economy - a very tight labor market and the prospect of higher inflation - the Fed is unlikely to easily agree to altering its current policy stance to accommodate the Treasury's preferred exchange rate policy. Academic literature finds that sterilized interventions are less effective than non-sterilized ones.4 For the Fed not to sterilize currency interventions aimed at weakening the dollar, it would need to allow commercial banks' reserves to rise. This would conflict with its current explicit objective of reducing commercial banks' reserves and shrinking its balance sheet (Chart I-11). Chart I-11U.S. Banks' Reserves and The Dollar Hence, the bar is presently very high for the Fed to agree to non-sterilized currency interventions to weaken the dollar, as it would go against its current policy objective of tightening and shrinking its balance sheet. Going on the Treasury's leash would substantially damage the Fed's creditability. Bilateral currency interventions are much more effective in achieving the desired objective than unilateral ones. Hence, for interventions to succeed it is critical to involve counterparts in other countries. Back in the 1970s and 1980s, the U.S. used its hegemonic leadership over Europe and Japan as well as tariffs (in 1971) and the threat of tariffs (1980s) to force its allies to agree to bilateral interventions to weaken the dollar. However, it is difficult to envision either Europe or Japan agreeing to allowing their respective currencies to strengthen a lot at this time. First, both Europe and Japan are actively fighting latent deflationary forces at home. Given the high-beta, export-dependent nature of both economies, a strong currency would negatively impact growth. Geopolitically speaking, Europe is not as dependent on the U.S. today as it was at the height of the Cold War. Russia is a "poor man's" Soviet Union, with the combined defense budget of the EU economies dwarfing its own. Besides, in the 1970s and 1980s, the U.S. was "the only market in town." Crossing American policymakers upped the threat of being evicted from the most lucrative global middle class consumer market. This is no longer the case with the rise of emerging markets, China and the common European market. Prominently, Trump's main objective is to depreciate the dollar versus the Chinese RMB. Yet, there is no chance that in the foreseeable future China will agree with the U.S. to engineer considerable yuan appreciation against the dollar. In fact, Beijing has been actively using CNY depreciation to offset the impact of tariffs imposed on its exports by the Trump administration. Chart I-12China: Exchange Rate and Interest Rate##br## Differential Are Correlated Notably, this week there was an article published by China's Xinhua news agency referring to the "... Plaza Accord, in which Tokyo agreed to strengthen the currency against the dollar, as cause of the country's economic woes. ... Rapid and steep yen appreciation and Japan's domestic policy mistakes eventually brought about the nation's "lost decade."5 Chinese policymakers have carefully studied and internalized Japan's mistakes in the late 1980s and early 1990s. The mainland will not accept a considerably stronger yuan at times when deleveraging remains an important policy objective - and the latter is bound to weigh on domestic demand. Amid deleveraging, China requires a weaker - not stronger - currency to mitigate deflationary pressures in the economy. For interventions to be effective, foreign counterparts need to also agree to adjust their monetary and fiscal policy stances to be in sync with exchange rate policy. Presently, both the European Central Bank and the Bank of Japan are still conducting QE and expanding their balance sheets. These policies are compatible with weaker - not stronger - currencies. It is highly unlikely these central banks will abruptly reverse their current policies to accommodate President Trump's economic preferences. With time, if the U.S. dollar overshoots on the strong side and the euro and yen plunge substantially, it is probable that the ECB and BoJ will become willing to support the U.S. administration's efforts to depreciate the dollar. However, conditions for bilateral interventions do not exist at the moment. As to China, policymakers are unlikely to push local rates higher to promote a major currency rally. Chart I-12 illustrates the tradeoff between the exchange rate and interest rates in China might be weak but exist - the CNY/USD rate broadly correlates with the China-U.S. interest rate differential. The PBoC may not be able to appreciate the yuan without tolerating higher money market rates. Yet China's corporate debt burden is enormous, and requires low - not high - borrowing costs to smooth the deleveraging process. Bottom Line: Conditions for effective foreign exchange market interventions do not presently exist in the U.S. For the time being, neither the Fed nor central banks in Europe, Japan and China will cooperate with the U.S. Treasury to depreciate the dollar. Can The U.S. Intervene In CNY/USD Market? Chart I-13Trade-Weighted RMB And Dollar Move Together The U.S. can intervene in the euro, yen and other currency markets, but the focus of President Trump is the dollar's exchange rate with the Chinese yuan. Provided China has capital controls, its government decides which foreign institutions/organizations can buy local currency and assets, and how much. It is highly unlikely the Chinese government will grant permission to the U.S. authorities to freely operate in the RMB market. In short, China will not allow the Fed and other U.S. institutions to act on behalf of the government and push around the exchange rate. The ongoing trade confrontation between the U.S. and China has not produced any agreement. There is, at this time, zero chance that China will agree to appreciate its currency considerably under U.S. pressure. In fact, our geopolitical strategy team still expects the Trump administration to impose tariffs on the announced $200 billion of Chinese imports at some point in September. While the ultimate figure may be smaller than $200 billion, the point remains that the trade war between the U.S. and China continues to heat up, not cool off. The only feasible option for the U.S. authorities is to devalue the dollar against the European and Japanese currencies, triggering a broad-based selloff in the dollar. In this scenario, the RMB might appreciate versus the greenback, but only moderately. The CNY/USD rate is tightly controlled by the PBoC, and the yuan typically depreciates (appreciates) in trade-weighted terms when the greenback weakens (strengthens), respectively (Chart I-13). Consequently, U.S. intervention in currency markets that does not directly embrace the yuan will likely lead to a weaker trade-weighted RMB and make China even more competitive versus other nations. In fact, such an effort would be welcomed by Chinese policymakers, as it would stabilize and even lift the yuan versus the dollar (fostering financial stability in China), but allow the renminbi to depreciate in trade-weighted terms (boosting China's overall trade competitiveness). Bottom Line: There is currently no effective way for the U.S. to intervene and achieve material RMB appreciation in trade-weighted terms. Investment Conclusions Chart I-14Go Long U.S. Dollar Volatility The global macro landscape warrants a continued dollar rally. Yet the U.S. administration will use frequent verbal attacks to halt the greenback's ascent. President Trump is likely to continue to publically oppose the Fed and its interest rate policy. At some point, potentially in the near future, his criticism could become a full-on assault. In this context, the U.S. currency will continue to appreciate, but its rally will be accompanied by large dips, i.e., substantially higher volatility. To capitalize on this theme, traders should consider going long dollar volatility (Chart I-14). The trajectory of the U.S. dollar is critical for many financial markets in general and EM in particular. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM in absolute terms and underweighting EM versus DM for stocks, credit and currencies. BCA's Emerging Markets Strategy continues to recommend shorting a basket of the following EM currencies versus the U.S. dollar: the Brazilian real, the South African rand, the Chilean peso, the Malaysian ringgit and the Indonesian rupiah. Potential dynamics that would persuade the Fed to arrest its tightening campaign include escalating EM turmoil that spills into U.S. financial markets. An intensifying EM selloff is our baseline view, and the dollar will spike materially in this scenario. Only after this occurs will the Fed likely contemplate halting its tightening, and only then will the dollar peter out. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Unit labor cost = (wage per person per hour) / (productivity per person per hour). 2 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, and "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available at gps.bcaresearch.com. 3 Bordo, M. et al (2010), "U.S. Foreign-Exchange-Market Intervention during the Volcker-Greenspan", NBER Working Paper, September 2010 4 Bordo, M., Humpage, O. & Schwartz, A. (2011), "U.S. Monetary-Policy Evolution and U.S. Intervention", Federal Reserve Bank of Cleveland, Working Paper, October 2011 5 South China Morning Post: Chinese state media cites Japan's 'lost decade' when warning of risks of giving in to US demands; https://www.scmp.com/news/china/diplomacy-defence/article/2160196/chinese-state-media-cites-japans-lost-decade-when Equity Recommendations Fixed-Income, Credit And Currency Recommendations