Oil
Crude oil has moved largely in a range for the past six months, with tightness in supply offset by some weakness in demand, especially from developed economies. Demand is likely to pick up in line with the global economy, and supply remains constrained by the…
Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth. Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth. In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”. The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2 BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights The correlation between oil and petrocurrencies has shifted in recent years. It no longer makes sense going long petrocurrencies versus the US dollar blindly. One of the reasons has been the impressive and prominent output from US shale. We are currently long a basket of petrocurrencies versus the euro, but intend to shift this trade towards a short USD position on more visible signs of a breakdown in the US dollar. Go short CAD/NOK for a trade. Feature Chart I-1Oil And Petrocurrencies Have Diverged Since the middle of the last decade, one of the most perplexing disconnects has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices more than doubled, but the petrocurrency basket has underperformed by a whopping 110% versus the US dollar. This has been a very perplexing result that has surprised many investors on what was traditionally a very sound correlation (Chart I-1). In general, an increase in oil prices usually implies rising terms of trade, which should increase the fair value of a currency. Throughout our modeling exercises, terms of trade were uncovered as what mattered the most for commodity currencies in general, and petrocurrencies in particular. In theory, this makes sense, given the improvement in balance-of-payment dynamics (that tend to be observed with a lag) and the ability for increased government spending, allowing a resident central bank to tighten monetary policy. In the case of Canada and Norway, petroleum represents over 20% and 50% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast, but it has now become a necessary but not sufficient condition. Oil Demand Should Recover We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt (Chart I-2). Chart I-2Oil Demand Has Been Weak Part of the slowdown in global demand is being reflected through elevated inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-3). Chinese oil imports continue to hold up well, and should easier financial conditions put a floor on the manufacturing cycle, overall consumption will follow suit (Chart I-4). Chart I-3Oil Inventories Are Elevated Chart I-4China Oil Imports Holding Up The increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity is only at 2%. This means that any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints – especially in the face of OPEC production discipline. Second, unplanned outages wiped out about 1.5% of supply in 2018, and should this occur again as oil demand recovers, it will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-5Opec Spare Capacity Is Low Bottom Line: A recovery in the global manufacturing sector will help revive oil demand. This should be positive for oil prices in general. A Necessary But Not Sufficient Condition Rising oil prices are bullish for petrocurrencies, but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. As the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-6). Chart I-6US Has Grabbed Oil Production Market Share This explains why the positive correlation between petrocurrencies and oil has been gradually eroded as the US economy has become less and less of an oil importer. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Meanwhile, falling production in Iran, Venezuela, and even Angola has been a net boon for US production and the dollar. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-7). Since then, that correlation has fallen from around 0.9 to around 0.2. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the US becomes a net energy exporter. Chart I-7Falling Correlation Between Petrocurrencies And The US Dollar Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Oil Consumers Versus Producers Our strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar downleg. We are long an oil currency basket versus the euro, but intend to make the switch once our momentum indicators for the dollar decisively break lower. With bond yields having already made a powerful downward adjustment, the valve for financial conditions to get any looser could easily be via the US dollar (Chart I-8). A loss of global market share has hurt the oil sensitivity of many petrocurrencies. The second strategy is to be long a basket of oil producers versus oil consumers. Chart I-9 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. It is also notable that the correlation has strengthened as that between petrocurrencies and the US dollar has weakened. Chart I-8The Dollar As An Arbiter Of Growth Chart I-9Buy Oil Producers Versus Oil Consumers Sell CAD/NOK The Norges Bank has been quite hawkish in spite of the dovish tilt by most other central banks. As such, the underperformance of the Norwegian krone, especially versus the euro, has been quite perplexing in the face of diverging monetary policies (Chart I-10). Our bias is that speculators have been using the thinly traded krone to play USD upside, but that momentum is now fading. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence, and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. A weak exchange rate will also anchor inflation expectations (Chart I-11). Chart I-10Diverging Monetary ##br##Policies Chart I-11A Weak Exchange Rate Will Anchor Inflation Expectations Higher The underperformance of the Norwegian krone has mirrored that of global oil and gas stocks. Perhaps sentiment towards the environment and climate change has been pushing investor flows out of these markets, but given the central role oil plays in the global economy, we may have reached the point of capitulation (Chart I-12). Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts. Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-13). The CAD/NOK briefly punched through the 7.1 level in October but is now seeing a powerful reversal. Our intermediate-term indicators also suggest the next move is likely lower. The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart I-14) Chart I-12ESG And Global Divestments Chart I-13NOK Will Outperform CAD (I) Chart I-14NOK Will Outperform CAD (II) Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been strong: The labor market remains tight: nonfarm payrolls increased by 128K in October, well above expectations of 89K. Average hourly earnings continue to grow by 3% year-on-year. Unit labor costs grew by 3.6% year-on-year in Q3. The ISM manufacturing PMI increased to 48.3 from 47.8 in October. The non-manufacturing PMI soared to 54.7 from 52.6 in October, well above expectations. The trade balance narrowed by $2.5 billion to $52.5 billion in September. The DXY index appreciated by 0.8% this week. ISM PMI data points to improvements in both manufacturing and services sectors, mainly supported by production, new orders, and the employment components. It will be interesting to monitor if this signals an improvement in the global manufacturing cycle, or is a US-centric issue. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Markit manufacturing PMI slightly increased to 45.9 from 45.7 in October. The services PMI also improved to 52.2 from 51.8. The Sentix confidence index increased to -4.5 from -16.8 in November. Retail sales grew by 3.1% year-on-year in September, an improvement from the 2.7% yearly growth rate in the previous month. EUR/USD fell by 0.8% this week. On Monday, Christine Lagarde, the former managing director of the IMF, gave her first speech as the new ECB president where she urged Europe to overcome self-doubt, aiming to boost investor and business confidence in the euro area. However, no comments were given regarding ECB monetary policy. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Vehicle sales shrank by 26.4% year-on-year in October. The monetary base grew by 3.1% year-on-year in October. The services PMI plunged to 49.7 from 52.8 in October. The Japanese yen depreciated by 1% against the US dollar this week. We remain short USD/JPY given global economic uncertainties and domestic deflationary tailwinds. Should the global economy pick up early next year, the yen could still remain bid against the USD, allowing investors time to rotate their short USD/JPY bets. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 49.6 from 48.3 in October. Services PMI increased to 50 from 49.5 in October. Retail sales increased by 0.1% year-on-year in October, compared to a contraction of 1.7% in the previous month. Halifax house prices grew by 0.9% year-on-year in October. GBP/USD depreciated by 1% this week. On Thursday, the BoE decided to leave its interest rate unchanged at the current level of 0.75%. However, unlike a unanimous decision as in previous policy meetings this year, two BoE officials unexpectedly voted to lower interest rates amid signs of deeper economic slowdown and entrenched Brexit chaos. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Retail sales grew modestly by 0.2% month-on-month in September. The Commonwealth composite PMI fell slightly to 50 from 50.7 in October. The services PMI also fell to 50.1 from 50.8. The trade balance increased by A$1.3 billion to A$7.2 billion in September. Both exports and imports grew by 3% month-on-month in September. The Australian dollar has been volatile against the US dollar, but returned flat this week. The RBA has left its interest rate unchanged this Monday, as widely expected. We remain positive on the Australian dollar and went long AUD/CAD last week, which is currently 0.3% in the money. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The participation rate increased marginally to 70.4% from a downward-revised 70.3% in Q3. The labor cost index increased by 2.3% year-on-year in Q3. The unemployment rate however, climbed to 4.2% from 3.9%, higher than expectations of a rise to 4.1%. The kiwi fell by 1.4% against the US dollar, making it the worst performing G-10 currency this week. Despite the rise of the unemployment rate in Q3, the under-utilization rate, a broad measure of labor market spare capacity has fallen to the lowest level in over 11 years, as suggested by the manager of Statistics New Zealand, Paul Pascoe. That said, we remain underweight the kiwi given it will likely lag other commodity currencies in a global growth upswing. We will change this view if New Zealand terms of trade start to inflect meaningfully higher. Stay with our long AUD/NZD and SEK/NZD positions. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI was little changed at 51.2 in October. The trade deficit narrowed marginally from C$1.24 billion to C$0.98 billion in September. Exports and imports both fell in September. Ivey PMI fell to 48.2 from 48.7 in October. USD/CAD increased by 0.3% this week. The recent uptick in oil prices support the Canadian dollar, but the loonie will likely underperform other petrocurrencies. We remain bullish on the oil prices, however, spreads will likely continue to move against the Western Canadian Select blend. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline CPI fell below 0 at -0.3% year-on-year for the first time over the past 3 years in October. On a month-on-month basis, it contracted by 0.2%. Real retail sales grew by 0.9% year-on-year in September. PMI improved to 49.4 from 44.6 in October. FX reserves were little changed at CHF 779 billion in October. The Swiss franc fell by 0.9% against the US dollar this week. Faced with deflationary pressures, the SNB will likely to use its currency as a weapon to stimulate the economy and exit deflation. This will favor long EUR/CHF positions. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Industrial production contracted by 8.1% year-on-year in September, mainly caused by the slowdown in extraction and related services. On the positive side, manufacturing output grew by 2.9% year-on-year. The manufacturing output of ships, boats, and oil platforms in particular, grew by 26.2% year-on-year in September. The Norwegian krone appreciated by 0.3% against the US dollar this week, despite the broad dollar strength. The WTI crude oil price increased by nearly 6% this week, which is a tailwind for petrocurrencies. We maintain a pro-cyclical stance and expect oil prices to increase further. The global growth recovery and a weaker US dollar should all boost the oil demand, and lift the Norwegian krone. Please refer to our front section this week for more detailed analysis on the NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The manufacturing PMI fell marginally to 46 from 46.3 in October. Industrial production growth slowed to 0.9% from 2.1% year-on-year in September. Manufacturing new orders contracted by 1.5% year-on-year in September. The Swedish krona has been flat against the USD this week. The PMI components of new orders, industrial production, and employment all continued to fall. On the positive side, the export component increased marginally. We expect the cheap krona to help improve the trade dynamics in Sweden and put a floor under the krona. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – are experiencing mass unrest. Protesters in both states are calling for the dismantling of sectarian based political systems, economic reforms, and reduced foreign interference. The unrest in Iraq is of greater consequence due to its role as a major global oil supplier. The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary. We remain tactically long spot crude oil on the back of the geopolitical risks to supply amid an expected revival in global demand. Feature A wave of popular uprisings has swept over Lebanon and Iraq. While the riots are to a large extent a product of long-standing economic and governance failures, the timing is consequential. The Middle East is experiencing a paradigm shift. With the US reducing its strategic commitment to the region, most recently evidenced by the withdrawal of its troops from northeast Syria, a power vacuum has emerged. This opens up the necessity for foreign actors – Russia – as well as regional powers – Saudi Arabia, Iran, and Turkey – to fill the void. The evolution of power could be unsettling given that it will likely generate greater instability in a region that is fertile ground for unrest. Iran has so far emerged a winner in this dynamic. It has expanded its influence in Iraq since the US pullout, it has played a critical role in saving the Assad regime, and it has seen Saudi initiatives fail in Syria, Yemen, Lebanon, and Qatar. It is making progress toward building its ‘land bridge’ to the Mediterranean (Map 1).1 Map 1Iran’s Aspirational ‘Land Bridge’ To The Mediterranean The tensions brought about by the US withdrawal from the JCPOA further illustrate Iran’s growing regional sway. It has hardened its stance. Meanwhile the US and its allies have been vacillating. The Saudi coalition – mired in a war in Yemen and confronting domestic risks – is reluctant to engage in a full-scale confrontation. Even though Iran has a higher pain threshold, it stands on shaky ground. Just last year it was rocked by domestic protests demanding less foreign adventurism. Lebanon and Iraq are the two countries most entrenched in Iran’s sphere of influence. Protesters in both countries are calling for greater national unity – demanding an overhaul of the political system, and arguing that the sectarian set-up has failed to meet their most basic needs. What occurs in Beirut and Baghdad will be of great consequence for Tehran. Deadlock In Iraq “Out, out, Iran! Baghdad will stay free!” - Chants by Iraqi protesters While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.2 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Chart 1AFertile Ground For Unrest In Iraq The protesters are also united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 1A & 1B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 1BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Where the election results failed to translate into real change for Iraq is in the appointment of the Prime Minister. Abdul-Mahdi – a technocrat – was a compromise candidate that surfaced as a result of a five-month long political standstill between the two rival Shia blocs, each claiming to have gained a majority of seats in parliament. On one end is the Iran-backed bloc led by Hadi al-Amiri head of both the Fatah Alliance and the PMF, and Nouri al-Maliki leader of the State of Law Coalition. On the other end is al-Sadr’s Sairoon coalition, which joined forces with Ammar al-Hakim of the Wisdom Movement, and champions greater unity and less foreign interference. The result has been a weak prime minister who is perceived to be incapable of pushing back against Iraq’s ruling elites and ushering in structural reforms. Instead the Prime Minister is seen as benefiting from a corrupt system. The rift between Iraq’s rival Shia blocks is deepening. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs. Last week Abdul–Mahdi responded to calls by al-Sadr and former Prime Minister Haider al-Abadi to resign by arguing that it is up to the main political leaders to agree to put forward a vote of no confidence in the Iraqi parliament. He agreed to resign, on condition that political parties jointly approve of a replacement. For now, that appears improbable. In a move that has been interpreted as a display of Iranian interference, al-Amiri changed heart after a reported meeting with Iranian Quds Force leader Qassem Suleimani last week in Baghdad. He backed down on his agreement to support al-Sadr to bring down Abdul-Mahdi, and has instead stated Abdul-Mahdi’s resignation will only bring about more chaos. This interference on the part of Iran was likely induced by fears that a crisis-stricken Iraq would weaken its hegemony over the region. Iraq is in a state of deadlock. A vote of no confidence would require a majority of 165 in parliament and would require the support of various Sunni and Kurdish parties (Chart 2). Al-Sadr is likely calculating that a new election is in his best interest. He would be able to capitalize on the movement given that he has aligned himself with the protesters, and will gain seats in parliament. Chart 2A Shia Schism In Iraq’s Parliament This would allow the nationalist bloc to gain a majority and appoint a government that is acceptable to the protesters. However, this scenario would also entail greater meddling from Iran, as it is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.3 Despite the death of over 260 Iraqis, the protesters have yet to be deterred by the violence. This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. The impasse could be resolved if the main actors – the rival Shia blocs – agree to compromise. However, that is precisely what transpired last year and resulted in Abdul-Mahdi’s appointment. It ultimately led to only a temporary resolution of the unrest: a one-year deferral. If a similar compromise is reached in the current environment, it too will result in only a temporary détente. The grievances afflicting Iraqis cannot be resolved easily or swiftly. Iraq is in for an extended period of instability. Bottom Line: Iraqi protesters and authorities are in stalemate. The rift in the Shia bloc is deepening. There does not appear to be a clear path to bridge the demands and desires of the protesters and the leadership. Any détente will be temporary. Even if under a new election the protests translate to greater seats for the nationalist bloc, it will not translate to a de-escalation of domestic tensions. It may resolve the protests, but Iran-backed groups will retaliate. Iraq is in for an extended period of instability. Deadlock In Lebanon “All of them means all of them” “No to Iran – No to Saudi” - Chants by Lebanese protesters Just as Iraqi protesters are expressing national unity in calling for an end to sectarian politics and foreign interference, Lebanon’s protests stand out for crossing religious and regional divides. They have swept across the country, and include the Shia-dominated southern region where anger is even being directed at Hezbollah. Among the protesters’ demands is the removal of all three heads of the pillars of government – the Maronite Christian President Michel Aoun, the Sunni Prime Minister Saad Hariri, and the Shia Speaker of Parliament Nabih Berri. Rather than being a source of division, the unrest is a demonstration of unity among Lebanese of all ideologies against the entire political system. Since Prime Minister Saad Hariri’s resignation on October 29, the movement rages on. Protesters are claiming that they are unwilling to back down until all their demands are met, including a complete overhaul of the sectarian power-sharing system, which has defined the country’s politics since the end of the 1975-1990 civil war.4 Chart 3Economic Deterioration In Lebanon The movement and the protesters’ complaints are not surprising. The government has failed to prevent the economy from moving toward collapse. It has long been in decline, with Lebanese feeling the pinch of corruption, economic stagnation, high unemployment, and the effects of the massive influx of Syrian refugees (Chart 3).The trigger of the uprising, a tax on WhatsApp calls amid clear signs of a domestic liquidity shortage, is a delayed response to what citizens have already known and felt for some time: a deteriorating economic situation. While the protests were caused by these economic grievances, they persist due to a crisis of confidence between the political class and the masses. Neither concessions on the part of the government in the form of a list of reforms nor the prime minister’s resignation convinced protesters to halt the movement. The uprising appears set to remain steadfast so long as the current politicians remain in power. The challenge for Lebanon’s protesters – and political elite all the same – is that while the protesters are united in their demands, they have so far been headless. The protesters have refused to present a list of acceptable replacement leaders, insisting that it is the government’s role to propose potential alternatives to the people. This has led to deadlock and will be a hurdle for the government in negotiating with demonstrators. On the other side of the conflict, the current political class, including Hezbollah leader Hassan Nasrallah, has expressed warnings about the chaos that would ensue with a government resignation. According to the Lebanese constitution, following Hariri’s resignation President Aoun is now tasked with consulting Lebanon’s fractured parliament to determine the next prime minister – a role reserved for a Sunni Muslim. However, if history is any guide, this process could take months and protesters are not that patient. Given that Hariri has sidelined himself and – unlike Parliament Speaker Nabih Berri or Foreign Minister Gebran Bassil – he is not the core target of protesters’ ire, there is a possibility that he may once again be appointed to the post of prime minister. While the outgoing government will take on a caretaker role until a new one is formed, demonstrators are standing their ground. This has generated a political standoff causing Lebanese assets to bear the brunt (Chart 4). The emergence of competing rallies – in the form of support for President Michel Aoun – only complicates and possibly prolongs the situation. For now, the army is staying on the sidelines, allowing the protests to be – for the most part – a peaceful one. However, with Hezbollah also subject to the protesters’ wrath, odds of greater regional tensions have increased. Hezbollah may attempt to regain lost support by provoking Israel. The instability could also prompt Hezbollah to reassert its willingness to use force against domestic enemies, namely any new government that attempts to disarm it. In the meantime, Lebanon’s economy and financial markets will remain under pressure. The economy depends on capital inflows from citizens living abroad to finance the large twin deficit and maintain the dollar peg. Thus, the decline in sentiment will weigh on the economy (Chart 5). While the government has not implemented official capital controls, banks have independently tightened restrictions and raised transaction fees to reduce capital outflow. Chart 4Further Unrest Ahead Chart 5Weak Sentiment Weighs On Lebanon's Economy Bottom Line: Lebanese protesters and the political class are in deadlock. The prime minister’s resignation has done little to ease the tension, and demonstrators are refusing to back down until a new non-sectarian, technocratic government is formed. The domestic economy will remain frail. Earlier this week the central bank asked local lenders to boost their liquidity by raising their capital by 20% or $4 billion in 2020 in anticipation of potential downgrades. A stabilization of the political situation is a necessary precondition to boost confidence and once again shore up capital inflows. Nevertheless, with the protest movement being largely headless, the path toward compromise with the government will be challenging, raising the odds of prolonged tensions. What Of Iran’s Sphere Of Influence? “Not Gaza, Not Lebanon, I Give My Life For Iran” - Chants by Iranian protesters, January 2018 Iran has a strong incentive to preserve the established systems in both Lebanon and Iraq. The protesters’ demands risk weakening its grip on power in the region. In both movements, pro-Iranian forces have taken a stance against the protests with Hezbollah in Lebanon advising against the resignation of Prime Minister Hariri while the Iran-backed bloc in Iraq voiced concern over the chaos that will ensue with the prime minister’s resignation. Meanwhile, Tehran’s position is hardening. Iran is taking further steps away from the nuclear deal, injecting uranium gas into centrifuges at its underground Fordow nuclear complex, making the facility an active nuclear site rather than a permitted research plant. Chart 6Popular Support For Iran’s Hardening Stance Chart 7US-Iran Détente Unlikely This reflects the loss of public support for the JCPOA and the loss of confidence that other countries will honor their obligations toward the nuclear agreement (Chart 6). In a speech on November 3 marking the fortieth anniversary of the 1979 US Embassy takeover, Supreme Leader Ayatollah Ali Khamenei renewed his ban on negotiations with the US. His stance mirrors public opinion, which is moving toward an increasingly unfavorable view of the US (Chart 7). However, this does not mean that President Hassan Rouhani’s administration is immune to popular discontent. Rather, with Iranians living through a continued economic deterioration and assigning the most blame to domestic mismanagement and corruption, there could be cracks forming in Iran as well (Chart 8). Chart 8A Case For Unrest In Iran? Bottom Line: The ongoing US withdrawal from the Middle East opens opportunities for Iran to increase its regional influence. It has been capitalizing on such opportunities by lending support to its proxies in Syria, Yemen, Iraq, and Gaza. However, the escalation of unrest in Lebanon and Iraq pose a risk to Iran’s grip on power in the region. On the one hand, if the movements there result in new governments, Iran will witness its wings clipped. This could incentivize retaliation and violence in Iraq, and provocations by Hezbollah along Lebanon’s southern border in an attempt to regain lost support. On the other hand, a prolonged standstill between protesters and the governments could result in greater Iranian influence over the long term. Other foreign powers are unwilling to wholeheartedly intervene to fill an emergent power vacuum. Investment Implications The risk of a decline in Iran’s control over its sphere of influence and the still unstable state of Iraqi domestic politics suggest that the geopolitical risk premium in oil prices should remain elevated. For now, President Trump is still enforcing sanctions and Iran’s oil exports have largely collapsed (Chart 9). The White House is continuing to add pressure by warning Chinese shipping companies – the largest remaining buyer of Iranian oil – against turning off their ships’ transponders. Chart 9The US Maintains Pressure On Iran News reports indicate that oil workers in Iraq’s southern region have started to join the government demonstrations. Moreover, reports on Wednesday indicate that the 30k b/d of production from the Qayarah oil field has been shut down due to road blockades in Basra that are preventing trucks from transporting crude to the Khor al-Zubair port. The geopolitical risk premium in oil prices should remain elevated. While the impact on the country’s oil production and exports have so far been minimal, a prolonged standoff between protesters and the government could result in supply outages. Today’s environment is notably different than that of the ISIS invasion of Iraq in 2014. Tensions then did not create a geopolitical risk premium in oil as they occurred amid an oil market share war, which kept supply abundant. Similarly, the September attack on Saudi Arabian oil facilities did not result in a lasting price spike as it occurred at a time of weak global demand. Moreover, Saudi Arabia possesses the technology and spare capacity that permitted it to swiftly restore output and maintain export commitments. The same cannot be said today about Iraq. A disruption there would be of greater consequence to oil markets, as illustrated by the 2008 Battle of Basra. Especially given Saudi Arabia's need to maintain high prices and amid the Aramco IPO and the tailwind created by a rebound in global growth. The fall in global economic policy uncertainty as the US and China move toward a trade ceasefire will weaken the dollar and support global demand for oil, which is overall bullish for oil prices. Moreover, US-Iran tensions remain unresolved which pose risks to production and shipping infrastructure in the region. We remain tactically long spot crude oil on the back of the geopolitical risks to supply as well as an expected revival in global demand. We are booking a 4.6% gain on our GBP-USD trade but remain long sterling versus the yen. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The ‘land bridge’ is an aspirational route by which Iran would create a strategic corridor to the Mediterranean, stretching through friendly territory. 2 Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 3 Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. 4 Under the current system, Lebanon’s president has to be a Maronite Christian, the parliament speaker a Shiite Muslim and the prime minister a Sunni. Cabinet and parliament seats are equally split between the two Muslims groups and Christians.
Pervasive global policy uncertainty continues to fuel USD safe-haven demand. This keeps the Fed’s broad trade-weighted dollar index for goods close to record highs, which continues to stifle oil demand. At present, we do not expect this pervasive uncertainty to dissipate. For this reason, we are lowering our oil-demand growth expectation slightly for this year and next. Our estimate of global supply growth is slightly lower for this year and next, as well; we continue to expect OPEC 2.0 to maintain production discipline and for capital markets to restrain U.S. shale-oil growth.1 Our price forecast for 4Q19 is $66/bbl on average, an estimate that includes a risk premium reflecting continued tension in the Persian Gulf. Our updated supply-demand balances for 2020 reduce our Brent price forecast to $70/bbl versus our earlier expectation of $74/bbl. We continue to expect WTI to trade $4.00/bbl below Brent next year. Highlights Energy: Overweight. The Trump administration likely will not renew Chevron’s waiver to operate in Venezuela when it expires October 25. This raises the likelihood the country’s oil output will fall below 300k b/d, down from the 650k b/d we currently estimate.2 Production could revive next year, if Russian or Chinese firms step in to fill the void. This is not certain, however, as the U.S. is pressing both to end their support for the Maduro regime. Separately, the Aramco IPO could occur as early as November, according to press reports. Base Metals: Neutral. Copper treatment and refining charges in Asia are staging a recovery, clocking in at $56.70/MT at the end of last week, according to Metal Bulletin’s Fastmarkets. The MB index fell to a record low of $49.20/MT in late August. Precious Metals: Neutral. Gold volatility remains elevated – standing at 15.1% p.a. on the COMEX – as markets continue to process news re a partial easing of tensions in the Sino-US trade war. Geopolitical tensions, which now encompass Turkey-US relations, remain elevated. Ags/Softs: Underweight. Uncertainty around a partial deal involving ag exports from the U.S. to China remains high, as negotiators deliberately minimize expectations of a successful outcome. The big sticking point appears to be whether U.S. tariffs on Chinese imports due to kick in in December will be removed. Feature Uncertainty arising from global economic policy risk continues to dominate commodity markets. This has been the case going on three years. While it is ubiquitous, it is difficult to isolate. In earlier research, we noted the tightening of global financial conditions – largely the result of the Fed’s rates normalization policy, which resulted in four rate hikes last year, and China’s deleveraging policy – were responsible for the sharp slowing of oil demand seen in 2H18-1H19.3 Recently concluded research allows us to extend our earlier thesis to account for the effect of pervasive global policy uncertainty over the past three years, which has dominated our analysis of commodity markets generally, oil in particular. To wit: We find a strong, positive correlation between uncertainty, as measured by the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index, and the Fed's USD broad trade-weighted index for goods (TWIBG) from January 2017 to now (Chart of the Week).4 Chart of the WeekUSD Absorbs Global Policy Uncertainty USD Absorbs Global Uncertainty Sudden policy shifts have, over the past three years, resulted in a steady increase in the level of the GEPU index. Prior to 2017, the correlations between the GEPU index and the USD TWIBG were running at 33% and 63% for the periods 2000 to 2016 and 2010 to 2016, the post-GFC period for y/y returns. However, as right- and left-wing populism gained ground globally and monetary policy generally became more “data dependent” and ad hoc at the Fed, ECB and BoJ, the GEPU and USD TWIBG indices became highly correlated, surpassing 90% (Chart 2).5 This period saw the U.S. become more and more assertive vis-à-vis trade and foreign policy, particularly in re China, Iran and Venezuela, which caused those states to implement their own policy responses. In addition, as monetary policy generally became increasingly accommodative, central banks – and policy analysts – became less certain about the effects of their policies on the broader economy (e.g., the Fed shifting away from rates normalization, the ECB’s re-launching of QE, and the BoJ’s interest-rate targeting regime). Chart 2Co-Movement In GEPU, USD TWIBG Often, commodity markets were forced to adjust to sudden policy changes – e.g., the imposition of trade tariffs against China, or the granting of waivers to Iran’s eight largest importers in November 2018 just before oil-export sanctions were re-imposed. Sudden policy shifts have, over the past three years, resulted in a steady increase in the level of the GEPU index. Increasing uncertainty translated into a steadily increasing USD TWIBG, with safe-haven demand for dollars rising, as the Chart of the Week indicates. To date, we have not decomposed the drivers of monetary conditions, particularly in re central-bank accommodation versus global economic policy uncertainty on the evolution of the USD. The GEPU index hit a record high in August 2019, while the USD TWIBG hit a record in September 2019. It is possible the effects of general policy uncertainty could be cumulative – as earlier uncertainties remain unresolved and new ones are added to the global mix (e.g., US-Turkey foreign-policy tensions now have been added to other geopolitical risks). It is entirely possible global monetary policy easing – particularly from the Fed – is accommodating safe-haven demand accompanying higher uncertainty. If the Fed were to tighten while uncertainty remains elevated the USD could rally sharply and impact commodity demand even more. Persistent USD Strength Lowers Oil Price Forecast Based on our analysis, the effects of the uncertainty we observe in the USD above are transmitted to GDP globally, which feeds through to commodity demand. As the USD strengthens, it raises the local-currency cost of commodities and the cost of servicing USD-denominated debt ex-US. In addition, on the supply side, a stronger dollar lowers local production costs at the margin, which stokes deflation globally. All else equal, these effects push oil prices lower by reducing demand and increasing supply at the margin. On the back of a stronger USD and persistent uncertainty, we are once again lowering our estimate of global demand growth. This is most pronounced in EM economies (Chart 3), but there are feedback effects into DM in the form of reduced trade volumes, which hits manufacturing economies like Germany harder than service-dominated economies like the US. On the back of a stronger USD and persistent uncertainty, we are once again lowering our estimate of global demand growth to 1.13mm b/d this year and 1.40mm b/d in 2020 (Chart 4). This is down slightly from 1.2mm b/d this year and 1.5mm b/d next year. In line with the U.S. EIA, we also lowered our estimate of 2018 demand, which has the effect reducing the level of demand we expect in 2019 and 2020. Chart 3Local-Currency Oil Costs Are High Chart 4BCA Research Supply-Demand Balances We maintain our expectation fiscal and monetary stimulus globally will revive demand, but, given the deleterious effects of global uncertainty and its effects on demand via the USD, we are moderating our position some, as the downward adjustment to consumption indicates. On the supply side, we expect KSA’s output to be fully restored by November, and for production in the Kingdom to average 9.9mm b/d in October and November. We are expecting overall OPEC 2.0 output growth of 250k b/d on average in the 2Q20 to 4Q20 interval, down from our previous growth estimate of 500k b/d. In the US, we expect shale-oil output to grow 900k b/d in 2020, versus 1.3mm b/d in 2019, which will leave overall U.S. crude output at 13.3mm b/d next year on average, as capital-market constraints continue to act as a governor on total output (Chart 5). Chart 5U.S. Shale-Oil Output Will Remain Capital-Constrained Overall, we expect global supply to finish 2019 at 100.8mm b/d and at 102.3mm b/d next year, which is down slightly from our earlier estimates (Table 1). Even with demand moderating, we expect inventories to continue to draw this year and into 3Q20 before they resume building, as the combination of OPEC 2.0 production discipline and capital markets constrain output (Chart 6). Chart 6OECD Oil Inventories On Track To Draw Table 1 Investment Implications Continued voluntary and involuntary production restraint will allow global inventories to draw despite slightly lower demand. Given our supply-demand expectations, we forecast Brent will trade lower next year, at $70/bbl on average versus our earlier expectation of $74/bbl. This is ~ $10/bbl above the median consensus. We continue to expect WTI to trade $4.00/bbl below Brent next year. Continued voluntary and involuntary production restraint will allow global inventories to draw despite slightly lower demand, which will keep Brent and WTI forward curves backwardated next year (WTI was in a slight carry earlier this week, while Brent was backwardated). We would caution that any resolution of the profound uncertainty currently dogging global markets could unleash pent-up demand that would sharply rally commodities generally, and oil in particular. This could take the form of a broad trade agreement that ends the Sino-US trade war – an unlikely, but not impossible, turn of events – or an unexpected reduction in tensions in the Persian Gulf, again, unlikely but not impossible. Bottom Line: Resolution of global policy uncertainty would revive commodity demand, as safe-haven USD demand gives way to higher consumer spending, renewed growth in global trade and investment. Until then, uncertainty will continue to hamper commodity demand growth, particularly for oil. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 OPEC 2.0 is the moniker we coined for the producer coalition formed at the end of 2016 to regain control of production following the disastrous market-share war launched by OPEC in 2014, which took Brent prices from above $100/bbl to $26/bbl by early 2016. The coalition is led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 Please see Venezuelan oil output could be halved without Chevron waiver extension: analysts, posted by S&P Global Platts October 14, 2019. 3 Please see our report entitle Central Bank Easing Key To Oil Prices, published September 5, 2019. It is available at ces.bcaresearch.com. 4 This GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange-weighted basis) are scoured monthly to create the index. Please see GEPU and Baker-Bloom-Davis for additional information. 5 Both series are plotted as percent changes y/y in Chart 2. For the 2017 - 2019 period, the coefficient of determination for this model is 0.81 using a regression of the USD on the GEPU. There was no statistically significant relationship between them either from 2000 to 2016, or from 2010 to 2016. Insert SOFTS text here Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights The manufacturing slowdown, on its own, is unlikely to tip the economy into a recession. The sector accounts for a small share of U.S. output and employment, and will gain a tailwind from a pick-up in global growth. A larger and more stable service sector mitigates manufacturing’s impact on the employment and consumption outlook. The bar is too high for manufacturing job losses to lift the overall unemployment rate towards recession-inducing levels. The recent divergence between alternative measures of U.S. manufacturing activity confirms the resilience of the domestic manufacturing sector relative to the rest of the world. Feature Manufacturing activity has been the most prominent casualty of the trade war between the U.S. and China, and global manufacturing PMIs have languished as tensions have intensified with no clear end in sight. Throughout the spring and early summer, manufacturing activity in the comparatively closed U.S. economy held up better than it did overseas. In August, however, the ISM Manufacturing PMI finally crossed the 50 expansion/contraction line and subsequently dipped well below it in September. Evidence of weakness was broad-based throughout September’s report and the fact that forward-looking components like new orders, new export orders and backlogs of orders all contracted further has caught our attention. Although, like most developed markets, the U.S. is a service economy, and consumption accounts for the lion’s share of its GDP, it is certainly not immune to manufacturing cycles. We are not turning a blind eye to the global manufacturing slowdown, nor downplaying its magnitude, but for now we are not overly worried about it. Regular readers know that we continue to believe that the fundamentals of the U.S. economy remain strong, supported most of all by an especially robust labor market. The manufacturing slowdown is near the top of investors’ concerns, however, so we measure how severe a manufacturing slowdown would have to be to cause serious harm to the U.S. economy. We find that the bar is high and the slowdown has low odds of getting that bad if, as we expect, global growth eventually recovers. Until a pick-up truly materializes, we remain comforted by our expectation that buoyant consumption and government spending will keep the U.S. economy out of too much trouble. David And Goliath Chart 1Services May Be Larger, But Goods Punch Harder Technology and globalization have revolutionized the manufacturing process and disrupted the global economic landscape. As the outsourcing of manufacturing activities to lower-cost countries has become more and more prevalent, developed markets have steadily transitioned to service economies. Since the 1950s, goods-producing sectors’ share of U.S. GDP has decreased from half to 29%. Nevertheless, a third of the economy is not negligible, especially when it swings much more wildly than the services sector, which is more than twice its size (Chart 1). In a previous report1 where we looked at the components of the U.S. GDP equation, we showed that smaller, more volatile fixed investment was considerably more likely to negate trend growth in the rest of the economy than giant, but stable, consumption. This narrative echoes the dynamics at play with the manufacturing portion of the U.S. economy. Given their greater variability, goods-producing sectors are just as likely to wipe out 2% trend growth in services as services are to wipe out 2% manufacturing growth (Table 1). Table 1Another Road To Recession This would be bad news if we thought the manufacturing slowdown had a lot more downside. We continue to believe in a global growth recovery narrative, however, powered by impending Chinese stimulus and revived trade negotiations. U.S. industrial production and capacity utilization both surprised to the upside in August and global growth is showing budding signs of a recovery (Chart 2). Moreover, our colleagues at Global Investment Strategy have found that industrial cycles last an average of 36 months, divided into an 18-month uptrend and an 18-month downtrend.2 Absent any major trade deterioration, the tenure of the current down leg suggests that an upturn in manufacturing activity is on its way (Chart 3). Chart 2Towards A Global Growth Pick-Up Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Another channel through which the manufacturing slowdown could hurt the U.S. economy is via manufacturing job losses and the detrimental effect they would have on overall U.S. consumption. Goods-producing sectors employ 21.1 million, including 12.9 million in manufacturing roles - a puny 14% and 8% of total nonfarm payrolls, respectively. The productivity gains that technological improvements and automated processes have unlocked over the years have allowed a modest share of U.S. workers who make tangible things to produce double their proportionate share of U.S. output. Bottom Line: Goods-producing sectors represent less than a third of U.S. GDP and less than a sixth of U.S. jobs. That’s enough for the global manufacturing slowdown to cause some domestic slowing, but not enough to end the expansion on its own. A High Pain Threshold Akin to the goods-producing sectors’ contribution to overall U.S. GDP, aggregate manufacturing payrolls tend to exhibit more volatility than aggregate services payrolls, particularly on the downside (Chart 4). Before the 1980s, because manufacturing activity accounted for a larger share of the U.S. economy and created a larger portion of jobs, a mere deceleration in the pace of payroll expansion was sufficient to tip the economy into a recession. The paradigm has shifted and it now takes a more severe manufacturing downturn to inflict real harm on the U.S. economy. Since the 1980s, no recession has occurred independent of a full-on contraction in manufacturing employment. We are not there yet, as manufacturing payrolls are still growing at a 1.1% pace. Aggregate manufacturing payrolls tend to exhibit higher volatility than aggregate services payrolls, particularly on the downside. Chart 4A Paradigm Shift Our Global Investment Strategy colleagues have previously shown that throughout the post-war era, whenever the 3-month moving average of the unemployment rate has risen by at least a third of a percentage point from its cyclical lows, a recession has ensued (Chart 5). The U.S. unemployment rate just made a fifty-year low and we do not expect a quick material reversal in the short run. A resilient service sector, ambitious hiring plans and elevated levels of job openings, coupled with a revival in global growth, should hold the U.S. unemployment rate in check for the time being (Chart 6). Chart 5The Recession-Inducing Level Of Unemployment... Chart 6...Is Not Imminent Given Strong Hiring Plans Investors are right to be concerned about the manufacturing slowdown nonetheless. To address those concerns more closely, and to challenge our own view, we calculated the number of manufacturing job losses that would be required to push the unemployment rate up to recession-inducing levels. The U.S. unemployment rate fell to a fifty-year low of 3.5% in September, tugging the 3-month moving average down to 3.6%. There are several paths the unemployment rate can take from current levels for its 3-month moving average to grow by a third of a percentage point. It may gain a linear 10 basis points a month and reach a 3.9% average in the fifth month. Myriad non-linear paths could get the moving average to 3.9% in more or less than five months. For the sake of this exercise, we do not choose a particular path, but simply assume that the 3-month moving average of the unemployment rate reaches 3.9% over three, six and twelve months. We build on the work of the economists at the Atlanta Fed and calculate the number of manufacturing job losses required to achieve a 3.9% target unemployment rate over those three timeframes. We used the Atlanta Fed Jobs Calculator’s3 default inputs, and the details and results of our subsequent calculations are summarized in Table 2. Table 2The Payroll Road To Recession Chart 7The Bar Is High For Manufacturing To Trigger A Recession Under the default assumptions of a constant participation rate and a population growth rate unchanged from the past twelve months’, it would take 313,000 job losses over three months for the overall U.S. unemployment rate to reach 3.9%. We assume that the private service sector, which shows no sign of distress, will continue to add jobs. It has done so at a historical average monthly growth rate of 0.19% but given that the overall economy has clearly slowed, we assume instead that the service sector will continue to add jobs at the slower 0.13% pace of the past twelve months. Under this more conservative assumption, the economy would gain 560,000 nonmanufacturing jobs over the next three months. Consequently, it would take 873,000 manufacturing job losses alone to offset these gains and lift the unemployment rate to 3.9% within three months. Over a six- and twelve-month horizon, the number of manufacturing job losses required to offset payroll expansion in services reaches 1.1 and 1.6 million, respectively.4 These levels of manufacturing job losses – equivalent to a 7% to 12% contraction in manufacturing payrolls - seem like a stretch in the current macroeconomic backdrop. The only time in the past seventy years when the U.S. economy experienced manufacturing job losses of this magnitude on a 3- month time period was in the first quarter of 1975, when the U.S. economy confronted a tripling of oil prices from the oil embargo. Manufacturing job losses in excess of 1.1 and 1.6 million jobs over a 6- and 12-month horizon have historically been more attainable (Chart 7). That said, manufacturing payrolls are still expanding on a 6- and 12-month horizon, albeit at a decelerating pace. Not only are manufacturing payrolls gains far from recession-inducing levels, manufacturing employment will gain a tailwind from the pick-up in global growth and turn in global industrial production cycles that we expect. These levels of manufacturing job losses – equivalent to a 7% to 12% contraction in manufacturing payrolls – seem like a stretch in the current macroeconomic backdrop. Bottom Line: The bar seems a little too high for the manufacturing slowdown alone to destroy enough jobs to tip the U.S. economy into a full-fledged recession. What Oil Shock? One can argue that the September oil shock caused by attacks on Saudi energy infrastructure will exert further pressure on global manufacturing activities. While it is true that large jumps in oil prices have often preceded recessions, we think the probability is slight that September’s event will jeopardize the prospects of a global growth recovery (Chart 8). Chart 8Oil Spikes And Recessions Chart 9U.S. Output Is Less Dependent On Oil First, not only was the September surge in oil prices tame relative to the spikes that have preceded past recessions, but the quicker-than-expected return of Saudi oil production has calmed markets. For now, the oil scare ended as quickly as it appeared. Second, higher oil prices are less of a drag on the U.S. economy than they were in the 1970s, as the country has become one of the largest oil-producing countries in the world and approaches true energy independence. The gradual shift from a manufacturing to services economy has also reduced the oil intensity of the U.S. economy to a little more than a third of what it was at the time of the 1970s oil embargo (Chart 9). Moreover, higher gasoline prices are less likely to hurt U.S. consumers now that filling the tank takes up a smaller portion of their wallets (Chart 10). As Fed Chair Jay Powell put it in a speech last week, “we now judge that a price spike would likely have nearly offsetting effects on U.S. GDP.” Chart 10Filling The Tank Takes Up A Smaller Portion Of Consumers' Wallets Conflicting Messages? Chart 11The ISM Manufacturing PMI's Sensitivity To Global Growth The ISM Manufacturing Composite PMI is our favored measure of U.S. manufacturing activity as its long track record allows for comparison across multiple business cycles. Although it only offers insights back to 2011, the alternative IHS Markit Manufacturing PMI is nevertheless widely watched by investors and we take note of its moves. While the recent ISM readings have been dismal, the Markit Manufacturing PMI for the U.S. accelerated to 51.1 in September. At first glance, it might seem that both readings are contradicting each other. In fact, the current divergence is not unprecedented and stems from differences in sub-component weighting methodology and in sample size and composition. The ISM reading focuses on larger multinational companies, whereas the U.S. Markit PMI polls a wider array of companies by size. Multinationals’ earnings are more directly affected by global growth developments than smaller and domestically-focused firms. Therefore, in periods of accelerating global and ex-U.S. growth, the ISM PMI tends to score higher than the Markit PMI, and vice versa (Chart 11). A still-expanding Markit Manufacturing PMI combined with a contracting ISM Manufacturing PMI simply reinforces the argument that the domestic manufacturing sector is more resilient than ex-U.S. manufacturing activity, and highlights the potential for an improvement in business confidence if the U.S. and China can reach some sort of detente. Investment Implications In spite of evidence that global manufacturing weakness is spreading, our overall assessment of the U.S. economy remains intact. Assuming an exogenous event does not snuff out the expansion, we do not expect the next recession to occur until after monetary policy turns restrictive. Since the Fed has pivoted to accommodation, along with the world’s other major central banks, we have pushed out our recession timetable back to at least the middle of 2021. We therefore think it is too early to de-risk investment portfolios. We have previously shown that bull markets tend to sprint to the finish line and we remain bullish on a 12-month cyclical horizon. Though we are not concerned that the end of the cycle is at hand, tariff tensions are squeezing trade flows and business confidence. Volatility is likely to remain elevated in the near term until trade tensions die down and the global economy demonstrates that an upturn is at hand. We are therefore neutral on equities over the tactical 0-to-3-month timeframe and recommend investors overweight cash to keep some dry powder at hand. We still recommend that investors underweight bonds in balanced portfolios. Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Footnotes 1 Please see U.S. Investment Strategy Weekly Report, “If We Were Wrong”, dated April 8, 2019, available at usis.bcaresearch.com. 2 The reason underpinning this cyclicality is that most purchased goods retain some value for a certain amount of time before they need to be replaced. 3 The Atlanta Fed Jobs Calculator tool is available at https://www.frbatlanta.org/chcs/calculator?panel=1 4 Had we assumed that the nonmanufacturing payrolls continue to grow at the historical average monthly rate of 0.19% instead, the levels of manufacturing job losses required to offset the nonmanufacturing gains and lift the unemployment rate to 3.9% would be 1.1 million, 1.6 million and 2.6 million manufacturing job losses over a 3-, 6- and 12-month time horizon, respectively.
Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Chart 12Oil Price Constrains U.S. Policy Toward Iran An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.
The price differential at which Canadian heavy-sour crude trades to the North American benchmark WTI will be pushed to -$20/bbl into 1Q20, as transportation constraints continue to slow the marginal barrel’s egress from Alberta. Increasing demand for low-sulfur distillate fuels as global marine-fuel standards tighten under IMO 2020 regulations next year also will contribute to weaker Canadian crude oil prices. Over the next three to five years, domestic politics will determine whether the Canadian oil industry will be able to attract the investment needed for growth. And that will depend on how uncertainty around pipeline expansion is resolved. Allowing pipeline capacity to expand so that more crude can be shipped south could lead to a significant rebound in Canadian producers’ equity valuations. The industry’s breakeven costs now are on either side of $50/bbl for heavy oil delivered at Cushing, OK. As light-sweet production in the U.S. shales rises, the demand for the relatively scarce, heavier crude likely will pick up, redounding to the benefit of Canadian producers. Highlights Energy: Overweight. Operations at Saudi Aramco’s Abqaiq crude oil processing facility and the Khurais oil field were largely restored by the end of September, in line with management guidance. Capacity in the Kingdom is at 11.3mm b/d, while production is running at 9.9mm b/d. Abqaiq and Khurais were attacked by drone and cruise missiles, an operation the U.S. and Saudi Arabia believe was orchestrated by Iran. On Sunday, Crown Prince Mohammad bin Salman, speaking on CBS News’s 60 Minutes, agreed with U.S. Secretary of State Mike Pompeo’s characterization of the attack as an act of war by Iran, and warned, “If the world does not take a strong and firm action to deter Iran, we will see further escalations that will threaten world interests. Oil supplies will be disrupted and oil prices will jump to unimaginably high numbers that we haven't seen in our lifetimes.” In the interview with Norah O’Donnell, he followed that up with a declaration that the Kingdom prefers “a political and peaceful solution” to resolve its issues with Iran. The crown prince, striking a conciliatory tone, said President Donald Trump and the Kingdom are seeking peace, but that “the Iranians don’t want to sit down at the table.”1 Base Metals: Neutral. China’s steel output rose 9.3% y/y in August to 87.3k MT, according to the World Steel Association (WSA). This was 56% of global output, based on WSA data. Chinese output reached a record 89.1k MT in May. Precious Metals: Neutral. Precious metals' prices collapsed as the broad trade-weighed USD surged earlier this week. Platinum prices were down 5.5% from Friday's close by Tuesday, while gold and silver were down 1.3% and 2%, respectively. Ags/Softs: Underweight. Corn and soybean prices surged earlier in the week in the wake of a bullish USDA stocks report. December corn was up 5.7%, while beans were up 4.1%. Feature Canadian heavy oil demand is running strong in Asia, as seen in the surge of exports via the U.S. Gulf over the May-to-mid-September period. By ClipperData’s reckoning, 16mm barrels of Canadian crude were shipped over that period, more than doubling the entire volume shipped to Asia in 2018.2 Canadian demand is being boosted by the collapse of Venezuela’s oil industry, which has removed some 1.5mm b/d of heavy crude from the market since 2016. While Canadian exports into Asia markets are surging, the pick-up in this demand hints at an even greater opportunity if north-to-south pipeline capacity is expanded. Year-to-date exports of Canadian crude to the U.S. are up ~ 2.5% y/y to an average 3.5mm b/d, according to the U.S. EIA. This growth is restrained by slowly expanding export capacity.3 Canadian Oil Takeaway Constraints From 2010 to 2017, Western Canadian oil production grew by an impressive 6.5% p.a., pushing pipeline and storage infrastructure to maximum utilization (Chart of the Week). The development of supporting infrastructure failed to produce the required takeaway capacity, locking bitumen production within the Western Canadian Sedimentary Basin (WCSB). Consequently, Alberta crude oil inventories grew above normal levels and the Western Canadian Select (WCS) discount to Cushing WTI exploded, reaching -$50/bbl in 3Q18. While this incentivized crude-by-rail (CBR) shipments, prices received by Albertan producers fell below $20/bbl, a level significantly below breakeven levels required to sustain investment. Chart of the WeekHeavy Crude Output Surges ... Facing multiple delays in pipeline developments, then-Premier Rachel Notley announced in December the provincial government would impose mandatory oil production restrictions of ~ 325k b/d starting in January 2019. Moreover, her government secured contracts to lease 4,400 rail cars – ~ 120k b/d by mid-2020 – with Canadian National (CN) and Canadian Pacific (CP) to move crude out of the WCSB. The Alberta government’s intervention rapidly distorted the market’s price mechanism. Initially, the government-mandated production curtailment had the desired impact. The transportation component of the WCS-WTI discount began to narrow, and Alberta’s crude inventory started declining (Chart 2). Chart 2... But Infrastructure Lags However, the Alberta government’s intervention rapidly distorted the market’s price mechanism. To be profitable, moving oil by rail requires a WCS-WTI discount that is somewhere between -$12/bbl to -$22/bbl on top of a quality discount, and possibly higher when additional investments in trains and crews are needed (Chart 3). In January 2019, the transportation discount overshot its equilibrium – narrowing to -$2.90/bbl below the quality component – which weakened crude-by-rail volumes and led to a build in inventories. Chart 3Provincial Government Policy Distorts Market's Heavy-Oil Pricing Dynamics The Great Balancing Act To address these imbalances, the provincial government gradually started easing production curtailments (Chart 4). But this is a work in progress: Ultimately, its goal is to find the right balance between production levels and the WCS-WTI spread – i.e. the necessary price incentive for the market to move further crude by rail (CBR). The following projects still are being advanced by developers. However, no significant additional pipeline takeaway capacity is expected before 2H20 (Chart 5): Chart 4Policy Remains A Work In Progress Chart 5Markets Are Attempting To Redress Takeaway Deficit Enbridge’s Line 3 replacement. This pipeline is part of Enbridge Mainline system. This project will restore the original capacity of the existing Line 3 pipeline to 760k b/d from 390k b/d. The replacement runs from Hardisty, AB, to Superior, WI in the U.S. Since its initial announcement in 2014, the project has faced multiple headwinds, most recently, a delay in permits from the State of Minnesota re the impact of a possible oil spill near Lake Superior. The company continues to expect the project will be completed in 2H20. The Canadian and Wisconsin portions are already completed. TC Energy’s Keystone XL. This is the largest of the proposed projects. It will increase Canadian export capacity to the U.S. by 830k b/d. The project was first proposed in 2008, and will run from Hardisty, AB to Steele City, NE. Recently, Nebraska’s Supreme Court approved the Keystone XL route, lifting one of the last remaining – and probably the most important – legal challenges facing the pipeline construction. This is a positive development for Canadian oil producers. Nonetheless, the project is still facing a federal lawsuit in Montana filed by environmental groups blocking President Trump’s new permit, which gave the project a green light. A hearing is scheduled on October 9, this is a crucial win for TC Energy.4 Reaching a Final Investment Decision (FID) before year-end makes a completion by end-2022 possible. Federally-owned Trans Mountain expansion. The initial application was filed in 2013 and is projected to add 590k b/d of capacity from Edmonton, AB, to Burnaby, B.C. The pipeline was bought for $4.5 billion last year by the Federal government. Earlier this month, a Federal Court of Appeals judge ruled out six of the 12 legal challenges to the expansion, dismissing claims centered on environmental issues. Construction will continue, the government expects the expansion will be operational by mid-2022. Capacity expansion at existing pipelines. We expect some marginal capacity increases at existing pipeline to take place between 3Q19 and 3Q20. Enbridge communicated it could add up to 450k b/d without building new pipelines by 2022. At the moment, we believe ~150k b/d will be gradually added before the end of next year. Additionally, Enbridge mentioned it could boost capacity on its Express line by ~60k b/d before the end of 2020. Lastly, Plains Midstream Canada announced additional capacity on its Rangeland line in both the North and South directions.5 This will assist Canadian producers awaiting for the 2H20 Line 3 replacement. Delays in bringing new takeaway capacity online forced the newly formed Conservative provincial government led by Jason Kenney, which came to power in April 2019, to extend the curtailment program until December 2020. We expect this balancing act to continue over the next 12 months.6 Short- and Medium-term outlook We expect CRB needs to surpass 450k b/d to balance the market In our March 7, 2019 report, we argued the transportation component of the WCS-WTI spread needed to increase by ~ $10/bbl to support incremental crude-by-rail volumes. From March to July, the transportation discount rose by only $4.80/bbl to ~$12/bbl – the floor of our estimated rail price range – and collapsed soon after that. This failed to catalyze sufficient rail volumes to clear the market overhang. Preliminary estimates of CBR volumes based on CN and CP data shows it was largely flat in August and September (Chart 6). Chart 6Crude-By-Rail Shipments Stall As the government continues to relax production curtailments – reaching 100k b/d in October – we continue to believe the transportation discount needs to rise from current levels. Recent movements in the discount, averaging $10.3/bbl since the beginning of the month, support our view, and we expect this to continue until it reaches ~$15/bbl. We expect CRB needs to surpass 450k b/d to balance the market until the Line 3 replacement is completed, somewhere in 2H20 (Chart 7). We also expect the quality discount for WCS crude oil to start rising as IMO 2020 approaches. YTD the quality discount has remained relatively narrow, due to the global shortage of heavy-sour crude supply (Chart 8).7 Starting in January 2020, demand for heavy crude will moderate as shippers adapt to the new marine-fuel regulation, offsetting some of the effect of the limited supply. We project this will add $5/bbl to the WCS-WTI spread. Chart 7Additional CBR Capacity Required Chart 8Heavy-Crude Market Remains Tight Combined, the quality and transportation discount should push the WCS-WTI spread toward -$20/bbl over the next 6 months, which will, we believe, hurt Canadian producers’ cash flows. We expect WCSB supply will remain flat y/y in 2019. Next year, output is expected to grow 4%, and in 2021 by another 1.2% y/y. Long-term Production Outlook Investment in the Canadian oil sector never truly recovered from the 2014 global oil price collapse, despite the pickup in oil prices (Chart 9). Canada’s total capex ex-oil and -gas has been increasing since 2016, pushing down the share of capex from oil and gas extraction to 14% from 27% in 2014 (Chart 10). This is showing up in our longer-term production forecast: We expect WCSB production will average 5.1mm b/d in 2022 vs. 5.3mm b/d being forecast by the Canadian Association of Petroleum Producers (CAPP). The finite pool of funding available to the Canadian oil and gas sector is competing with U.S. shale development. A favorable regulatory and tax environment, shorter investment cycles and faster initial returns attract most of the funds allocated to oil and gas development to the U.S. at the expense of Canada (Chart 11).8 Most recently, the divergence in investment flows centers on market access Chart 9Canadian Oil Investment Lags Chart 10Canada's Oil & Gas Sector Losing Weight Chart 11U.S. Perceived As Favorable Investment Alternative Foreign companies are exiting the Canadian oil patch, divesting more than $30 billion since 2017.9 The government’s intervention to curtail production led firms to postpone new projects in Alberta. The rig count in Canada remains weak and shows no sign of picking up (Chart 12).10 Nonetheless, the sector should offer an opportunity for investors in the coming years. Once uncertainty around pipeline completion is resolved, we believe there could be a significant rebound in Canadian producers’ equity performance (Chart 13). Technology improvement has reduced oil-sands’ breakeven costs to somewhere between $45/bbl-$55/bbl for oil delivered at Cushing.11 Moreover, the low decline rates of oil-sands supply makes it a more stable and predictable source of supply compared to shale production. Chart 12Capex Reductions Reduce Rig Counts Chart 13Energy Stock Prices Could Rebound The upcoming new pipeline capacity allowing more Canadian heavy crude oil to be delivered to the complex U.S. Gulf Coast refineries will revive sentiment towards Canadian oil sand projects. Canada is judiciously positioned to be the clear winner of the market-share war fought by heavy oil-producing countries to secure capacity at U.S. Gulf refineries. Canadian oil is already dominating PADD 2 imports, and has been increasing its share of PADD 3 imports (Chart 14). The above-mentioned shortage of heavy crude oil presents an excellent opportunity for Canada to capture additional space at PADD 3 refineries. The collapse of Venezuela and the recent attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) highlight the attractiveness of Canadian heavy crude to U.S. refiners. Chart 14Strong U.S. Demand For Canada's Oil Impact Of The Upcoming Canadian Federal Election Canada is gearing up for a federal election on October 21. The consensus holds that the Liberal Party of Prime Minister Justin Trudeau will remain in power with a minority government, or possibly in a coalition with the left-wing New Democratic Party (NDP) and/or the Green Party. Our Geopolitical Strategists think the chances of Trudeau maintaining a single-party majority are much higher than consensus (which is about 25%), given that he is running on the back of a fairly strong economy, a renegotiated trade deal with the United States, and a stable socio-political environment (Chart 15). Chart 15Canadian Political Risk Is Muted And Should Stay That Way While Trudeau’s popularity has waned, his approval rating still puts him in the higher range of Canadian prime ministers and he does not face a charismatic challenger. He has a firm base in both of the traditional bastions of political power, Ontario and Quebec, and seat projections show the Liberals leading in both provinces. The small parties are not polling well; the NDP is faring poorly in Quebec and unlikely to steal many Liberal votes. There could still be surprises but it is telling that the Liberals remain in the lead despite the scandals and last minute controversies threatening them. The Canadian election should produce a status quo result that does not change the energy sector outlook. For the energy sector, the most positive outcome is a Conservative majority; otherwise a renewed Liberal majority is the status quo and hence least negative outcome. Trudeau is criticized by the Conservatives and in Alberta for compromising Canada’s energy interests, yet his support of the Trans-Mountain pipeline has him at odds with the left-wing parties. The worst scenario for the energy sector is if Trudeau is forced to rely on these parties in parliament – and this is a real possibility though not our base case. Bottom Line: The Canadian election should produce a status quo result that does not change the energy sector outlook – however, it holds a non-trivial risk of forcing the Liberals into a coalition with left-wing parties whose stances are market-negative for the energy industry. If this outcome is avoided, expect the market to celebrate in the short term, although the long-term effects of a second Trudeau term are not positive on the energy front. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Please see Mohammad bin Salman denies ordering Khashoggi murder, but says he takes responsibility for it, which aired Sunday September 29, 2019, on CBS News. In a related development last week, Saudi Arabia announced a limited ceasefire with the Iranian-backed Houthi Movement in Yemen, with which it has been engaged in a war since 2015; please see Saudi Arabia agrees to limited ceasefire in Yemen, published by Arabian Business September 28, 2019. 2 Please see Canada's heavy oil exports to Asia from U.S. surge: data, traders published September 27, 2019, by reuters.com. 3 Enbridge Inc.’s 100k b/d pipeline expansion scheduled to be operational by December will marginally increase Canadian shipments south Enbridge us the dominant oil pipeline operator in western Canada. It is attempting to get shippers to sign long-term contracts – vs. existing monthly contracts – during its current auction for pipeline space. Its regulator has “has concerns regarding the fairness of Enbridge’s open season process and the perception of abuse of Enbridge’s market power.” Please see Canada regulator orders Enbridge to halt pipeline overhaul plan due to 'perception of abuse' published by reuters.com September 27, 2019. 4 Please see Court affirms alternative Keystone XL oil pipeline route through Nebraska, published August 23, 2019, by reuters.com. 5 Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. 6 The new government made additional small changes to the previous policy. For instance, it will give producers 2 months’ notice of any changes to the limits, increased the base limit to 20k b/d from 10k b/d and allows the energy minister to use discretion to set production limits after M&A. Please see the oil production limit section of the government of Alberta’s website. 7 As discussed in our March 2019 report, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and sanctions on Iranian oil exports volume limits the supply of heavy crude available to consumers. 8 In June 2019, the Canadian government passed Bill C-69, called “The modernization of the National Energy Board and Canadian Environmental Assessment Agency.” This law changes the federal environmental assessment process. Critics argued this would repel energy investors and limit pipeline projects approval. Additionally, Canada’s Senate passed Bill C-48 – which aims to ban large oil tankers from waters off the north of B.C.’s coast. This law makes it harder for Alberta to ship its oil via northern B.C. export facilities. Companies are now testing shipment of semi-solid bitumen rather than in liquid form to avoid complying with the new legislation. Please see Oilsands crude sails from B.C., sidestepping federal ban, published by the Edmonton Journal on September 26, 2019. 9 Please see The $30-billion exodus: Foreign oil firms keep bailing on Canada's energy sector published by the Financial Post on August 22, 2019. 10 Rig count does not fully capture Canadian oil production. Bitumen production from mining represent ~30% of total production. However, we believe rig count remains a good proxy of capex in the sector. 11 Please see “Canadian Oil Sands Supply Costs and Developments Projects (2019-2039),” published by the Canadian Energy Research Institute (CERI), July 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades