Global
Highlights When it meets in Vienna at the end of this month, OPEC 2.0 will look through the pipeline leaks in South Dakota, which are expected to take some 500k b/d of Canadian crude shipments to the U.S. off the market until repairs are done at the end of November. While this will provide an unexpected assist in draining U.S. inventories, it truly is a transitory event (no pun intended). The larger issue for prices is gauging market expectations going into the OPEC 2.0 meeting at the end of this month. We believe the market is giving high odds to the coalition extending its 1.8mm b/d production cut to cover all of 2018 at its Vienna meeting. This is without doubt the result of the synchronized messaging coming from the leaders of OPEC 2.0, the Kingdom of Saudi Arabia (KSA) and Russia. Based on our balances models, an extension of the cuts to end-June - our base case - will draw OECD stocks down below their five-year average by mid-2018 (Chart of the Week). An executed extension to end-December 2018 would produce even sharper draws. This leaves the only material risk to prices a failure to extend the cuts on Nov. 30, or a reduction in the cuts themselves. Of the two, a failure to extend the cuts is the only material downside risk we see going into the Vienna meetings. Should OPEC 2.0 fail to extend its production cuts at month-end, and cause the markets to sell, we would view it as a buying opportunity: a Mar/18 expiry runs counter to OPEC 2.0's strategy. Energy: Overweight. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 41.4%, since they were recommended in September and October. Our long Jul/18 WTI vs. short Dec/18 WTI trade initiated November 2, 2017 in expectation of steepening backwardation is up 27.7%. Base Metals: Neutral. A weaker USD is providing a tailwind for copper, which is up ~ 2% over the past week. Our U.S. Bond Strategy desk expects the Fed to remain behind the inflation curve, which will translate into lower real rates and continue to support base metals.1 Precious Metals: Neutral. Gold continues to trade on either side of $1,280/oz, hardly budging following the upheaval in KSA. U.S. financial conditions - particularly a weaker USD - are driving gold. Our long gold portfolio hedge is up 4.2% since inception May 4, 2017. Ags/Softs: Neutral. Updated projections of record-high yields from U.S. corn farmers is behind the upward revision to 2017/2018 corn ending stocks in the November WASDE. This led to a massive increase - by 7.56mm MT - in U.S. corn output, which was partially offset by an increase in expected world demand and a downward adjustment to global beginning stocks. Corn prices were down more than 3% in the week following the revisions, but have since regained 2.5%. Feature Markets appear to be pricing in an extension of OPEC 2.0's production cuts to end-2018 when the producer group meets in Vienna at the end of the month around OPEC's regularly scheduled meeting. Our updated balances suggest a sharp sell-off triggered by market disappointment in OPEC 2.0 would represent a buying opportunity, particularly in 2H18. We continue to expect Brent to average $65/bbl next year in our base case (OPEC 2.0 cuts extended to end-June), with WTI trading $2/bbl under that. An extension of OPEC 2.0's cuts to end-December could lift our 2018 Brent forecast as much as $5/bbl, although the Brent-WTI spread likely would widen to $4 to $5/bbl, if this occurs. We do not believe additional cuts are in the offing. Nor do we expect an even-more-dramatic announcement of cuts being extended beyond 2018. We are deliberately keeping our base case more conservative than the apparent market expectation of an extension to end-2018. This suggests markets will be disappointed with anything less than an extension of the OPEC 2.0 cuts to end-June. Given our balances modeling, we believe any disappointment in the market's expectation that leads to a sell-off would represent a buying opportunity, since a Mar/18 expiry – the current terminus of the OPEC 2.0 production cuts, defeats the coalition's strategy of reducing OECD inventories. Under our base case, inventories draw to their five-year average levels by mid-year 2018 (Chart of the Week). In our updated balances model, we have a 100k b/d downward revision in expected U.S. oil-shale output for 2018 tightening the supply side for next year. The U.S. EIA has repeatedly revised its historical estimated shale production lower in recent months, and late-2017 rig counts have deteriorated slightly, which have shifted our historical production curve lower as well. On the demand side, we expect growth of ~ 1.65mm b/d on average in 2017 - 18. These assumptions give an upward bias to our 2018 price forecasts for Brent and WTI crude oil (Chart 2). Chart of the WeekSupply-Demand Balances##BR##Point Toward Tight Markets Chart 2Balances Are Tightening,##BR##Giving An Upward Bias To Prices Inventory Draw Could Be Sharper Chart 3Extending OPEC 2.0 Cuts To End-December##BR##Will Result In Sharper Draws An extension of the OPEC 2.0 cuts to end-Dec/18 would translate to a deeper storage draw than our end-June base case expectation (Chart 3). The Keystone pipeline leaks referenced above also provide an unanticipated assist in drawing down inventories, by temporarily removing ~ 500k b/d from the market in the 2H of November. While we have modeled price-induced additions to U.S. shale-oil output next year in our base case, an extension of OPEC 2.0's cuts to end-December likely will accelerate this production increase as additional production is added in 2H18. This will tend to temper price hikes, but not arrest them, given the differential storage draws we expect of 127 mm bbls. As we have noted, an extension of the OPEC 2.0 production cuts to the end of 2018 could lift Brent and WTI prices by as much as $5/bbl. However, given the still-insufficient pipeline take-away in the U.S. shale basins, we would expect higher production would widen the Brent - WTI price spread to $4 to $5/bbl next year. Practically, if the extension of the production cuts pushes Brent to $70/bbl, we're more inclined to expect WTI prices to average ~ $65/bbl next year. EM Continues To Lead Growth In Oil Demand EM oil demand strength continues to be the dominant feature of the oil market this year, and, we expect, into next year. We are modeling a 1.13mm b/d and 1.22mm b/d increase in EM demand this year and next, respectively. This accounts for 75% and 77% percent of global growth in 2017 and 2018 (Table 1). DM demand, which we proxy with OECD oil consumption, is expected to average 47.5mm b/d over the two-year interval, an average gain of 490k b/d over the interval, vs. 1.18 mm b/d gain in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) China and India account for slightly more than one-third of the 52mm b/d of consumption we are modeling for non-OECD demand over this period, and ~50% of the non-OECD demand growth from 2016 to 2018. The indicators we use to confirm or refute the demand trends we see - EM imports and global PMIs - continue to support the global-growth theme we've noted throughout the year, particularly in the EM markets (Charts 4 and 5). Chart 4EM Trade Volumes Remain Strong,##BR##Supporting The Global Growth Hypothesis Chart 5Global Manufacturing Activity##BR##Remains Robust Continue Watching The Fed EM oil demand and import volumes are highly dependent on Fed policy, which is of particular concern now, because the U.S. central bank is trying to carry out its rate-normalization policy (Chart 6). Still, as our colleagues on the U.S. Bond Strategy desk note, "To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve." This will be bullish for trade, since as we've shown in the past, U.S. monetary policy has a huge effect on trade.2 For the near term - into 1H18 - fundamentals will dominate the evolution of price: Supply, demand and inventories will matter more than U.S. monetary policy effects on the USD and real rates. Nonetheless, should the hawks in the Fed carry the day, we would expect a strengthening of the USD, which, all else equal, would act as a headwind to oil prices next year. For the time being, a weaker USD is reinforcing stronger prices brought about by tighter fundamentals, particularly in the Brent market (Chart 7). Chart 6Continue Watching The Fed Chart 7A Weaker USD Provides A Slight Tailwind Bottom Line: Markets are expecting OPEC 2.0 to extend its 1.8mm b/d production cut to end-2018. We are deliberately using a more conservative extension to end-June in our balances modeling, which produce 2018 Brent and WTI prices forecasts of $65/bbl and $63/bbl. An executed extension of the OPEC 2.0 cuts to end-December 2018 likely would add as much as $5/bbl to Brent prices, and perhaps $2/bbl to WTI prices, which would widen the Brent - WTI spread to $4 to $5/bbl on average next year. Fundamentals will continue to dominate the evolution of prices into 2018 - supply growth (falling), demand growth (rising), and inventories (falling) will drive prices. For the moment a weaker USD is supportive for commodities generally, particularly oil and copper. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "The Fed Will Fall Behind The Curve," published October 24, 2017, by BCA Research's U.S. Bond Strategy. It is available at usbs.bcaresearch.com. 2 Please see footnote 1 above. U.S. monetary policy effects on EM oil demand and trade volumes, and the feedback loop back to the key indicators used by the Fed, have been a recurrent theme in our research. Please see, e.g., "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Our line of research recently found support in IMF research published earlier this month; please see "Global Trade and the Dollar," published by the IMF November 13, 2017. The IMF research is available at http://www.imf.org/en/Publications/WP/Issues/2017/11/13/Global-Trade-and-the-Dollar-45336?cid=em-COM-123-36197 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.
Highlights A growing list of indicators is pointing to a potential slowdown to the strong global growth. However, the key deflationary anchors in the global economy - U.S. deleveraging, Europe's crisis, and Chinese excess capacity - have been mostly slayed. Any slowdown is likely to be brief and shallow, generating a buying opportunity in risk assets. In the meantime, commodity currencies, especially the AUD, could suffer. EUR/JPY is also at risk. Buy CAD/SEK. Feature Chart 1-1Global Growth Has Boomed Global growth has continued to fire on all cylinders, and global industrial activity is at its strongest in 13 years (Chart I-1). However, five weeks ago, we highlighted three yellow flags that we believe are pointing toward a period of cooling in the global economy.1 One month later, it is time to look at the data and evidences to see if these yellow flags are being followed by additional symptoms. We posit that yes, a temporary and mild slowdown will materialize. But the global economy remains fundamentally sound. Yet, this cooling of growth could have implications for commodity currencies and EM assets. The Original Worries The key original worry that we highlighted in early October was that global money growth had been decelerating, which has historically presaged a slowdown in global industrial production, global trade and commodities prices (Chart I-2). This deceleration in money growth has only deepened since, adding further saliency to our original concern. Moreover, Chinese monetary and fiscal conditions are being tightened. The Chinese economy continues to hum at a healthy pace, and deflation has been vanquished as producer prices are expanding at a nearly 7% pace and core CPI continues to accelerate to its highest levels since 2010. This is giving Chinese policymakers an opportunity to tighten policy. Chinese monetary condition indices (MCI) are becoming less supportive of industrial activity and fiscal spending has decelerated. These policy moves potentially explain the recent rollover in the Keqiang index - which approximates industrial growth -- and the contraction in new capex projects (Chart I-3). Chart I-2Money Growth Points To A Pause Chart I-3China Is Tightening Policy Bottom Line: Global money growth continues to decelerate, and Chinese monetary and fiscal conditions are tightening. This could create a dent in global industrial activity. The Additional Worries Some other key growth indicators are also raising the alarm bell: The average of Korean and Taiwanese exports growth decelerated sharply. After having hit a peak of 32% in September, they have now decelerated to 5%. Additionally, Swedish and Australian manufacturing PMIs have also rolled over (Chart I-4). Korean and Taiwanese exports as well as Swedish and Australian PMIs are highly sensitive to global trade and the global industrial cycle. Our global growth indicator has rolled over. This indicator did forecast the rebound in industrial production in 2016 and 2017. It is now pointing toward a slowdown in global activity (Chart I-5). Likewise, our boom/bust indicator has rolled over, further highlighting the risks to global industrial production (Chart I-6). Chart I-4Key Barometers Have Turned Significantly Lower Chart I-5One Growth Indicator Slowing... Chart I-6...And Another One Too BCA's German industrial production model has turned down (Chart I-7). Germany is at the forefront of the global industrial cycle, and its own industrial production is highly geared to global trade. This is because manufacturing represents 23% of Germany's output and Germany's exports account for 38% of GDP. Furthermore, 30% of German exports are destined to EM economies, the epicenter of the global secondary sector. Thus, if German IP weakens, it will reflect an ebbing in the global industrial cycle. The global yield curve has continue to flatten in recent weeks (Chart I-8). This could be a reflection of the deceleration in global money growth. The weakness of banks across the world in recent days suggests the message from the yield curve should not be ignored. Chart I-7Manufacturing-Sensitive Germany Set To Slow Chart I-8Global Yield Curve Still Flattening Bottom Line: Beyond the slowdown in global money growth and tightening in Chinese policy, additional signs of softness have begun to emerge. Korea and Taiwanese exports as well as Swedish and Australian PMIs have weakened, our global growth indicator has rolled over, our boom/bust indicator is also softening. Likewise, our German IP model is pointing south and the global yield curve is flattening. A deceleration in global activity is likely in the cards. Reading Market Tea Leaves A few market developments are likely to be reflecting some of the underlying shifts in growth pinpointed by the set of worries highlighted above. First, commodity currencies have begun to soften, which normally herald a period of softening growth (Chart I-9). What is very interesting is the context in which this currency weakness has begun to emerge: The Australian dollar has weakened despite strengthening metals prices (Chart I-10); Chart I-9The Message From Commodity Currencies Chart I-10Why Is The AUD Weak? The Canadian dollar has weakened despite Brent breaking out above US$60/bbl; The Norwegian krone has weakened against the euro despite the same rise in oil prices and despite a 12% surge in industrial production. Chart I-11Global High Yield Experiencing Weakness Second, the breadth of EM equities has rolled over and is falling below the zero line, indicating that more stocks within EM have begun weakening than appreciating, pointing toward a very narrow participation in the current rally. Third, junk bond prices have started to fall in the U.S., with the JNK ETF breaking significantly below its 200-day moving average, the first time since September 2014. EM high yield bond prices have also broken below their moving average, and have further punched below a key upward sloping trend line that had been in place since the beginning of 2016 (Chart I-11). The EM bond ETF (EMB) is also testing its 200-day moving average. The last point bears particular significance. If EM bonds continue to weaken, this will represent a significant tightening in EM financial conditions. EM financial conditions have eased since 2016, which was a key factor underpinning the improvement in global IP. If EM financial conditions begin deteriorating now, a crucial support to the global economy will dissipate. Moreover, falling EM bond prices tend to be synonymous with falling EM exchange rates. In fact, the Russian ruble, the Turkish lira, the South African rand, the Brazilian real and the Mexican peso have all been weakening since the end of the summer. This suggests outflows out of these markets have begun. As investors pull money out of these markets, liquidity conditions in these economies will tighten, which will hurt their economic activity. This could be the mechanism that catalyzes the softening in global industrial activity highlighted above. All these developments are also emerging at a time when new, untested leadership will soon take hold of the Federal Reserve. Now that U.S. President Donald Trump has selected Jay Powell to helm the Fed, he still has three seats to fill on the board. Historically, transition periods at the Fed can be associated with market volatility. This time around may not be an exception. Bottom Line: Commodity currencies are weakening, market breadth in EM equities is deteriorating rapidly and junk bonds as well as various EM fixed income products are experiencing weakness. Not only do these developments tend to foreshadow ebbing global industrial activity, the weakness in EM bonds could in of itself tighten financial and liquidity conditions. The latter has been a key driver of the global industrial cycle. This represents a potentially dangerous environment. How Dangerous Exactly? Chart I-12Global Utilization Not##br## Deflationary Anymore All of this sounds very dire, but the reality is more nuanced. This softness in economic activity is unlikely to be very pronounced. As we argued last week, the three key factors that have created a strong deflationary anchor in the global economy seem to have been vanquished: U.S. deleveraging is over, the euro area has healed as banks have been cleaned up, and Chinese excess capacity has been purged.2 As a result of these developments, global capacity utilization is in a much better spot than it was in 2015 (Chart I-12). This means the deflationary impulse likely to emerge out of the dynamics described above should be much more muted than it was two years ago. Moreover, commodities markets are not as oversupplied as they once were; in fact, oil inventories are falling as the OPEC 2.0 setup is proving stable. This implies that commodities prices are unlikely to weaken as much as they did back then. This obviously corroborates the idea that the deflationary impact of this slowdown is likely to be smaller and also suggests that the impact on global capex should be more muted. Thus, since growth and inflation are likely to prove more resilient than in 2015, the impact on asset prices of the slowdown is likely to be short lived. If anything, it is likely to provide a buying opportunity in risk assets. Some markets are more out of line with fundamentals than others, which implies that they will suffer more. Below, we discuss key tactics that could be used to navigate this environment. Bottom Line: Because the U.S. deleveraging is over, the euro area has healed and because Chinese excess capacity has been curtailed, the global economy is less prone to deflationary tendencies than two years ago. This means that any growth slowdown will be shallow and brief. Thus, only in the assets most mispriced or most exposed to the risks above will there be playable moves that we will seek to exploit. The relevant currency market implications are explored below. Investment Implications The most mispriced asset in the face of this potential slowdown in global growth seems to be EM equities. EM stocks are very sensitive to the global industrial cycle and EM financial conditions. Both are set to deteriorate. Moreover, since 2008, EM stocks have traded closely with junk bonds, but currently EM equity prices seem very pricey relative to U.S. high yield bonds (Chart I-13). Weakening EM stock prices continue to be a negative for commodity currencies, as it implies a slowdown in global industrial activity. Moreover, commodity currencies remain over-owned. As Chart I-14 illustrates, speculators are very long "risky currencies" versus "safe currencies," implying that a slowdown in global growth, however minute it may be, is likely to be a negative shock for these investors. When these relative net speculative positions roll over, it tends to be associated with violent weakness in commodity currencies. Thus, the recent bout of weakness could only be the first innings. We think the AUD is the worst-placed commodity currency right now. Not only are speculators very long the Aussie, but as we have shown in recent weeks, the AUD is expensive against the USD, the NZD and the CAD. Its premium is so pronounced relative to other commodity currencies that, at current levels, valuations alone warrant shorting the AUD against the CAD or NZD. We are already short these crosses. It therefore follows that if we anticipate commodity currencies in general to weaken, AUD/USD also has downside. Chart I-15 makes this case. Australian equities relative to U.S. equities have historically led AUD/USD. Nearly half of the Australian equity market is financials, and Australian equities have been underperforming. This suggests investors continue to foresee a negative output gap in Australia both in absolute terms and relative to the U.S. - and thus a dovish Reserve Bank of Australia relative to the Fed, which hurts AUD/USD. Moreover, AUD/USD has overshot the mark implied by relative equity prices. Additionally, AUD/USD is expensive relative to interest rate differentials at both the short- and long-end of the yield curve. Chart I-13EM Stocks Offer##br## No Cushion Chart I-14Speculators In Commodity ##br##Currencies Are Not Ready Chart I-15AUD Is Most ##br##Vulnerable The euro could also experience some weakness. We have argued that as European financial conditions tighten relative to the U.S., this will hurt euro area inflation relative to the U.S., pointing to an environment where investors will likely once again price in monetary divergences in favor of the USD.3 Growth dynamics between Europe and the U.S. could also be affected by the tightening in China. As Chart I-16A and Chart 16B illustrates, tightening Chinese MCI or slowing Chinese M1 relative to M2 - which proxies a faster growth in savings deposits than checking deposits, and thus a rising marginal propensity to save tends to translate into slowing PMIs and industrial production in the euro area relative to the U.S. This is because Europe has a larger manufacturing sector and export sector as a share of GDP than the U.S. German exports, Europe's growth locomotive, are also highly geared to the Chinese industrial sector. Thus, when Chinese investment slows, Europe feels it more acutely than the U.S. With investors still very long the euro relative to the USD, a negative relative growth surprise on top of a negative relative inflation surprise will hurt EUR/USD. Chart I-16AEuro Area Versus U.S. Growth: ##br##Don't Ignore China (I) Chart I-16BEuro Area Versus U.S. Growth: ##br##Don't Ignore China (II) The picture for the yen is more complex. Falling EM assets and a temporary growth slowdown are positive for the yen. But bond yield differentials remain the key driver of USD/JPY. Since we anticipate the global growth slowdown to be shallow and brief, any weakness in U.S. bond yields will also be shallow and brief. Since we expect U.S. bond yields to regain vigor fast, and we doubt the global slowdown will affect the Fed's path much, the effect on USD/JPY will also be quick. Thus, we are keeping our cyclical long bet on USD/JPY. In fact, a positive U.S. inflation surprise is a growing risk that could cause bonds to sell off, hurting global liquidity conditions in the process. Chart I-17EUR/JPY: Ripe For A Correction Instead, we will hedge our long USD/JPY exposure by tactically shorting EUR/JPY. Japan will also suffer from a slowdown in global industrial activity, especially as 43% of its exports are shipped to emerging markets. Moreover, Japan has a very large manufacturing sector. However, Japanese yields have no downside from here. This means the deflationary impact of a global growth slowdown, however small it may be, will weigh on Japanese inflation expectations more than it will hurt nominal rates, resulting in higher Japanese real rates.4 This support for the JPY is likely to get magnified in EUR/JPY. Currently, speculators have been massive buyers of the euro against the yen, betting on growing monetary divergence between Europe and Japan. This has pushed net speculative positions in the euro versus the yen to levels historically associated with a reversal in this cross (Chart I-17). This pair is thus a coiled spring in the face of the risk that Japanese real rates rise against European ones, especially if investors begin pushing back expectations surrounding the first ECB rate hike. Investors have already given up hope of any tightening of policy in Japan in the foreseeable future, implying a very minimal chance of them pricing in any easing by the Bank of Japan in response to a temporary global growth slowdown. The last factor supporting shorting EUR/JPY is that Japan has a net international investment position of 60% of GDP, while Europe's NIIP stands at -3% of GDP. Also, Japanese investors have been aggressive buyers of European assets, especially since Emanuel Macron secured the French presidency, causing a positive reassessment of European political risk. In an environment where global volatility increases, Japanese investors are likely to retreat to their home market, accentuating EUR/JPY selling. Finally, CAD/SEK is likely to benefit in this environment as well, as Sweden is more exposed to EM conditions than Canada is. We are buying this cross this week, but we'll explore the reasoning behind it in greater detail next week. Bottom Line: Commodity currencies are likely to be the main casualty of the slowdown we expect to occur over the next 3 to 6 months. The AUD seems particularly vulnerable as it is expensive and investors are still very long this currency. USD/JPY could experience some downside, but we do not anticipate the growth slowdown to be strong enough to permanently knock Treasury yields off their course toward 3%. Instead, we will short EUR/JPY to protect our gains in our long USD/JPY. CAD/SEK has upside. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Melanie Kermadjian, Senior Analyst melanie@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?" dated October 6, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How To Transform Gold Into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "All About Credit" dated October 20, 2017, available at fes.bcaresearch.com and Foreign Exchange Strategy Weekly Report, "Are Central Banks Behind the Curve Or Ahead of It?," dated July 21, 2017, available at fes.bcaresearch.com 4 For a more detailed discussion of the interplay between growth and the yen, please see Foreign Exchange Strategy Weekly Report, titled "Down The Rabbit Hole" dated April 15, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Initial and continuing jobless claims underperformed expectations coming in at 1.901 mn and 239,000 respectively; JOLTS job openings climbed to 6.093 mn, beating expectations of 6.091 mn, and more than the previous 6.09 mn openings; Consumer credit increased to USD 20.83 bn from USD 13.14 bn, also beating expectations of USD 18 bn. The DXY enjoyed an up week, but a large spike in German Bund yields on Thursday caused the DXY to weaken. This is most likely a temporary event prompted by the unwinding of dovish ECB trades. We expect the greenback to continue its climb alongside stronger U.S. data. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has generally been upbeat: The German trade balance and current account improved to EUR 21.8 bn and EUR 25.4 bn, but this first and foremost reflected a 1% contraction in imports; French trade balance also improved to EUR -4.668 bn, beating expectations of EUR -4.8 bn; European retail sales increased by 3.7% on a yearly basis, and 0.7% monthly; However, German industrial production growth slowed to 3.6%. This allowed the euro to regain some of its lost value. However, we believe that euro area inflation will disappoint going forward - especially relative to the U.S. This will limit any appreciation in the euro as investors will begin pricing in a tightening of the Fed's policy relative to the ECB. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has surprised to the downside: Core machinery orders massively underperformed expectations, as they contracted by 8.1% on a month-on-month basis and by 3.5% on an annual basis. Moreover, bank lending yearly growth also underperformed, coming in at 2.8%, and declining from last month's reading. Moreover, the leading economic indicator came below expectations, at 106.7. It also declined from last month's number. After 2 years into the recovery from the 2015 commodity/ EM carnage, global growth seems prime for some slowdown. Indeed, many indicators like high yield and EM bond yields have started to break down. This is could be positive for the yen, given its risk-off currency status. However we prefer to not play this strength though USD/JPY. Instead we are shorting EUR/JPY, a cross which cancels the exposure to the dollar. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed Markit Services PMI outperformed expectations, coming at 55.6. It also increased from 53.6 last month. Halifax House Prices Month-on-Month growth also outperformed, coming in at 0.3%. However, the RICS Housing Price Balance underperformed expectations, coming in at 1%. The pound has been relatively flat after plunging following the "dovish" hike by the Bank of England. Overall, we see very little upside from here on for cable, as the BoE has little incentive to hike beyond what is priced into the SONIA curve, as both consumer confidence and real retail sales yearly growth are near 3-year lows. Meanwhile, the Fed will likely surprise the market by following its projected path. This will increase rate differentials between these two countries, and put downward pressure on GBP/USD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 It has been quite an uneventful week for the AUD, as it has stayed flat relative to the USD. The following data came out: TD Securities Inflation increased to 2.6% from 2.5% on a yearly basis, and 0.3% on a monthly basis; ANZ Job Advertisements increased by 1.4% in September; AiG Performance of Construction Index declined to 53.2 from 54.7; Home loans contracted b 2.3%. The RBA rate decision and statement were in line with expectations, and the AUD saw little to no movement. Governor Lowe identified several capacity issues with the economy, noting that "In underlying terms, inflation is likely to remain low for some time, reflecting the slow growth in labour costs and increased competitive pressures", and that inflation is only being boosted by tobacco and electricity. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Wednesday, New Zealand decided to keep its reference rate unchanged at 1.75%. The kiwi rose after the announcement, as the Reserve Bank of New Zealand brought forward their expectations for a hike from the third quarter of 2019 to the second quarter of 2019. Furthermore, the RNZ now expects inflation to hit the mid-point of its target range by the second quarter of 2018, nine months sooner than before. The RBNZ also toned down its rhetoric on the currency as governor Grant Spencer stated that "the exchange rate has eased since the August statement, and if sustained, will increase tradable inflation and promote more balance growth". Overall we expect the NZD to outperform the AUD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data in Canada has been positive: Ivey PMI moved up to 63.8 from 59.6, also outperforming the expected 60.2; Housing Starts increased by 222,800 annually, beating expectations of 210,000; Building permits also increased by 3.8% on a monthly basis; The most recent Business Outlook Survey report indicates that more than 40% of the surveyed businesses believe the shortage of labor has become worse, which is usually a reliable indicator of wage growth. This will allow the BoC to continue on its hiking path next year, which will mean that CAD will outperform other G10 currencies. NAFTA negotiations remain the greatest risk to the BoC view and the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation underperformed expectations, coming in at 0.7%. It stayed constant from last month's number. Meanwhile, unemployment was unchanged from last month at 3.1%. This number was in line with expectations. After peaking in late October, EUR/CHF has depreciated slightly, mainly due to the weakness in the euro. However, betting for CHF strength still means fighting against the SNB. Inflation in Switzerland is still too tepid for the SNB to stop their interventions in currency markets. Meanwhile, real retail sales yearly growth is still in negative territory. Thus, until we see a significant improvement in economic activity in the alpine country, we are reluctant to bet against the SNB. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Registered unemployment declined from 2.5% in September to 2.4% in October However, industrial production surged to more than 12% on an annual basis Since the Norges Bank policy statement at the end of October, USD/NOK has been flat. This has been because this cross has been squeezed between two conflicting forces: On one hand, oil has gone up nearly 5% just this month. On the other hand, the rise in the dollar has counteracted any downside that rising oil prices could provide to USD/NOK. Although we continue to be bullish on oil, we are bullish on USD/NOK, as this cross is more correlated to real rate differentials than it is to oil. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was positive this week: Industrial production's monthly growth increased to 2.2% from a 1.6% contraction; the yearly measure is growing at a 4.5% pace, albeit less than the previous 7.5%; New orders are increasing at a very high 11.2% annual pace, a good forward-looking indicator for industrial production. While the Swedish economy remains robust, the SEK will see some downside against the USD and the EUR due to the Riksbank's dovishness. Also, the recent dip in EM high yield bonds could be a risk for the Swedish economy. We are therefore opening a long CAD/SEK trade. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Portfolio Strategy Rising oil prices, a weakened U.S. dollar, ongoing global oil producer discipline and still compelling valuations argue for maintaining an above benchmark allocation in the S&P energy index. Wide crack spreads, sticky price hikes and sustained inventory drawdowns are a harbinger of more gains in the S&P refiners sub-index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities plowed higher last week, as earnings growth continues to surprise to the upside and synchronized global growth alongside fiscal easing remain the key macro themes. Over 81% of the companies have now reported earnings, with EPS growth pushing the Q3 blended figure to 8.0% on the back of 5.2% revenue growth. Last quarter's margin expansion is in line with the S&P 500's historical operating leverage of 40%.1 In the context of synchronized global growth macro backdrop, we have been adding deep cyclical exposure to our portfolio at the expense of defensives over the past few months, participating in the SPX's march higher. A simple manufacturing versus services indicator, comparing ISM manufacturing with ISM non-manufacturing, suggests that not only are there more gains ahead for the broad market, but cyclicals will also continue to outpace defensives (Chart 1). When the most cyclical part of the U.S. economy is flexing its muscle, typically a capex upcycle sustains the self-reinforcing earning upsurge. In mid-October2 we posited that such an investment boom will be the dominant macro theme next year. While this theme continues to fly under the radar, our confidence of a durable and broad-based capital spending cycle notched higher following the recent Q3 real GDP print. Table 2 shows the evolution of real GDP, real capex growth and real capex contribution to real GDP growth over the last year. CEOs are voting with their feet and making the longer-term oriented investment decisions as animal spirits are lifting, despite a very slow moving Washington, D.C. Chart 1Most Cyclical Part Of##br## U.S. Economy Is Flexing Its Muscle Table 2Evolution Of GDP ##br##And Capex Growth Chart 2 depicts these data on a longer time horizon. There are high odds that capital outlays will remain upbeat if BCA's view of a tax bill passage materializes3 in the next 6 months with some of the money making its way toward investment, sustaining the virtuous cycle. Were the GOP's tax plan to pass and allow businesses "to immediately write off the full cost of new equipment", then almost certainly CEOs will embark on a capex binge. Importantly, similarly to the synchronized global growth macro backdrop, there is a synchronous capex upcycle brewing. The top panel of Chart 3 shows our equal-weighted real gross fixed capital formation composite of 23 DM and EM countries using national accounts alongside our diffusion index. Our Global Capex Composite has stabilized, but more importantly the diffusion index (percentage of countries with an improving year-over-year capex) is showcasing a coordinated global capex recovery. Chart 2Capex... Chart 3...Is Growing Globally True, DM capex is more advanced than EM capex, but the V-shaped recovery in corporate profitability nearly guarantees a pickup in capital outlays in the coming quarters (middle and bottom panel, Chart 3). Another way we show this simultaneous global capex upcycle is the color coded map in Table 3, with green denoting an expansion in year-over-year real capex, and red a contraction. Green is taking over the table (please click here if you would like to receive this table with more details from our client services department). Table 3Synchronized Global Capex Growth Encouragingly, this is not only a national accounts reported capex phenomenon, but is also borne out by stock market reported data. Using Datastream-compiled stock market reported data, Charts 4, 5, & 6 show capital expenditures growth around the globe covering a number of DM and EM. Similar to our mid-October analysis, we advance operating earnings by one year, and investment should follow profit growth higher in the coming quarters underpinning the virtuous cycle. Chart 4Virtuous... Chart 5...Global Capex... Chart 6...Upcycle The implication of this synchronous capex growth backdrop is that high operating leverage deep cyclicals will dominate defensives next year and we reiterate our recent preference of cyclical versus defensive sectors. This week we update a deep cyclical sector we continue to overweight, and highlight one niche subcomponent. A Burst Of Energy? We lifted the S&P energy index to an overweight stance on July 10, and in Q3 the energy complex bested the market by over 200bps. While this was a timely upgrade, we still believe there is more room for additional relative gains in the coming months. All the reasons we cited during our summer upgrade call4 have started to move in our favor, signaling more upside ahead. Namely, the U.S. dollar remains down significantly for the year (Chart 7) and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $11/bbl to $55/bbl or ~24% since July 10th, but energy stocks are up only 7% in absolute terms (Chart 8). Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. Chart 7Weakened U.S. Dollar Is Bullish Energy Chart 8Catch Up Phase On the supply front, both the overall U.S. oil & gas and horizontal only rig count peaked in late July, and Cushing and OECD oil stocks are now contracting. As global oil inventories get whittled down and OPEC stays disciplined oil prices will remain well bid. Tack on the synchronized global growth macro backdrop, and the upshot is that global oil demand will continue to grind higher. The implication is that the relative share price advance is still in the early innings (Chart 9). Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. On a price to book, prices to sales and price to cash flow basis energy is trading at a 40%, 30% and 5% discount, respectively, to the broad market. The recent carnage in EPS skews the results with the energy sector trading at a 47% forward P/E premium to the overall market (Chart 10). Our Technical Indicator has also tentatively troughed. Historically once the one standard deviation below the historical mean level gives way, a sling shot recovery ensues (Chart 10). Finally, the budding recovery in energy earnings remains intact and our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline (Chart 11). Chart 9Oil Inventory Drawdown = Buy Energy Stocks Chart 10Compelling Valuation Backdrop Chart 11EPS Model Is Still Flashing Green Adding it up, firming oil prices, the depreciated U.S. dollar, continued global energy producer restraint and still compelling valuations argue for maintain an above benchmark allocation in the S&P energy index. Bottom Line: We reiterate our early-July S&P energy sector upgrade to overweight. Refiners Are Heating Up In the summer we lifted the S&P oil & gas refining & marking index to neutral from underweight locking in impressive gains and that tilted our overall S&P energy sector exposure to above benchmark.5 Subsequently in early-September we further augmented exposure in this pure play energy downstream index to overweight.6 Since then, relative performance is up over 8%. Is it time to book profits? The short answer is not yet. While these relative gains are impressive in such a short time span, we are staying patient before monetizing them, as leading indicators of refiners' profits continue to flash green. Our thesis in September was that the Hurricane Harvey catastrophe presented a trading opportunity from the long side for the S&P refining index. Not only did production get substantially curtailed, but also, as a result, inventories gave way. The longer the disruption, the sweeter the profit spot for the refining industry, as only higher industry selling prices could bring the market back to equilibrium. Indeed, the Brent/WTI crude oil spread, a great proxy for refining margins, recently vaulted to $8/bbl, the highest since early-2015 (Chart 12). Refining margins and gasoline prices also jumped to multi-year highs. While the industry has recovered since the hurricane devastation and brought production back online, selling price inflation is proving sticky, which is a boon for industry margins and thus profits. Already, this earnings season has seen all of the index's component stocks report double-digit margin expansion; the sell-side community has clearly taken notice and earnings revisions have spiked higher (Chart 13). Looking closer at the inventory backdrop, the refined product drawdown is ongoing. From the early 2017 peak, gasoline and distillate fuel supplies have collapsed by roughly 100mn bbl (inventories shown inverted, top panel, Chart 13). In particular, gasoline stocks are now contracting at 5% per annum (inventories shown inverted, middle panel, Chart 13). Historically, industry inventory accumulation has been weighing on relative share prices and vice versa. Evidently, the market has yet to reach an equilibrium, which is a boon for refining profits and relative share prices. Finally, following the collapse in refined product net exports as refiners focused on primarily fulfilling domestic demand, net exports have jumped back to all-time highs near 3mn bbl/day. This represents an over 6mn bbl/day swing in net exports over the past decade (bottom panel, Chart 14). A weak U.S. currency coupled with the higher prices oil products fetch abroad should continue to underpin exports and represent another sizable avenue for industry profits. Chart 12Too Early To##br## Lock In Profits Chart 13Decreasing Refined Product ##br##Stocks Are A Boon For Refiners Chart 14Export Relief ##br##Valve Reopened Netting it out, it is still too soon to take profits on the S&P oil & gas refining & marketing index. Refined product inventories continue to fall, crack spreads are wide and industry price hikes are sticky. This is a fertile profit margin and EPS backdrop, underscoring that the path of least resistance is higher for relative share price, at least until an equilibrium is reached. Bottom Line: Stay overweight the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," dated April 17, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 5 Ibid. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Still Goldilocks," dated September 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The synchronized upturn lifting global GDPs will pull demand for stainless steel higher, as consumers increase purchases of autos, ovens, refrigerators, freezers and other household durables. That's good news for nickel, since roughly two-thirds of demand for the metal worldwide is accounted for by the stainless steel market. This means the current nickel supply deficit will persist into 2018, which will be supportive of prices over the next 3 - 6 months (Chart of the Week). Going into 2H18, however, we expect nickel supply growth to pick up, which is keeping us neutral on the metal for now. Chart of the WeekDeficit Will Further Support Prices Into 1H2018 Energy: Overweight. Leaders of OPEC 2.0 are strongly signaling they will extend their 1.8mm b/d production cuts to end-December 2018, when they meet at the end of the month. This could lift our 2018 Brent and WTI forecasts - $65/bbl and $63/bbl, respectively - by as much as $5.00/bbl, should it materialize. We remain long $55/bbl calls vs. short $60/bbl Brent and WTI call spreads expiring in May, July and December 2018; they are up an average 26.5%. In anticipation of a more pronounced backwardation arising from tighter supply-demand fundamentals in the WTI forward curve, we are getting long Jul/18 WTI vs. short Dec/18 WTI at tonight's close. Base Metals: Neutral. Nickel markets will remain in deficit into next year, as stainless steel demand is lifted on the back of the synchronized global upturn in GDP (see below). Precious Metals: Neutral. Gold markets appear to have fully discounted the appointment of Jerome Powell as the next Fed Chair, trading on either side of $1,280/oz since the beginning of October. Ags/Softs: Neutral. U.S. ag officials on the ground in Argentina reported corn production for the 2017/18 crop year is projected to be 40mm tons, or 2mm tons below the USDA's official estimate, due to smaller areas planted in that country. Wheat production is expected to be 16.8mm tons, 700k tons below the USDA's official forecast, due to excess rain. Directionally, these unofficial posts are supportive of our long corn vs. short wheat position, which is up 4% since inception on October 5, 2017. Feature Focus On Demand For Nickel Price Guidance Synchronized global GDP growth will fuel demand for consumer durables - autos, refrigerators, freezers, etc. - which will lift demand for stainless steel. This, in turn, will increase consumption of nickel, given the stainless steel market accounts for some two-thirds of nickel demand (Chart 2). Receding fears of an imminent slowdown in China, which accounts for 46% of global nickel demand, also is supportive: China's manufacturing PMI currently stands at multi-year highs (Chart 3). Likewise, the pace of investment in China's real estate, automobile, infrastructure, and transportation sectors - all of which are stainless steel end users - remains strong (Chart 4). Chart 2Consumer Durables Demand##BR##Will Lift Nickle Consumption Chart 3Easing Fears Of China##BR##Slowdown Also Supportive Chart 4Stainless Steel End-Use##BR##Markets Growing We do not foresee a near-term slowdown in China's consumer sector, following the conclusion of the 19th National Congress of the Communist Party of China. On the contrary, we expect stainless steel demand will remain strong, and a bullish factor in nickel fundamentals going into the beginning of next year.1 However, we are watching the evolution of China's economy closely, now that President Xi has consolidated power.2 Weak ore output from nickel mines was the main culprit behind the deteriorating nickel balance since 2014. Although the global deficit has contracted significantly from its 2016 record, declining consumption - rather than accelerating production - was the driver of the improvement in the supply-demand balance to this point. Increased Supply Won't Be Enough In The Short Run Over the short term, growth in stainless steel demand will outpace increased nickel ore output, which is slowly adjusting to the return of Indonesian ore exports following the 2014 ban. Indonesia's ban on nickel-ore exports fundamentally shifted the market in several ways. In 2013, just before the export ban, China's imports of Indonesian nickel ore stood at more than 41mm MT. Providing almost 60% of China's nickel ore imports, Indonesia was vital to China's thriving nickel pig iron (NPI) industry - which uses low grade nickel ores to produce a cheaper alternative to refined nickel. Output of NPI is then used in the production of stainless-steel. An immediate consequence of the Indonesian export ban was the emergence of the Philippines as China's main nickel ore supplier. It exported 29.6mm MT of nickel ores to China in 2013, accounting for the remaining 40% or so of China's nickel ore imports then. With the Indonesian export ban, the Philippines became China's top, and practically only, supplier of nickel ores (Chart 5). Although the Philippines captured almost all of China's nickel ore trade, it failed to grow the volume of its exports. This had a profound impact on China's domestic processing and refining market. Restricted access to nickel ores meant that China no longer had the necessary supply to keep its NPI industry churning. Instead, it turned to NPI imports, which grew more than 5-fold in the three years following the ban (Chart 6). Similarly, China's unwrought nickel net imports stand above pre-ban levels. The loss of access to Indonesian ores also coincided with a fall in China's laterite inventory.3 Chart 5Indonesia Export Ban Crippled China Imports Chart 6China NPI Imports Up 5-Fold Since 2013 Loss Of Ore Exports Created Refined Nickel Deficit The shrinking supply of nickel ores had a knock-on effect on refined supply. Global production of refined nickel - which was expanding by an average 11.4% yoy between 2011 - 2013 collapsed by 7.3% in 2014, and has remained largely unchanged since. At the same time, demand remained strong, growing by 11.4% and 7.4% in 2015 and 2016, respectively. The combined characteristics of shriveling production amid stable demand put nickel in a large deficit in 2016. This is also evidenced in LME inventory data, which by the end of last year was down 20% from its mid-2015 peak (Chart 7). Chart 7Inventory Draw On Shriveling Production However, Indonesia's export ban appears to have attracted some $6 billion in nickel smelter investments, which allowed it to capture value-added revenues above and beyond those associated with simply exporting raw ores. In fact, many of the NPI operating plants in Indonesia - now in excess of 20 - were built by Chinese companies looking to circumvent the ban by off-shoring NPI production. While Indonesia's minerals export ban was partially lifted in May of this year, we do not expect the market to suddenly return to its pre-2014 fundamentals. The government still maintains an export quota, and has limited the granting of exemptions to companies that have already constructed a value-add processing plant within Indonesia. Instead, we expect Indonesia will lift the quota gradually. Just this past week, the government granted state-owned miner Aneka Tambang additional export rights equal to 1.25mm MT of laterite ore over the next 12 months. The company's initial export capacity, approved in March, was 2.7mm MT.4 This would be a windfall for China's domestic nickel processing plants as their unrefined ore supplies from Indonesia would increase. However, longer term, the reversal of the country's export ban could eventually lead to nickel smelter closures in Indonesia. Virtual Dragon is a China-backed NPI smelter in Indonesia which shipped its first 10k MT to China in August and has a 600k MT annual output target in its first stage. Yet the smelter is concerned with the impact of the ban's reversal on its longer run plan, and reportedly put a $1.83 billion expansion on hold following the policy change.5 In any case, we expect the complete lifting of the ban to transpire gradually, rather than shock the market. Consequently, we do not foresee a sudden flooding of nickel ores to international markets. Bottom Line: Indonesia's ban on nickel ore exports altered trade flows and reversed production trends. While the eventual lifting of the export quotas will change the nickel market, we expect this to transpire gradually. Thus the policy U-turn is not a bearish force in our near term assessment of the nickel market. Stainless Steel Demand To Dominate In Near Term Despite Indonesia's move towards scraping its export ban, we expect strong consumption to drive the evolution of the market in the near term. Solid demand from the stainless steel sector will dominate over supply side growth, and we expect the market to remain in deficit until early next year. In fact, despite the partial return of Indonesian ores to global markets, nickel ore production grew by a modest 1.3% yoy while refined production fell 4.2% yoy in the first 8 months of 2017. A 65% increase in refined output from Indonesia could not offset declines from many of the top producers, including an 11.3%, 22%, and 18.5% yoy decrease in production from China, Russia, and Brazil, respectively. Chart 8Stainless Steel Demand To##BR##Recharge Nickel Market China's share of global stainless steel production has stalled at around 52% since Indonesia's export ban. Stainless steel production was strong - growing an average of 22.4% yoy prior to 2014 (Chart 8). Although it continues to grow, it is doing so at a slower rate. In fact, production stayed largely unchanged last year. We expect the re-emergence of Indonesia's nickel ores will recharge China's stainless steel market. Furthermore, reports of capacity closures in Shandong will stifle China's NPI production. These closures - which aim to reduce smog and pollution during the wintertime - are expected to begin next month and last until mid-March. Thus even with an increase in global ore exports, China's NPI production will be limited in the short run by domestic capacity closures and will continue to depend on imports. Eventually, we expect a supply boost from the return of Indonesian ores to global markets. Refined production has been falling by 2.5% per year since the ban, compared to an average annual production growth rate of 11.4% in the three years prior to the ban. However, we do not expect production to immediately return to the pre-2014 growth pace. While global production has been on the uptrend since June, a comeback in demand will keep nickel in shortage. In fact, the supply deficit would have been significantly wider were it not for declining consumption so far this year. Global refined nickel consumption fell a staggering 7.8% yoy in the first 8 months of 2017, reflecting the 24.8% yoy decline in Chinese consumption. Thus, nickel demand from its top user - the stainless steel sector - will determine the market's direction for the remainder of this year and the beginning of next. The main risk to this view comes from a stronger-than-expected U.S. dollar. This would make the commodity more expensive to holders of other currencies, reducing its demand. Furthermore, while we do not anticipate it, a sudden - rather than gradual - reversal of Indonesia's export ban would tilt the balance to a surplus. Bottom Line: Declining refined nickel production from top producers this year is worrying. However, a simultaneous fall in China's demand - the world's top consumer - means that the net effect on the nickel balance was a shrinking of the supply deficit. Going forward, we expect a gradual increase in supply on the back of a steady expansion of Indonesian ore export quotas. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Given the slow adoption of EVs we project over the next 20 years or so, we do not expect Electric Vehicle (EV) batteries to be a material source of demand growth for nickel for the next 3 - 5 years. Please see "Electric Vehicles Part 3: EVs' Impact on Oil Markets Muted Over Next 20 Years," part of a three-part Special Report jointly researched and written by BCA Research's Technology Sector Strategy, Energy Sector Strategy and Commodity & Energy Strategy. It was published August 29, 2017, and is available at ces.bcaresearch.com. EV battery demand currently accounts for 70k TH, or 3%, of nickel usage. According to estimates from UBS, nickel demand from EVs will reach 300-900k MT annually by 2025. Goldman Sachs are much more conservative in their nickel demand estimate, expecting it to remain under 100k MT prior to 2020, and to grow to 200k MT thereafter. 2 Please see BCA Research's Geopolitical Strategy and China Investment Strategy Special Report "China: Party Congress Ends ... So What?," published on November 1, 2017. Available at gps.bcaresearch.com and cis.bcaresearch.com. 3 Laterites are a type of soil containing nickel, and account for more than 70% of world nickel reserves, according to "Geology for Investors." Please see https://www.geologyforinvestors.com/nickel-laterites/ 4 Please see "PT Antam approved to export another 1.25m tonnes of nickel ore from Indonesia," dated October 26, 2017, available at metalbulletin.com. 5 Please see "Indonesia's Virtue Dragon smelter ships first nickel pig iron," dated September 28, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016