Commodities & Energy Sector
On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and,…
Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Chart 6... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market. Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms\ Chart 9Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.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
Chinese copper imports came in strong in September. While unwrought copper imports reached a 2.5-year high, ores and concentrates forged new record highs. Copper inventories at the three major global exchange warehouses have been declining steadily and…
Dear Client, You will see in this Monthly Portfolio Update that we have expanded our table of Recommendations to include a wider range of the views that Global Asset Allocation (GAA) regularly discusses in its publications. Please see our most recent Quarterly Portfolio Outlook1 for a detailed explanation of those recommendations that we do not specifically touch on in this Monthly. A note on our publication schedule. We will not publish a Monthly for December, or a Q1 2019 Quarterly in mid-December. Instead, we will send you in late November the BCA 2019 Outlook (BCA's annual discussion with Mr. and Ms. X). This will be accompanied by a short GAA note, updating our recommendation tables with a brief commentary. Best Regards, Garry Evans A Correction, Not A Bear Market Investors have a tendency to forget that corrections are common in bull markets. The current equity run-up, which began in March 2009, has seen five corrections (defined as a 10-20% decline in the S&P500). We may now be experiencing the sixth, with the index already down 9.9% from its peak on September 20. Recommendations But we think the evidence is fairly strong that this is just a correction and not the beginning of a new bear market (using the common definition of a 20% or greater fall). It is highly unusual for bear markets to occur - and for bonds to outperform equities - except in the run-up to, and during, recessions (Chart 1). We see little to suggest that a recession in on the horizon over the next 12 months. Chart 1Corrections Are Not At All Rare What caused the correction? The immediate trigger was a seemingly concerted series of statements in early October from FOMC officials, including even doves such as Lael Brainard, that economic circumstances are "remarkably positive" and that rates remain "a long way from neutral" (to quote Fed Chair Jay Powell). In particular, New York Fed President John Williams argued that the neutral rate of interest (the r*) is very uncertain - even though he was joint creator of the main model that estimates it. The implication is that the Fed will keep on raising rates until the economy clearly slows. This pushed the 10-year Treasury yield above 3.2%. Markets are starting to worry that the Fed will make a policy mistake and that certain segments of the economy (housing, emerging markets?) may be too weak to withstand tighter monetary policy. Moreover, this is in a context in which global growth has been weakening (Chart 2), China appears to be slowing quite sharply (Chart 3), the trade war is escalating (with the U.S. now threatening to impose tariffs on all Chinese imports), and valuations for most assets are stretched. Chart 2Outside The U.S., Growth Is Slowing Chart 3Sharp Slowdown Ahead For China? So how worried should investors be? Most of the usual indicators of generalized risk aversion have not flashed strong warning signals during the equity market sell-off (Chart 4). The move up in bond yields came mostly from a rise in real yields, not inflation expectations, and the yield curve steepened, suggesting that markets are pricing in stronger growth not excessive Fed action. Safe haven assets, such as gold and the Swiss franc, did not perform particularly strongly. Credit spreads rose a little, by around 70 basis points, but do not yet signal stress. Chart 4No Signals Of Strong Risk Aversion Moreover U.S. growth, in particular, remains robust. Though the r* may be tricky to estimate, monetary policy is still clearly accommodative and is likely to remain so until at least mid-2019, even if the Fed hikes by 25bp a quarter (Chart 5). Fiscal policy will be stimulative until the end of 2019, adding 1.1 percentage points to growth this year and 0.5 next, according to IMF estimates. Earnings growth will slow from its current lick - Q3 U.S. earnings look like coming in at 23% year-on-year, compared to a forecast of 19% before the results season - but our models suggest that 2019 bottom-up estimates are about right, with growth slowing to around 10% in the U.S. and to somewhat less in the euro area and Japan (Chart 6).2 Chart 5Fed Policy Still Accomodative Chart 6Earnings Growth To Continue, Albeit More Slowly If we have a concern, it is that a few interest-rate sensitive elements of the U.S. economy are showing signs of softness. Housing starts have been weak for a while, but higher mortgage rates may now be having an effect, with residential investment subtracting from GDP growth in all three quarters so far this year (Chart 7). However, mortgage rates are unlikely to continue to rise at the same pace and so the effect should weaken in further quarters. Capex intentions and durable orders have also slipped, perhaps suggesting that corporations have reined back investment plans due to global uncertainties (Chart 8). But these signs point to slower growth next year, not recession, with the U.S. likely to continue to grow above trend. Historically, higher long-term rates have proved a drag on the economy only when they have risen above trend nominal GDP growth, currently around 3.8% (Chart 9). We have some way to go before we reach that tipping-point. Chart 7Housing Is Hurting Chart 8...And Capex Is Getting Cautious Chart 9Rates Matter When They Exceed Nominal Growth We moved to neutral on risk assets, including equities, at the beginning of July. Many of the worries we flagged then have come about. This is late in the cycle, and so volatility will probably remain elevated. However, we do not expect the next recession to come until 2020 at the earliest. Moreover, none of the warning signals on our bear market checklist (which includes the shape of the yield curve, profit margins, a peak in cyclical spending as a percentage of GDP, Fed policy becoming restrictive etc.) are yet flashing, though several may do by mid next year. Equity market valuations are no longer expensive after the recent sell-off (Chart 10). If the current correction were to continue and the drop in the S&P 500 extend to 15% and in global equities to 20% from their most recent peaks, we might be inclined tactically to move back overweight on risk assets. Chart 10Stocks Are No Longer Expensive Currencies: We expect further U.S. dollar appreciation. Divergences in growth and monetary policy between the U.S. and other developed markets will continue. While we expect the Fed to continue to hike once a quarter until end-2019, we could imagine the ECB turning more dovish if euro zone growth continues to slow and Italian BTP 10-year bond yields rise above 4%. The Bank of Japan will stick to its Yield Curve Control policy, which will prevent the yen rising. Emerging market currencies look vulnerable as their economies slow as a result of central bank rate hikes earlier in the year. Asian currencies might undertake competitive devaluations if the renminbi falls below 7, as a result of a worsening trade war. Fixed Income: Long-term rates are unlikely to have peaked for this cycle. Core inflation will stay at around 2% for a few more months because of a favorable base effect, but underlying inflation pressures (the result of rising wages and increases in import tariffs) will push up U.S. inflation by mid next year (Chart 11). A combination of higher inflation, steady Fed hikes, and deteriorating supply/demand conditions (which will raise the term premium) will move 10-year rates above 3.5% by mid-2019 (Chart 12). We accordingly recommend being short duration and overweight TIPs. U.S. high-yield bonds look somewhat attractive, with a default-adjusted spread of 270 bps, after their recent modest sell-off (Chart 13). But this is dependent on our assumption (based on Moody's model) of credit defaults of only 1.04% over the next 12 months.3 Given where we are in the cycle, and considering the elevated corporate leverage in the U.S., we do not consider this a risk worth taking, and so maintain our moderate underweight in credit. Chart 11Underlying Inflation Pressures Are Strong Chart 12Indicators Point To Treasury Yields Above 3.5% Chart 13Are Junk Bonds Attractive Again? Equities: We prefer DM equities over EM, and favor the U.S. and, to a degree, Japan. Emerging markets continue their deleveraging process and will be hurt by rising U.S. rates, a stronger dollar, and slowdown in China. Valuations for EM equities, though one standard deviation cheap relative to global equities, are not yet sufficiently attractively valued to permit investors to buy EM stocks irrespective of their poor fundamentals. Moreover, analysts are still far too optimistic on the outlook for EM earnings, flattering the valuation metric (Chart 14). Stronger growth and an appreciating currency point to an overweight in U.S. equities which, moreover, would be likely to outperform in the event of a deeper correction, given their low beta. Chart 14EM Equities Aren't As Cheap As They Seem Commodities: The crude oil price has fallen back a little in recent weeks, as a result of increases in OPEC production, a modest slowing of demand, and releases of the U.S. Strategic Petroleum Reserve. Our energy strategists have slightly lowered their 2019 Brent forecast to $92 a barrel, from $95 (Chart 15). However, they warn that geopolitical risks, such as widespread application of sanctions on Iran and a collapse in Venezuela, and limits to capacity in Saudi Arabia and U.S. shale production could easily cause spikes above $100.4 A 100% year-on-year rise in oil prices has historically been a clear warning of recession. That would equal Brent at $120 in 1H 2019. Metal prices will continue to be driven by China. At the moment we see no sign of China implementing a major stimulus, which would boost infrastructure spending and therefore demand for commodities (Chart 16), and so we expect further falls in industrial commodities prices. Chart 15Oil Prices Can Rise Further Chart 16No Sings Of Big China Stimilus Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see GAA Quarterly Portfolio Outlook - October 2018, available at gaa.bcaresearch.com 2 For details of these models and the assumptions behind them, please see The Bank Credit Analyst November 2018, available at bca.bcaresearch.com 3 For details please see BCA U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For details please see BCA Commodity & Energy Strategy & Bond Strategy Weekly Report, "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity", dated October 25, 2018, available at ces.bcaresearch.com GAA Asset Allocation
Highlights After tumbling more than 20% between June and August, copper prices have remained largely static. This reflects the tug-of-war between the near-term bullish physical market fundamentals, and the cloudier macro headwinds ahead, arising from a stronger U.S. dollar. Furthermore, Chinese policymakers are unlikely to abandon their reform agenda and stimulate massively, which will put downside pressure on copper prices further down the road. Despite our negative 12-month outlook, we do not rule out the potential for some upside going into year-end, on the back of falling inventories. Energy: Overweight. News leaked earlier this week indicates the Trump administration is divided over whether to grant waivers on Iranian crude oil imports to big importers like China, India and Turkey, following the re-imposition of sanctions on November 4.1 The U.S. State Department, in particular, appears worried the sanctions will produce a price spike that could derail growth in the U.S. and its allies. This suggests the Administration will be less determined to enforce its Iranian export sanctions, until it has been assured Saudi Arabia and Russia will be able to bring enough production on line in 1H19 to cover the lost Iranian exports, and possible deeper Venezuelan losses. Markets will remain focused on actual export losses from Iran - if they come in at the high end of expectations (i.e., greater than 1.5mm b/d), we expect higher prices; if it becomes apparent the U.S. will go soft on enforcing sanctions, prices would fall. Expect higher volatility. Base Metals: Neutral. Copper prices could rally over the short term, on the back of lower inventories. However, longer term, we see no catalysts to push prices toward recent highs of ~ $3.30/lb on the COMEX. Precious Metals: Neutral. Gold's break above $1,200/oz is holding, but it continues to grind in a $1,210 to $1,240/oz range. Ags/Softs: Underweight. The USDA will report on export sales of grains and oil seeds today. Soybean exports were down 21% y/y for the current crop year, based on the Department's October 18 report. Feature Tight Market Conditions Suggest A Brief Upswing ... After remaining in the $2.90-$3.30/lb trading range for the better part of 1H18, copper prices plunged ~20% since their June peak. The trigger? The escalation of the U.S.-China trade war. The increasingly acrimonious trade relationship acted as a reality check. Investors betting on strike-induced mine supply shortfalls earlier this year were forced to adjust expectations regarding the resilience of the global, and, more specifically, the Chinese business cycles.2 The negative impact of the trade war is clear: copper prices moved to the downside with each escalation in the dispute (Chart of the Week). While current market fundamentals do not necessarily warrant such drastic declines, we see these developments as a wake-up call to market participants. Copper sentiment - previously buoyed by expectations of mine strikes (which failed to materialize) - has come crashing down (Chart 2). Chart of the WeekCopper Down On Trade War Chart 2Sentiment Has Come Crashing Down However, the outlook in the very near term is not so bleak. The evidence below suggests tight physical conditions, indicating copper's next move could be to the upside: Chinese copper imports came in strong in September (Chart 3). While unwrought copper imports reached a 2.5-year high, ores and concentrates forged new record highs. Chart 3Chinese Imports Came In Strong The resilience of Chinese purchases comes on the back of restrictions on scrap imports, which account for a significant share global copper supply (Chart 4). As we have been highlighting, Chinese restrictions on the purity of scrap imports require other forms of the metal to fill the supply gap.3 At the same time, the 25% tariff imposed on Chinese imports of U.S. scrap since August also manifests itself in greater demand for other forms of the metal. This is evident in weak scrap copper imports (Chart 5). Chart 4A Dependable Secondary Market Is Essential For Global Supply Chart 5Scrap Import Restrictions Raise Need For Other Forms Of Copper Copper inventories at the three major global exchange warehouses have been declining steadily and together now stand at half their late April peak (Chart 6). This is their lowest level since late 2016. Chart 6Exchange Inventories At Two Year Low The above evidence of a tight market is in line with copper's futures curve, which is recently pricing a premium for physical delivery (Chart 7). Chart 7Markets Pricing A Premium For Physical Delivery Going into the winter, smelter disruptions may lend further upside support amid these tight conditions: The Vedanta copper smelter in the Indian state of Tamil Nadu was forced to shut down in May due to violent protests. The smelter has an annual production of over 400k MT. In Chile, Codelco gave notice to the market that two of its four smelters will undergo weeks-long outages, in order to comply with tightening of emissions rules - requiring smelters to capture 95% of emissions - due to take effect in December. This will halt production from smelters at the Chuquicamata and Salvador mines for 75 days and 45 days, respectively. Furthermore, in mid-October BHP Billiton reduced its 2018 copper production forecast by 3% to between 1.62mm MT and 1.7mm MT, due to shutdowns at its Olympic Dam facility in Australia and Spence in Chile. Bottom Line: Dynamics at the scrap level in China and disruptions at major smelters in India, Chile and Australia justify tight copper market conditions. This offers potential for a minor rebound in copper prices in the very near term. ... Ahead Of Macro Headwinds In the medium term, macro headwinds will dominate the physical market, capping gains in copper prices. Most notably, fall-out from the U.S.-China trade war in absence of aggressive traditional forms of stimulus, will weigh on demand there. Furthermore, U.S. dollar strength on the back of economic and monetary policy divergences, will make the red metal more expensive for global consumers. Ex-U.S. Growth Unpromising Given the stimulative fiscal policies in the U.S., our House View still does not expect a recession before late-2020. However in the meantime, the global economy will be characterized by divergence in favor of the U.S. (Chart 8). Chart 8Global Economic Divergence Favors U.S. Of utmost importance is, of course, China - where roughly half of global refined copper is consumed. The trade dispute with the U.S. has raised concerns over the resilience of the Chinese economy. Recent data releases have done little to ease fears of a manufacturing slowdown. The Li Keqiang Index and our China construction proxy - both of which are strongly correlated with copper prices - are on a slight downtrend (Chart 9). Chart 9Ominous Signs From China China's 3Q18 GDP data indicate the Chinese economy grew by the slowest pace in nearly a decade (Chart 10). At the same time, PMI's have fallen to or near the 50 level - the boom-bust line - reflecting pessimism in the manufacturing sector. The real estate market - where 45% of China's copper is consumed - also looks gloomy. Home sales rolled over, boding ill for future housing starts. Chart 10Weak Q3 GDP Mirrors Manufacturing And Property Sectors What's more, we are not betting on a flood of stimulus to rescue China's ailing economy. As our colleagues at BCA's Geopolitical Strategy service have been highlighting, the drive to combat vulnerabilities in financial markets raised the pain threshold of Chinese policymakers.4 As such, they are not likely to abandon their reform agenda at the first sign of weakness, as they traditionally have. Although some measures have already been implemented to ease policy, the current response is not yet as promising for commodity markets as has historically been the case. For one, credit growth is constrained by China's de-leveraging campaign. Although there is some evidence that the clampdown on shadow financing is easing, it is not yet at simulative levels (Chart 11). And while the money impulse is rebounding thanks to Reserve Requirement Ratio cuts, the credit impulse is still falling deeper into negative territory. Chart 11Shadow Banking Restrained By Reform Agenda Additionally, as Peter Berezin who heads BCA's Global Investment Strategy highlights, China's more recent forms of (consumption-based) stimulus such as income tax reforms do not boost commodity demand. The same goes for the other way in which Chinese authorities are trying to stabilize their economy: by depreciating the RMB. This is in clear contrast to traditional measures such as fixed asset investment, which stimulate demand for raw materials and capital goods.5 Overall, the current level of stimulus is not sufficient to boost the Chinese economy. Nor, by extension, is it enough to lift EMs, and commodity prices in the process. In fact, copper markets have been oblivious to various announcements by Chinese authorities that they are easing policy (Chart 12). Chart 12Copper Markets Oblivious To Chinese Stimulus Our Geopolitical Strategists warn that the U.S.-China trade war could get worse before it improves. Thus, while policymakers are not yet compelled to throw in the towel with their reform agenda, they are pragmatic and will likely intensify their response if conditions deteriorate further. If authorities were to deploy massively stimulative fiscal and monetary policy by propping up infrastructure and the real estate sector - as they traditionally have done - chances are that we would be able to escape further price weakness in copper markets. For now, the evidence points at a more modest policy approach. Green Dollar, Red Metal As a counter-cyclical currency, the U.S. dollar will shine in the current weaker ex-U.S. growth environment. What's more, limited spare capacity in the U.S. and a strong labor market foreshadow rising U.S. inflation readings. This will justify continued tightening by the Fed. Economic divergences favoring the U.S. economy will amplify the impact. Rising U.S. borrowing costs will be painful for debt-laden EM economies. Their Central Banks will struggle to keep the pace with the Fed. Similarly, the European Central Bank - conscious of turmoil in Italy - will be forced to maintain a more dovish stance. This will weigh down on the EUR/USD. A stronger dollar generally dents demand by making commodities - priced in U.S. dollars - more expensive for foreign consumers. While energy markets dominated by supply risks remain disconnected from their long-term negative correlation with the U.S. dollar, the relationship with metals has re-converged (Chart 13).6 This leaves copper more vulnerable to the downside amid dollar strengthening. The impact will be magnified for Chinese consumers as the RMB weakens further, forcing the top consumer to cut down on imports of the red metal. Chart 13USD-Copper Relationship Re-converged Bottom Line: Headwinds from weakness in China and a stronger dollar will be a drag on demand next year. Unless Chinese policymakers temporarily abandon their reform agenda and stimulate massively, medium term copper prices will face pressures to the downside. Model Updates Given the macro headwinds outlined above, we revised our copper demand forecast. Our balances now point to a slight surplus in 2019 (Chart 14). In the context of 24mm MT of consumption p.a., a 100k MT surplus can be characterized as a balanced market. This makes prices vulnerable to upside or downside surprises, which can easily tip the scale. Chart 14Broadly Balanced Market In line with our market assessment, we simulated forecasts for copper prices based on a 5% and 10% appreciation in the USD over the coming 12 months (Chart 15). Chart 15Macro Headwinds In 2019 Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Reuters published an interesting analysis containing the apparently leaked information re the internal disputes in the Trump administration entitled "Trump's sanctions on Iran tested by oil-thirsty China, India" on October 29, 2018. 2 In the Commodity & Energy Strategy Weekly Report published January 25, 2018, we highlighted the risk to mine supply in 2018 on the back of an unusually large number of labor contract renegotiations taking place this year - representing ~ 5 mm MT worth of mined copper. Most noteworthy was the risk of a strike at the Escondida copper mine in Chile. These have been largely resolved with minimal impact on supply. Please see "Stronger USD, Slower China Growth Threaten Copper," available at ces.bcaresearch.com. 3 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Copper: A Break Out, Or A Break Down?" dated May 17, 2018. Available at ces.bcaresearch.com. 4 Please see BCA Research Geopolitical Strategy Special Report titled "China Sticks To The Three Battles," dated October 24, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report "Chinese Stimulus: Not So Stimulating" dated October 26, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Correlations Vs. USD Weaken," dated June 14, 2018. Available at ces.bcaresearch.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 Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Chart 5Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Mounting supply-side uncertainty will keep the risk premium in oil prices - and volatility - elevated after U.S. export sanctions against Iran kick in November 4 (Chart of the Week). Chart of the WeekOil-Price Risk Premium Will Continue To Increase These sanctions likely will remove 1.0 - 1.5mm b/d of Iranian exports, and absorb the combined spare capacity of the Kingdom of Saudi Arabia (KSA) and Russia (Chart 2) in the process. Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put the supply-side risks sharply in focus. Chart 2Lost Iranian Exports Could Exceed KSA's and Russia's Spare Capacity OPEC 2.0's production increases last month calmed markets.1 All the same, it is worth noting they occurred just before a widely expected U.S. Strategic Petroleum Reserve (SPR) release coinciding with refinery turnarounds, and one-off Asian demand shocks. On the back of these supply boosts, and an upward revision to U.S. shale output (see below), and a slight decrease in our expected demand growth next year, we lowered our 2019 Brent forecast to $92/bbl from $95/bbl. We now expect Brent prices to peak in April 2019. WTI will trade $6/bbl lower (Chart 3). Our forecasts are conditioned on Iranian export losses of 1.25mm b/d, and Venezuelan losses of just over 450k b/d. A loss of 1.7mm+ b/d of Iran exports, as Platts Analytics expects, or a Venezuela collapse, means an unplanned outage anywhere will take prices above $100/bbl. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 Highlights Energy: Overweight. The IMF downgraded global GDP growth expectations from 3.9% to 3.7% p.a. this year and next. This reduced our base case demand growth for 2019 slightly, to 1.5mm b/d from 1.6mm b/d previously. Base Metals: Neutral. Global copper stocks stand at half their late April peak - the lowest level since late 2016, on the back of restrictions on Chinese scrap imports. Precious Metals: Neutral. Palladium traded to record levels above $1,140/oz this week, as persistent physical deficits into 2020 are priced into the market. Ags/Softs: Underweight. The USDA's Crop Progress Report showed soybean harvests accelerating: 53% of the crop was harvested as of last week, below the 2013 - 17 average of 69%, but well above the previous week's 38% level. Feature U.S. Treasury Secretary Steve Mnuchin is convinced global oil markets have fully priced in the loss of Iranian crude oil exports arising from the re-imposition of export sanctions by the U.S. November 4. Speaking with Reuters over the weekend, he said, "Oil prices have already gone up, so my expectation is that the oil market has anticipated what's going on in the reductions. I believe the information is already reflected in the price of oil."2 We are not so sure. The price-decomposition model shown in the Chart of the Week is a bottom-up fundamental model that assesses how changes in OPEC and non-OPEC supplies, global demand and inventories contribute to overall price changes, as new information becomes available regarding these variables. These variables are shown in Chart 4 and Table 1.3 Chart 4BCA Global Oil Supply-Demand Balances The "residual" term in the model covers everything not explained by these fundamental variables.4 We believe the unexplained effect on prices in the residuals reflects market participants' perception of riskiness - either to supply or demand - given the big fundamental drivers of price are accounted for in the other variables. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) Close inspection reveals the residual term has been increasing as we approach the deadline for the re-imposition of U.S. sanctions on Iran. And the fact is, estimates of the loss in Iranian exports are widely dispersed - from less than 1mm b/d to 1.7mm b/d by tanker trackers like Platts Analytics. As Chart 2 shows, export losses at the high end of this range would absorb almost all of the world's spare capacity - the 1.3mm b/d the U.S. EIA estimates for OPEC (most of it held by KSA, plus whatever other Gulf Arab producers can muster). Russia, which is producing at a record of ~ 11.4mm b/d, likely has ~ 250k b/d of spare capacity at its disposal. With the increase in global demand largely being covered by U.S. shales, which are constrained to ~ 1.3mm b/d of growth p.a. until 2H19, when we expect production to increase at a 1.44mm b/d annual rate, this leaves the global market perilously exposed to any and all unplanned production outages. Any deterioration in Venezuela's production, which we expect to fall to 865k b/d on average in 2019 (versus 1.3mm b/d on average this year), or an unplanned loss in exports from historically unstable states like Nigeria and Libya - where we raised our production estimates to 1.75mm b/d and 1.05mm b/d in line with OPEC survey data - almost surely will spike prices above $100/bbl.5 OPEC 2.0 Got Lucky OPEC 2.0 - the producer coalition led by KSA and Russia - picked a fortuitous moment to increase production this past month. OPEC, led by KSA, lifted crude and liquids production 140k b/d in September, while Russia's production rose 150k b/d. It is worth noting these output increases occurred just before a widely expected U.S. SPR release in October - November, which overlapped with refinery maintenance (turnaround) season in the U.S. Midwest refiners were expected to take 300k to 460k b/d of capacity offline in September and October, a relatively high level of maintenance, while Gulf Coast refiners were expected to take 430k to 535k b/d down.6 Both events raise the supply of crude relative to demand, and reduce inventory drawdowns. In addition, one-off Asian demand shocks - an earthquake and typhoon in Japan - dented demand. KSA lifted its production to 10.5mm b/d in September, bringing average 3Q18 production to 10.4mm b/d versus a bit more than 10mm b/d in 1H18. Russia's crude and liquids output rose to 11.45mm b/d in 3Q18 versus 11.2mm b/d in 1H18. The higher production calmed markets somewhat. OPEC 2.0 effectively got a two-month assist from the U.S. refinery turnarounds and a U.S. SPR release, just as markets were fretting prices would breach $90/bbl earlier this month.7 These production boosts will allow OECD inventories to rebuild somewhat going in to the Northern Hemisphere's winter (Chart 5). Nonetheless, OPEC 2.0 has begun tearing into spare capacity with these output increases. Chart 5OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild KSA Talks Markets Lower... While the U.S. SPR release and inventory builds associated with U.S. turnarounds progressed, KSA's Energy Minister Khalid al-Falih was reassuring markets the Kingdom can ramp production to 11mm b/d, and even 12mm b/d if needs be. KSA has been increasing rig counts in 2H18 as Brent prices rise, but we remain highly dubious KSA can ramp production to 11mm b/d - let alone 12mm b/d - and sustain it for any meaningful length of time (Chart 6). Chart 6KSA Increasing Rig Counts, After Price-Induced Slowdown The likelihood KSA can significantly boost production before the end of 1H19 became even more doubtful, following reports the Kingdom and Kuwait were having difficulty agreeing on restarting Neutral Zone production. We've downgraded our assessment that 350k b/d of Neutral Zone production will be returned to the market beginning in 2Q19 to a 50% likelihood, following reports KSA and Kuwaiti officials are diverging on operational control of the production. Apparently, the two states also differ on geopolitical issues in the Gulf, as well - e.g., the Qatar blockade lead by KSA, and Iran policy.8 While core Gulf Arab producers are raising output, we expect the non-Gulf members of the Cartel continue to see output decline (Chart 7). Indeed, with the exception of the core OPEC Gulf Arab producers, U.S. shale operators and Russia, the rest of the world is barely keeping its output level (Chart 8). Chart 7Non-Gulf OPEC Output Continues to Decline Chart 8Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia ...And Shores Up Export Capacity Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put global supply-side risks sharply in focus. KSA has added 3 mm b/d of oil export capacity to the Red Sea coast of the Kingdom, with an upgrade to its Yanbu crude oil terminal. Prior to the expansion, Yanbu terminal's export capacity was 1.3mm b/d; it was used mainly for refined products and petrochemicals shipments, due to its relative proximity to refineries in Yanbu, Rabigh, Yasref, Jeddah and Jazan. Shipping via the Red Sea port allows KSA to move crude to Asia through the Bab el-Mandeb Strait to the south, which at times is threatened by Yemen's Houthi militia, and the north to Western markets through the Suez Canal. In addition, KSA's national oil company, Aramco, says it intends to restore operations at al-Muajjiz crude oil terminal, which has been out of operation since Iraq's invasion of Kuwait in 1990. Aramco intends to integrate the Muajjiz terminal into the Yanbu facilities to expand Red Sea export capacity from ~ 8 mm b/d to some 11.5 mm b/d. KSA's total export capacity is scheduled to reach 15mm b/d by year-end. These expansions give KSA the option to reroute all of its ~ 7mm b/d exports through the Red Sea, in the event the Strait of Hormuz is closed by Iran. However, this option could be limited by pipeline infrastructure. The current capacity of the East - West crude pipeline is 5mm b/d, although Aramco signalled its intention to boost capacity to 7mm b/d by end-2018. No announcements indicating this was on schedule or completed could be found. Global Demand Holds Up The IMF downgraded its global GDP growth expectation from 3.9% p.a. to 3.7% this year and next. This reduced our base case demand growth for 2019 to 1.5mm b/d from 1.6mm b/d. Even so, we note that oil prices for EM consumers in local-currency terms are at or close to post-GFC highs (Charts 9A and9B). A number of EM governments relaxed or removed subsidies on fuel prices following the oil-price collapse of 2014 - 16, which means consumers in these states are feeling most or all of the effect of higher prices directly for the first time in the modern era (beginning in the 1960s, when OPEC became the dominant producer cartel in the market).9 Chart 9ALocal-Currency Cost Of Oil In Select EM Economies Chart 9BLocal-Currency Cost Of Oil In Select EM Economies As we've noted previously, high fuel costs (in local-currency terms) coupled with high absolute prices deliver a double-whammy to EM consumers, which are the driving force in global oil-demand growth. In fact, 1.1mm b/d of the 1.5mm b/d of demand growth we expect next year in our base case is accounted for by EM growth. In our scenarios analysis, we assume every $10/bbl jump in prices above $90/bbl destroys 100k b/d of EM demand. This lowers the unconstrained oil-price trajectory, and reduces our base case growth estimate of 1.5mm b/d next year to 1.3mm b/d (Chart 10). Chart 10An Oil-Supply Shock Would Lower Demand An oil-supply shock that seriously erodes EM demand would - in the course of months, we believe - translate into a disinflationary impulse into DM markets. This could force the Fed to change course and dial its rates-normalization policy back, as we recently noted.10 Bottom Line: Volatility will remain elevated following the re-imposition of sanctions against Iran's oil exports next month. OPEC 2.0's fortuitously timed production increases - coincident with a scheduled U.S. SPR release and refinery turnarounds - will be absorbed by markets once turnaround season ends in the U.S. Global spare capacity is insufficient to cover Iranian export losses at the high end of market expectations, if Venezuelan production falls more than expected or that state collapses. Any unplanned outage anywhere will quickly push prices through $100/bbl, necessitating further U.S. SPR releases. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by KSA and Russia. This coalition likely will be formalized at the December 7 OPEC meeting in Vienna via treaty. This has been alluded to over the past year, most recently in an interview given to Tass, the Russian state-owned news agency. Please see "Saudi energy minister Al-Falih speaks to TASS on OPEC+, oil prices and Khashoggi," published by TASS, October 22, 2018. 2 Please see "Mnuchin says it will be harder for Iran oil importers to get waivers," published by uk.reuters.com October 21, 2018. 3 The Federal Reserve Bank of New York publishes a similar price-decomposition model weekly in its "Oil Price Dynamics Report," which is available online. 4 We can assume USD effects will be reflected in demand and supply at the margin - i.e., a stronger USD reduces demand by raising the local-currency costs of oil, and increases supply by lowering the local-currency costs of production, and vice versa. Uncertainty as to the USD's trajectory adds to overall uncertainty in the model. 5 This likely would trigger withdrawals from the U.S. SPR, or the EU's strategic petroleum reserves, but that will take time to implement. Both Libya and Nigeria likely will hold elections next year: Nigeria in February, Libya possibly on December 10, but more likely next year following passage of a UN resolution to extend the mandate of its political mission there to September 15, 2019. Civil unrest in Libya has been increasing, as ISIS fighters increase the tempo of operations on the ground. 6 Please see "Falling into refiner Turnaround Season & Maintenance outlook," published by Genscape August 23, 2018. 7 This occurs at a fortuitous time in the U.S. election cycle, as mid-terms will be held November 6, two days after Iran sanctions kick in. We expected an SPR draw ahead of midterms; please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018. It is available at: ces.bcaresearch.com. 8 Please see "Oil output from Saudi, Kuwait shared zone on hold as relations sour," published by uk.reuters.com October 18, 2018. 9 The U.S. Federal Reserve is in the process of a rates-normalization cycle, which likely will keep the USD appreciating against EM currencies into next year. Our House view calls for five additional hikes between December and the end of 2019. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018, for further discussion. ces.bcaresearch.com. 10 We discuss this at length in a Special Report published last week with BCA Research's entitled "Man Bites Dog: Could Sharply Rising Oil Prices Lead To Lower Global Bond Yields in 2019?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017 Summary Of Trades Closed In 2017
Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations