Commodities & Energy Sector
Highlights As the Fed proceeds with its policy tightening this year, higher real rates and a stronger USD will weigh on silver and platinum prices, and, to a lesser extent, palladium prices. Offsetting these downward pressures, silver, and to a lesser extent platinum, could take their lead from the gold market, and outperform on the back of increased equity volatility and understated geopolitical risks this year.1 Palladium, as always, will march to its own drummer, as this market's defining feature remains chronic physical deficits and depleted inventories, which will prevent prices from reacting too severely to tighter Fed policy this year. Energy: Overweight. Supply-demand fundamentals still are supportive of crude oil prices overall, and continued backwardation in forward curves. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, which gains as backwardation becomes more pronounced, is up 47.4% since inception on November 2, 2017. Base Metals: Neutral. Base metals remain well supported by still-strong global growth, estimates of which were revised higher by the IMF in its most recent World Economic Outlook. Precious Metals: Neutral. Fed tightening this year will weigh on silver and platinum, less so palladium (see below). Our long gold portfolio hedge is up 7.9%. Ags/Softs: Underweight. The USDA revised down its forecast of U.S. corn ending stocks in the latest WASDE on the back of an upwards revision to U.S. corn exports. Feature The term "precious metals" is something of a misnomer: Gold, silver, and platinum-group metals (PGMs) - chiefly platinum and palladium - do not constitute a single asset class, and should not be treated as such (Chart of the Week). Nevertheless, as with most commodity markets we cover, the evolution of these markets is highly sensitive to U.S. financial variables, particularly as regards monetary policy. Palladium is something of an outlier: It behaves more like an industrial metal, while silver, and to a lesser extent platinum, are more sensitive to the fundamental drivers of gold prices - i.e., the evolution of the USD's broad trade-weighted index (USD TWIB), and real U.S. interest rates. Palladium's demand is dominated by its use in catalytic converters in gasoline-powered cars, whereas industrial applications form a more limited source of demand for platinum and silver (Chart 2). Chart of the WeekA Schism In Precious Metals Chart 2Industrial Uses Dominate Palladium Gold, silver, and, to a more limited extent platinum are cointegrated in the long run, meaning their prices follow their own random walks, even though they share a long-term trend. Palladium, on the other hand, is more responsive to the physical realities of the automobile market - chiefly, demand for gasoline-powered cars. In our econometric analysis of the behavior of PGMs and silver, we use the CRB Metals Index as a proxy for industrial activity. We find that while all three are sensitive to changes in the CRB Metals Index, palladium prices are significantly more responsive (i.e., elastic) to industrial activity than platinum and silver (Table 1). Table 1Palladium Behaves Like An Industrial Metal Furthermore, while gold prices impact both silver, and, to a lesser extent platinum, they are not significant when it comes to the palladium market. Bullish Fundamentals Tightened Palladium Market Palladium registered a 60% gain in 2017. Its forward curve has been backwardated since June (Chart 3). This backwardation - i.e., spot prices trade higher than deferred prices - is a symptom of a tight market. In fact, according to Thomson Reuters GFMS data, the palladium market has been in a chronic deficit since 2007, with the 2017 deficit the largest since 2000. The culprit in this case has been strong demand and stagnant supply. While supply has been growing ~ 1% year-over-year (yoy) over the past 5 years, demand growth has averaged 1.7% yoy over the same period. Palladium demand over this period has been driven by its growing use in automobile catalytic converters, most notably in China, where sales of gasoline-powered cars exceed those of diesel-powered cars, which typically use platinum in their catalytic converters (Chart 4). Chart 3Tight Fundamentals In##BR##The Palladium Market Chart 4Growing Demand For##BR##Autocatalysts Dominated In The Past... Growth in global demand for palladium-based autocatalysts averaged 4.8% yoy in the past 5 years. The use of palladium for autocatalysts now makes up more than 75% of global palladium demand, up from 56% 10 years ago. Chinese demand for palladium used in autocatalysts grew from 10% of global demand in 2007 to more than a quarter of global demand last year. Given autocatalysts' oversized contribution to demand growth, the palladium market is highly dependent on car sales. Our modelling highlights global car production as a significant explanatory variable when it comes to palladium prices. Most significant are the U.S. and Chinese markets, which are the largest markets for gasoline-powered cars. While vehicle sales in China were strong in 2016, they have slowed considerably and recorded yoy declines in the most recent November and December data (Chart 5). Slowing demand growth for cars in China likely comes on the back of the phasing out of tax cuts on small vehicles. This will limit the upside for palladium prices from China's industrial demand. Growth in car sales in the U.S. has been even more muted, contracting in 2017 for the first time since 2009. However, a more concerted adoption of gasoline-powered cars in Europe - largely in response to efforts by cities to reduce emissions of particulate matter from diesel engines, and the highly publicized emissions-testing scandals involving European carmakers - will, at least partially, mitigate the negative impact of slowing demand from the top two gasoline-powered markets. On the supply side, global mine supply has been relatively stagnant over the past 5 years, expanding an average 1.2% yoy during this period. Russia, South Africa and Canada account for almost 90% of total palladium mine supply. And while Russian and South African supplies have been relatively flat over the years, Canadian palladium has grown to account for ~11% of global supply in 2017, up from 4% in 2010. Global palladium supply has been supported by metal recovered from autocatalyst scrap, which has been averaging 4.8% yoy growth in supply over the past 5 years. In fact, the share of palladium recovered from autocatalyst scrap has almost doubled in the past 10 years, and now makes up almost 20% of total supply. Growth in this source of supply has come down significantly (Chart 6). However, we expect palladium's exorbitant price and elevated steel prices to incentivize an increase in the metal's recovery from scrap. Indeed, GFMS expects recycled palladium to pave record highs this year and to surpass 2 million ounces next year. Chart 5...But Beware Of Slowing Gasoline Car Sales Chart 6Palladium Needs Restocking Strong demand, combined with limited supply growth, has weighed on palladium inventories. Furthermore, ETF holdings of palladium have come down sharply while net speculative long positions have skyrocketed. Given that stocks are so low, we do not expect a severe fall in prices. Bottom Line: Palladium behaves like an industrial metal and is especially sensitive to changes in demand for automobiles. While the stars were aligned for palladium last year - a weak USD, low real interest rates, and bullish fundamentals - car sales in the U.S. and China have been slow recently. Even so, a physical deficit will prevent a crash in the palladium market this year. Platinum Trading At A Discount To Palladium In contrast with palladium's remarkable performance last year, platinum was up a mere 3.4% in 2017. In fact palladium, which usually trades at a discount to platinum, has been more expensive since October (Chart 7). This can be attributed to differences in fundamentals. Palladium's market conditions have been significantly tighter than platinum. Greater demand for the physical metal than supply put the market in deficit last year, which supported platinum prices. As with palladium, catalytic converters are a major demand source for platinum; however, they account for ~ 40% of platinum demand - considerably less than the roughly 80% share of palladium demand accounted for by catalytic converter demand. Europe is the largest market for diesel cars, and, while total vehicle sales in Europe have remained healthy, diesel-powered cars have been losing market share since the Volkswagen emissions-rigging scandal came to light in 2015 (Chart 8). This hit platinum use in autocatalysts particularly hard. In addition, weaker demand from its second use - jewelry - is keeping a lid on platinum prices (Chart 9). In fact, Chinese demand for the white metal, which accounts for more than 50% of global platinum jewelry demand, has been falling. Despite weakening demand, global balances remained in deficit on the back of muted supply. Chart 7Platinum Now Cheaper Than Palladium Chart 8EU Diesel Car Market Losing Momentum Chart 9Platinum Jewelry Losing Its Appeal Platinum's market balance could be at risk if carmakers start using more of it in catalytic converters, now that it trades at a discount to palladium. Platinum is a superior material for autocatalysts, but palladium has been traditionally favored on a cost basis. Platinum's lower price incentivizes carmakers to switch to this metal. According to Johnson Matthey, it will be two years before the impact of such substitution begins to affect the palladium market. Bottom Line: Subdued demand for platinum jewelry combined with the loss of market share for diesel-powered cars in Europe will keep a lid on the platinum market this year. However, platinum follows gold, and this could support prices if equity investors hedge market volatility and future corrections by purchasing the metal. Silver Follows Gold Silver, and, to a lesser extent, platinum are not as exposed to the industrial business cycle as palladium. These metals' prices instead move in line with gold (Chart 10). Our modeling reveals that a 1% increase in gold prices is associated with a 0.76 pp increase in silver prices. Thus gold's spillovers to the silver market are significant. Even so, there are periods when this relationship disconnects. This is because, although industrial uses do not account for as large a share of silver demand as they do for palladium, such fundamentals do account for a significant source of demand. Thus, in addition to the financial factors which drive gold, silver's industrial applications give it some exposure to economic activity. In fact, a 1% increase in the CRB Metals Index is associated with a 0.17pp increase in silver prices. This explains why, in some instances, silver's cointegration with gold weakens. As a practical matter, gold is a superior hedge against equity downfalls than silver (Chart 11). While gold month-on-month (mom) returns outperform S&P 500 mom returns almost 80% of the time in periods of decreasing equity returns, the ratio for silver comes in at a lower 67%. On the other hand, gold mom returns outperform S&P 500 returns less than 30% of the time during periods when equities are increasing, while silver outperforms the stock market almost 40% of the time. Chart 10Silver And Gold##BR##Move In Tandem Chart 11Gold Outperforms Amid Equity Downfalls,##BR##Not During Rising Stocks In addition, although both gold's and silver's correlations with the S&P 500 become large and negative when the S&P 500 decreases in yoy terms, this negative correlation in the case of gold is significantly larger than for silver (Chart 12). In fact, along with silver's relatively weaker negative correlation with the S&P 500 during periods of negative equity returns, silver also exhibits a relatively stronger positive correlation with equities during periods of positive returns. While silver is an effective hedge against geopolitical and economic crises, gold's hedging ability remains superior (Chart 13). Silver and gold post similar returns during geopolitical crises; however, gold returns are significantly higher during economic crisis. Chart 12Negative Correlations More##BR##Pronounced During Equity Downfalls Chart 13Gold Is A##BR##Superior Protection This supports the finding that silver's hedging ability is hampered by its use in industrial applications, which make it more responsive to the business cycle than gold. Bottom Line: Gold and silver prices are cointegrated. However, given silver's industrial applications, it is more sensitive to business activity. This explains the periods of divergence in the two precious metals, and limits silver's ability to hedge against economic crises and falling equities. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 For a discussion of the gold market fundamentals, please see Commodity & Energy Strategy Weekly Report titled "Gold Still Shines Despite Threat Of Higher Rates," dated February 1, 2018. Available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Feature Chart 1Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... Chart 3...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Chart 5...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Chart 7Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Chart 16...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Chart 18Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A2 Chart A3 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation
Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Chart 9Elevated Policy Uncertainty##BR##Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Chart 10Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Chart 13High Confidence##BR##Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Overweight In a welcome reversal of fortunes, the S&P energy services index caught a bid last month, lifted by rising oil prices, healthy earnings and bullish 2018 forecasts. We think this is just the beginning for the beleaguered sector. OPEC crude oil production remains firmly in contraction territory with the mantle being taken up by non-OPEC producers (second panel), the key customer group for the energy services index. However, the increases have not been enough to offset the declines and OECD oil stocks have fallen for the past year, a trend that has sparked the biggest revival in oil patch capex in the last five years (third panel). In the context of the valuation pounding the sector has taken during the oil downturn, the rebound has a very long runway. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5ENRE- SLB, HAL, FTI, NOV, BHGE, HP.
Highlights A thorough audit of our trade book highlights that our country and sector allocation recommendations have been quite profitable for investors. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return. A review of the original basis and subsequent performance of our trades suggests that investors should close 6 out of 12 of our active positions, predominantly related to resource & construction and domestic stock market themes. We will be looking for opportunities to add new trades to our book over the coming weeks and months that have broad, "big-picture" relevance. Watch this space. Feature In this week's report we conduct a thorough audit of our trade book, by revisiting the original basis and subsequent performance of all 12 of our active trades. While these trades have been initiated at different points over the past five years, they can be broadly grouped into five different themes: Core Equity Allocation & General Pro-Risk Trades (4 Trades) Reform-Oriented Trades (2 Trades) Resource & Construction Plays (2 Trades) Domestic Stock Market Trades (2 Trades) Trades Linked To Hong Kong (2 Trades) Overall, our trade book performance has been excellent. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return (since December 2015). As a result of our trade book review, we recommend that investors close six trades and maintain six over the coming 6-12 months. The closed trades predominantly fall into the resource & construction and domestic stock market categories, although we also recommend closing our long China H-share / short industrial commodity trade as well as our long Hong Kong REITs / short Hong Kong broad market trade. We present our rationale for retaining or closing each trade below. Over the coming weeks and months we will be looking for opportunities to add new trades to our book. Stay tuned. Core Equity Allocation & General Pro-Risk Trades We have four open core equity allocation and pro-risk trades: Overweight MSCI China Investable stocks versus the emerging markets benchmark, initiated on May 2, 2012 Long China H-shares / short industrial commodities, initiated on March 16, 2016 Short MSCI Taiwan / Long MSCI China Investable, initiated on February 2, 2017 and Long China onshore corporate bonds, initiated on June 22, 2017 We recommend that investors stick with three of these trades, but close the long China H-shares / short industrial commodities position for the following reasons: Chart 1Be Overweight China Vs EM In This Environment Overweight MSCI China Investable Stocks Versus The EM Benchmark (Maintain) This trade represents one of the most important equity allocation calls for Chinese stocks, and is one of the ways that BCA expresses a view on the Chinese economy in our House View Matrix.1 While it hasn't always been the case, we noted in a recent Special Report that Chinese stocks have become a high-beta equity market versus both the global aggregate and the emerging market benchmark, even when excluding the technology sector.2 China's high-beta nature, the fact that EM equities remain in an uptrend (Chart 1), and our view that China's ongoing slowdown is likely to be benign and controlled all suggest that investors should continue to overweight Chinese stocks vs their emerging market peers. Long China H-Shares / Short Industrial Commodities (Close) We initiated this trade in March 2016, one month after Chinese stock prices bottomed following the significant economic slowdown in 2015. At that time it was not clear to global investors that a mini-cycle upswing in the Chinese economy had begun, and this pair trade was a way of taking a limited pro-risk bet. Given our view of a benign, controlled economic slowdown in China, this hedged trade is no longer needed, especially given the uncertain impact of ongoing supply side constraints in China on global commodity prices. As such, we recommend that investors close the trade, locking in an annualized return of 15.7%. Short MSCI Taiwan / Long MSCI China Investable (Maintain) Chart 2If The TWD Declines Materially, ##br##Upgrade Taiwan (From Short) We initiated our short MSCI Taiwan / long MSCI China investable trade last February, when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). We reviewed the basis of this trade in a report last month,3 and recommended that investors stick with the call despite significantly oversold conditions (Chart 2). A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. Long China Onshore Corporate Bonds (Maintain) Chinese corporate bond yields have risen materially since late-2016, largely in response to expectations of tighter monetary policy. These expectations have been validated, with 3-month interbank rates having risen over 200bps since late-2016. We argued last summer that the phase of maximum liquidity tightening was likely over, and that quality spreads and government bond yields would probably drop over the coming three to six months. While this clearly did not occur (yields and spreads rose), the total return from this trade has remained in the black owing to the significant yield advantage of these bonds versus similarly-rated bonds in the developed world. Chart 3 highlights that Chinese 5-year corporate bond spreads are also considerably less correlated with equity prices than their investment-grade peers in the U.S. This underscores that the rise in yields and spreads over the past year has reflected expectations of tighter monetary policy, not rising default risk. Our sense is that barring a significant improvement in China's growth momentum, significant further monetary policy tightening is improbable, meaning that corporate bond yields are not likely to rise much further. As a final point, as of today's report we are changing the benchmark for this trade from a BCA calculation based on a basket of 5-year AAA and AA-rated corporate bonds to the ChinaBond Corporate Credit Bond Total Return Index. Chart 3Chinese Corporate Spreads Aren't A Risk ##br##Barometer Like In The U.S. Reform-Oriented Trades We have two open trades related to China's rebooted reform initiative, both of which were initiated on November 16, 2017: Long China investable consumer staples / short consumer discretionary stocks and Long China investable environmental and social governance (ESG) leaders / short investable broad market These trades were recently opened, and we continue to recommend that investors maintain both positions: Long China Investable Consumer Staples / Short Consumer Discretionary Stocks (Maintain) The basis for the first trade stems from the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. We argued in our November 16 Weekly Report that Chinese investable consumer staples would be a better play on Chinese consumer spending owing to the material weight of the automobiles & components industry group in the discretionary sector, which may fare poorly over the coming year due to the environmental mandate of President Xi's proposed reforms. We argued in the report that this trade would likely be driven by alpha rather than beta, and indeed Chart 4 illustrates that staples continue to rise relative to discretionary against a backdrop of a rising broad market. Long China Investable ESG leaders / Short Investable Broad Market (Maintain) In the same report we recommended that investors overweight the China investable ESG leaders index, based on the goal of favoring firms that are best positioned to deliver "sustainable" growth in an era of heightened environmental reforms. The index overweights firms with the highest MSCI ESG ratings in each sector (using a proprietary MSCI ranking scheme), and maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that the trade is progressing in line with our expectations, suggesting that investors stick with the position over the coming 6-12 months. Chart 4Staples Vs Discretionary Isn't A Low Beta Trade Chart 5Likely To Continue To Outperform Resource & Construction Plays We have two open trades related to the resource sector: Long China investable oil & gas stocks / short global oil & gas stocks, initiated on April 26, 2014 and Long China investable construction materials sector / short investable broad market, initiated on December 9, 2015 We recommend that investors close both of these positions, based on the following rationale: Chart 6Similar Earnings Profile, ##br##But Weaker Dividend Payouts Long China Investable Oil & Gas Stocks / Short Global Oil & Gas Stocks (Close) This trade was initiated based on the view that the valuation gap between Chinese and global oil & gas companies is unjustifiable given that the earnings off both sectors are globally driven. Indeed, Chart 6 shows that the trailing EPS profiles of both sectors in US$ terms have been broadly similar over the past few years, and yet China's oil & gas sector trades at a 40% price-to-book discount relative to its global peers. However, panel 2 of Chart 6 highlights that this discount may represent investor concerns about earnings quality and/or state-owned corporate governance. The chart shows that while the earnings ROE for Chinese oil & gas companies is higher than that of the global average, the dividend ROE (dividends per share as a percent of shareholders equity) is considerably lower. While China's oil & gas dividend ROE has recently been rising, the gap remains wide relative to global oil & gas companies, suggesting that there is no significant re-rating catalyst that is likely to emerge over the coming 6-12 months. Close for an annualized return of 1.4%. Long China Investable Construction Material Stocks / Short China Investable Broad Market (Close) The relative performance of Chinese investable construction material stocks has been positive over the past two years, with the trade having generated an 8.1% annualized return since initiation. There are two factors contributing to our view that it is time for investors to book profits on this trade. The first is that China's investable construction materials are dominated by cement companies, which may suffer in relative terms from China's rebooted reform initiative this year.4 The second is that the relative performance of construction materials stocks is closely correlated with, and led by, the growth in total real estate investment (Chart 7). Residential investment makes up a significant component of total real estate investment, and Chart 8 highlights that a significant gap between floor space sold and completed has narrowed the inventory to sales ratio over the past three years. But the ratio remains somewhat elevated relative to its history which, when coupled with the ongoing growth slowdown in China and the deceleration in total real estate investment growth, implies a poor risk/reward ratio over the coming 6-12 months. Chart 7Cement Producers Trade Off Of Real Estate Investment Chart 8No Clear Construction Boom Is Imminent Domestic Stock Market Trades We have two open trades related to China's domestic stock market: Long China domestic utility sector / short domestic broad market, initiated on January 22, 2014 and Long China domestic food & beverage sector / short domestic broad market, initiated on December 9, 2015 Similar to our resource & construction plays, we recommend that investors close both of our recommended domestic stock market trades: Long China Domestic Utility Sector / Short Domestic Broad Market (Close) We initiated this trade in early-2014, following a comprehensive reform plan released in late-2013 by the Chinese government. The plan called for allowing market forces to play a decisive role in allocating resources, which we argued would grant utilities more pricing power, reduce their earnings volatility associated with policy risks, and lead to a structural positive re-rating. Chart 9 illustrates that this trade gained significant ground in 2014 and early-2015, even prior to the significant melt-up in domestic stock prices that began in Q2 2015. However, the trade has underperformed significantly since the middle of last year, which has been driven by a sharp deterioration in ROE. This decline in ROE appears to have been cost-driven, as coal is an important feedstock for Chinese utility companies and has risen substantially in price over the past two years. While domestic utilities are now significantly oversold in relative terms, we recommend that investors close this trade because the original reform-oriented basis has shifted significantly. The priorities that emanated from October's Party Congress were decidedly environmental in nature, meaning that coal prices may very well remain elevated over the coming 6-12 months (due to restricted supply). This means that a recovery in ROE would rest on the need to raise utility prices, which is a low-visibility event that will be difficult to predict. Close for an annualized return of 3%. Long China Domestic Food & Beverage Sector / Short Domestic Broad Market (Close) We initiated this trade in December 2015, based on this sector's superior corporate fundamentals and undemanding valuation levels. We argued that the anti-corruption campaign since late-2012 was likely the cause of prior underperformance, given that the group is dominated by a few high-end alcohol producers. The market overacted to the high-profile crackdown, and ultimately the fundamentals of the sector did not deteriorate materially. Our view has panned out spectacularly, with the trade having earned a 32% annualized return since inception5 (Chart 10 panel 1). While the group's ROE remains significantly above that of the domestic benchmark, valuation measures suggest that investors have more than priced this in (Chart 10 panel 2). The trade has mostly played out and we would not like to overstay our welcome. In addition, panel 3 illustrates that technical conditions are extremely overbought, suggesting that investors are being presented with an excellent opportunity to exit the position. Chart 9Sidelined By A Major Hit To ROE Chart 10Time To Book Profits Trades Linked To Hong Kong We have two open trades related to Hong Kong: Long U.S. / short Hong Kong 10-Year government bonds, initiated on January 15, 2014 and Short Hong Kong property investors / long Hong Kong broad market, initiated on January 21, 2015 We recommend that investors stick with the first and close the second, based on the following perspectives: Long U.S. / Short Hong Kong 10-Year Government Bonds (Maintain) Hong Kong has an open capital account and an exchange rate pegged to the U.S. dollar, meaning that its monetary policy is directly tied to that of the U.S. Yet, Hong Kong's 10-year government bond yield is non-trivially below that of the U.S., which argues for a short stance versus similar maturity U.S. Treasurys. While it is true that the Hong Kong - U.S. 10-year yield spread does vary and can widen over a 6-12 month horizon, Chart 11 highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Short Hong Kong REITs / Long Hong Kong Broad Market (Close) There are cross-currents facing the outlook for Hong Kong REITs vs the broad market, arguing for a neutral rather than an underweight stance. Close this trade for an annualized return of 3.6%. While the relative performance of global REITs is typically negatively correlated with bond yields, Chart 12 shows that the relationship with Hong Kong property yields has been positive and lagging (i.e. falling yields lead declining relative performance, and vice versa). Under this regime, a rise in U.S. government bond yields, as we expect, would suggest an improvement in the relative performance of Hong Kong REITs. Chart 11A Straightforward Carry Pick Up Trade Chart 12Rising Bond Yields Implies ##br##Positive HK REIT Performance Chart 13 highlights that periods of positive yield / REIT performance correlation have tended to occur when Hong Kong property prices are rising significantly relative to income, as they have been for the past several years. One interpretation of this dynamic is that when house prices are overvalued and potentially vulnerable, REIT investors react positively to an improvement in economic fundamentals (which tends to push yields up due to higher interest rate expectations). The risk of an eventual collapse of Hong Kong property prices is clear, but we cannot identify an obvious catalyst for this to occur over the coming 6-12 months. Importantly, the fact that property prices have continued to rise during a period of tighter mainland capital controls suggests that only a significant economic shock will be enough to derail the uptrend in prices, circumstances that we do not expect over the coming year. Finally, Chart 14 highlights that Hong Kong REITs are deeply discounted relative to book value when compared against the broad market. This suggests that at least some of the risks associated with the property market have already been priced in by investors. Chart 13Yields & REITs Positively Correlated ##br##When House Prices Are Overvalued Chart 14Hong Kong REITs Are Cheap Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 https://www.bcaresearch.com/trades 2 Please see China Investment Strategy Weekly Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst", dated December 14, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 5 Please note that the total return from this trade had been erroneously reported for some time due a data processing error on BCA's part. The return since inception now properly sources the China CSI SWS Food & Beverage index from CHOICE. We sincerely regret the error and any confusion it may have caused. Cyclical Investment Stance Equity Sector Recommendations
Highlights While bullish sentiment for copper remains high, concerns that policymakers' attempts at a managed slowdown in China this year goes too far will weigh on the market. Fundamentally, support for copper prices from potential supply shortfalls at both the mining and refining levels will be offset by a stronger USD and slower growth in China this year (Chart of the Week). Despite our expectation a slight physical supply deficit will emerge this year, we remain neutral copper. We do not believe this will be enough to rally prices in a meaningful way. Energy: Overweight. Ministers from Saudi Arabia and Russia confirmed OPEC 2.0 - the oil-producer coalition led by these states - will survive beyond the expiry of their production-management deal at the end of this year. What and how they will manage the production of coalition members, however, remains unknown. Base Metals: Neutral. Positive fundamentals for copper are at risk if the USD rallies on the back of Fed tightening this year or China's managed economic slowdown is too severe (see below). Precious Metals: Neutral. Gold prices remained well bid, despite expectations for three or four Fed rate hikes this year, suggesting the market is pricing in either fewer rate hikes and lower real rates, or geopolitical risk - most prominently in Venezuela or North Korea. We remain long gold as a strategic portfolio hedge. Ags/Softs: Underweight. Soybean has been gaining ground on concerns about yield damage due to droughts in parts of Argentina. Expectations of a bumper year for Brazil will mitigate the impact on global supply. Feature Bullish copper sentiment is at a multi-year high, with four bulls for every bear in the market (Chart 2). The strong global economy, weak USD, and elevated risk of further supply-side disruptions - at mines as well as at the refining level - are feeding into buyers' optimism. Chart of the WeekChina Fears Weighing##BR##On Copper Prices Chart 2Bullish Sentiment Remains##BR##At Multi-Year Highs Our outlook for 2018 calls for another, albeit smaller, refined copper deficit (Chart 3). This will come on the back of escalated risks from supply side disruptions at mines in Chile and Peru, and potential constraints on primary and secondary refined output from China, the largest refined copper producer (Table 1). Chart 3A (Smaller) Deficit##BR##In 2018 Table 1China Is Significant For##BR##Copper Supply And Demand China also is the world's largest refined-copper consumer, which makes the risk of a more severe downturn in China arising from too much policy-driven restraint in the metal's top consumer acute. In the following sections, we present our expectations for the fundamentals: copper mine output, refined copper production, and refined copper consumption. Industrial Action Will Threaten Mine Output Again In 2018 Copper had an exceptional year in 2017. The synchronized global upturn and weak USD set the stage for a memorable performance. On the supply-side, disruptions at some of the world's largest mines pushed prices up 8% in 1H17. Although the risk of further production shocks had subsided by 2H17, copper gained another 22% on the back of restrictive Chinese scrap import policies and better than expected demand fundamentals. Last year, the copper market registered a physical deficit, mainly on the back of a decline in copper mine supply. A 0.3% yoy fall in copper ores and concentrate output in the first eleven months of the year kept production broadly unchanged compared to the same period last year. In fact, this was the first yoy decline for that period since 2002, and contrasts with an average 5% expansion in ore and concentrate output for that period since 2012 (Chart 4). The most notable supply side disruptions last year were: Chart 4Supply Disruptions Put##BR##Copper In Deficit Last Year A 9% yoy decline in output from top producer Chile in 1H17. Chile accounts for more than a quarter of global ore & concentrate supply. The decline is a result of strikes at the Escondida mine as well as lower output from Codelco mines. The Indonesian government's ban on exports of copper ores in the first four months of the year led to a 6% yoy decline in production in the first eleven months. U.S. output, which accounts for~7% of global copper ores & concentrates supply is down 12% yoy in the first eleven months of 2017. In fact, the last time the U.S. recorded a positive yoy growth rate was in October 2016. The decline in U.S. output came mainly on the back of lower grade ores, a fall in mining rates, and poor weather conditions. The majority of these disruptions occurred in 1H17 - the first five months of the year witnessed a 1.6% yoy fall in output, while the Jun-Oct period experienced a 0.7% yoy increase. Nonetheless, the ramp up in second part of the year is significantly slower than the 6% yoy and 5% yoy increases in the same period in 2015 and 2016. Global supply was partially supported by Peruvian and European production. Peruvian output grew 3.6% yoy in the first eleven months of the year. However this rate is dwarfed in comparison to previous years. Output grew almost 40% yoy in 2016 and 23% yoy in 2015. Similarly, European output - which accounts for 8% of global supply - seems to be continuing its uptrend. It expanded by 2.4% in the first eleven months of 2017 to record the highest level of output for that period. In fact, growth in output is above the average 0.8% yoy pace in the same period in 2014-2016. We expect a small rebound in mine production in 2018. According to the International Copper Study Group, temporarily shut down capacity in the Democratic Republic of Congo (DRC) and Zambia will resume operations, supporting mine supply this year. Supply-side disruptions pose a significant risk to mine supply again this year. An estimated more than 30 labor contracts, representing ~5mm MT of mined copper - a quarter of global production - will expire this year.1 While surely not all of these negotiations will result in strikes and supply disruptions, the figure is noteworthy as it is significantly above the average 1.7mm MT worth of annual copper supply at risk from contract renewal between 2011 and 2016. The most significant of these renewals is that which was most damaging last year. The 44-day strike at BHP Billiton's Escondida mine in Chile last year, which resulted in a 7.8% yoy fall at the world's most productive copper mine, ended without agreement. Although the contracts were extended, they are due for renegotiation in June. In fact, one of the unions at Escondida held a day long "warning strike" in November, an indication that they do not intend to back down from their demands. Unless management gives in, this implies a heightened risk of disruptions. Bottom Line: Supply disruptions negatively impacted mine supply in some of the world's top producers in 1H17. Although European and Peruvian supply has been somewhat supportive, global supply stagnated in 2017. Industrial action remains the major risk to mined copper this year. 5mm MT worth of copper ores and concentrates are at risk of supply side disruptions in 2018 - the highest figure since 2010. Environmental Reforms Limit Refined Production From China Chart 5China's Scrap Imports Cushion##BR##Against High Prices World refined production grew 1.3% yoy in the first eleven months of 2017, the slowest growth rate for that period since 2009. This reflects significant declines in refined copper production in Chile and the U.S. Supply disruptions at mines in Chile - the world's second-largest producer of refined copper - led to a 182k MT fall in refined output in the first eleven months of 2017, compared to the same period in 2016. Refined output from the U.S. fell by 91.4k MT in that period. However, the downside pressure on refined output from lower ore production was mitigated by increased secondary production from scrap, which accounts for ~20% of global refined copper production. Chinese copper producers took advantage of the oversupply in global scrap and ramped up their production. According to the ICSG global secondary output expanded by almost 10% yoy in the first ten months of last year. China's copper scrap imports increased 9% yoy in the first eleven months of last year, following four years of declines (Chart 5). China makes up less than 10% of global mined copper, but it is the largest producer of refined copper in the world, accounting for 36% of the global production. China is expected to remain the main contributor to world refined production growth (Chart 6). However, Beijing's environmental reforms, and measures to curb the imports of "foreign trash" will limit secondary refined production. Chart 6China Remains Most Significant Factor In Refined Production Growth New policies affecting refined output in China are supportive of copper prices this year: 1. In relation to scrap copper, Beijing recently imposed two policy changes, in line with its environmental reforms. First, since the start of 2018, only copper scrap end-users and processors will be granted import licenses. Second, a proposal to limit the hazardous impurity levels in scrap copper imports to 1% by March. Both these policies will curtail China's scrap copper imports. China imports an estimated 3mm MT of scrap copper annually, accounting for roughly half of its total scrap copper supply. Such limitations would severely dent China's scrap supply. Furthermore, scrap copper imports play a significant role in China. They act as a buffer against high prices, soaring during periods of high prices and dwindling when prices are low - as they were between 2013 and 2016. If China does in fact go through with the tighter regulations on scrap imports, Chinese copper consumers would not be able to fall back on the secondary metal when prices rise - as they have been over the past year - leading to greater demand for imports of primary products, chasing prices higher. However, over the long term, we are likely to see Chinese scrap traders move their businesses offshore, notably in Southeast Asia, where they will process the scrap until it meets the regulations necessary to be imported by China.2 In fact, this has already started to happen in the case of the category 7 scrap - derived from end-of-life electronics, households, cars and industrial products - which is widely believed will be banned by year-end. Nevertheless, these recycling plants do not yet exist. Thus, the transition cannot occur overnight, and we expect the tighter policies on scrap imports to support prices in the interim as China increases its imports of ores and refined copper in order to fill the supply gap. 2. China's environmental reforms also pose a risk on refined supply this year. Smelters and refiners risk being shut down if they do not comply with tighter pollution controls. This could limit copper output this year. Similar to the winter production cuts occurring at steel and aluminum producers, China's second largest copper smelter - Tongling Nonferrous Metals Group - announced plans to reduce its smelter capacity by up to 30% during the winter.3 In addition, late last month, China's largest smelter - Jiangxi Copper Co. - was forced to curb output while local pollution levels were assessed.4 The extent to which these measures are adopted by other producers will interrupt refined output this year. Given the more elevated pollution levels during the winter months, this risk is most notable in the November to March period. Bottom Line: The major risk to refined copper supply is China's environmental reforms which will likely constrain copper scrap imports, and could lead to temporary shutdowns of polluting smelters and refineries. If Beijing tightens these regulations, we are likely to witness disruptions in both primary and secondary refined output, while the copper supply chain readjusts to be able to comply with these policies. Slowdown In China Would Temper Copper World refined copper consumption grew 0.8% yoy in the first eleven months of 2017. Weaker consumption was mainly in the 1H17, during which global consumption fell 1.8% yoy, whereas consumption in the July-to-November period accelerated by 3.9% yoy. Weaker demand in the first half of the year came on the back of weaker demand from China, which accounts for half of global consumption. China recorded a 7.7% yoy fall in consumption of refined copper in the January-to-April period. However, Chinese copper demand subsequently strengthened, accelerating by 7.4% yoy in the May-to-November period. While demand from the rest of the world muted the impact of weaker Chinese consumption in the first half of the year, it weakened in the second half of the year, falling 3.3% yoy in the May-to-October period. This fall in copper demand was driven by a 5.5% yoy fall in the U.S., and to a lesser extent, a 2.0% yoy fall in demand in Japan in the May-to-November period. According to China Customs data, China's refined copper imports fell 5.1% in 2017 after growing 3.7% in 2016 (Chart 7). However, what is noteworthy is that while imports fell 18.3% yoy in H1, they picked up in H2, increasing by 11.3% yoy, mainly on the back of strong demand in Q3. This is in line with strong economic performance in China in 2H17 - an upside surprise which supported copper prices. Going into 2018, we expect a managed deceleration in China - and in China's demand for copper - to be mitigated by stronger demand from the rest of the world. In fact, the IMF revised up its 2018 and 2019 global growth forecasts in the latest WEO Update earlier this week (Table 2). Global growth is now forecast to reach 3.9% in 2018, up from the estimated 3.7% last year. Chart 7China's Q4 Imports Were Strong Table 2Upward Revisions To IMF Growth Projections Chart 8Speed Bump Ahead For China? That said, our China construction Indicator - which includes several variables measuring construction activity in China - shows strong growth in the main end-user for copper (Chart 8). Given that building construction accounts for 43% of copper end-use in China, this indicates demand for copper should remain healthy in the near term. Furthermore, despite concerns of a slowdown, China's manufacturing PMI still points to a healthy economy. Even so, a decline in the Li Keqiang Index, which tracks industrial activity, warrants caution and could be signaling trouble ahead for the Chinese economy. In addition, government spending has decelerated significantly from its mid-2017 peak. Against these risks, the global economy is expected to remain strong. Thus the biggest risk to our assessment is a pronounced deceleration in China which would hit demand for the red metal. Bottom Line: The major risk to refined copper demand this year is a slowdown from China. Downside Risk From A Stronger USD In addition to the fundamental variables highlighted above, U.S. monetary policy - and its effect on the USD - will also be an important driver of the copper market. We expect the Fed to embark on its interest rate normalization process more aggressively this year, hiking its policy rate up to four times. This would see copper prices weaken as the red metal becomes more expensive in USD terms. The USD is significant because a weaker dollar means that dollar-based commodities are cheaper for foreign buyers. Thus, foreigners tend to buy dollar-denominated commodities when the USD is weak, and sell when the USD is strong, in order to also benefit from exchange rate differentials. Continued weakness of the USD has been supportive of copper prices since the beginning of 2017. A risk to our outlook is an unexpectedly dovish Fed, which would keep the dollar muted and be favorable to copper. Bottom Line: We expect the copper market to record a small physical deficit this year. A stronger USD and deceleration in China will prevent a repeat of 2017's performance. However supply side disruptions at the mine and refined levels will provide opportunities for some upside in the market. Synchronized global demand will be a tailwind throughout the year. In the near term, we expect copper to continue gyrating around its current level of $3.10/lb. Absent a marked slowdown in China, we expect a rally into mid-year as contract renegotiations get underway. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "Copper soars to 4-year high as funds bet on shortages," dated December 28, 2017, available at reuters.com. 2 Please see "As China restricts scrap metal companies look to process copper abroad," dated January 8, 2018, available at reuters.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," dated December 7, 2017, available at Bloomberg.com. 4 Please see "Copper Rallies to Three-Year High as China Plant Halts Output," dated December 26, 2017, available at Bloomberg.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Slower global demand growth, coupled with surging production from the U.S. shales and higher OPEC 2.0 production, risks reversing the progress made in draining global commercial oil storage and tanking prices in 2019.1 Our updated balances modelling is in agreement with the backwardation in forward Brent and WTI curves, but, if anything, indicates the backwardation should be more pronounced: We are forecasting Brent and WTI prices next year will average $55 and $53/bbl, respectively, vs. $62.80/bbl and $57.40/bbl average prices for 2019's forward curves. For 2018, we are maintaining our $67 and $63/bbl expectation for Brent and WTI, although our modelling indicates higher prices are a distinct possibility, given our fundamental assumptions of falling supply and rising demand this year (Chart of the Week). Energy: Overweight. We liquidated our May and July Brent and WTI $55 vs. $60/bbl call spreads last week with gains of 110.1% and 129.0%. We will be liquidating our Dec/18 Brent and WTI $55 vs. $60/bbl call spreads at tonight's close; they were up 62.3% and 82.1% as of Tuesday. We remain long Jul/18 vs. Dec/18 WTI (up 47.4%), and long the S&P GSCI (up 8.5%), expecting backwardation. We will get long $55 Brent Puts vs. short $50 Brent Puts in 4Q19 at tonight's close. Base Metals: Neutral. We continue to expect base metals to remain well supported in 1H18 by environmental reforms in China, and supply uncertainty around contract renegotiations at the copper mines. The global expansion underpinning demand will compensate for slower Chinese growth in 2H18. Precious Metals: Neutral. Our long gold portfolio hedge is up 8.5% since inception in May/17. Ags/Softs: Underweight. Soybean markets rallied following last week's USDA WASDE report, but grains fell amid data indicating these markets will remain oversupplied. Feature If there is one truth in commodity markets it is this: The best cure for high prices is high prices, and vice versa. This is being dramatically demonstrated by OPEC 2.0 in its collective action to remove 1.8mm b/d of production from the market following disastrously low prices in 2015 - 16. Higher prices in 4Q17 and 1H18 oil futures are incentivizing a surge in U.S. shale output, and will give OPEC 2.0 comfort in slowly feeding output taken offline at the beginning of 2017 back into the market in 2H18 and 2019 (Chart 2). Higher prices and tightening monetary conditions globally will slow the rate of growth in demand next year (Chart 3). Chart of the WeekFundamentals##BR##Support Oil In 2018 Chart 2Non-OPEC Production##BR##Will Surge Chart 3Strong Consumption Growth In 2018,##BR##Tempered By Higher Prices In 2019 Given these fundamental inputs, we expect to see Brent averaging $55/bbl next year, and WTI averaging $53/bbl next year. Our forecast is highly uncertain, given the actual evolution of prices will, once again, depend on actions taken by OPEC 2.0 and the forward guidance provided by its leadership, KSA and Russia. Our forecast for 2018 - $67/bbl for Brent and $63/bbl for WTI - remains unchanged. If anything, our unconstrained models (Chart of the Week) have more upside risk than our forecast suggests, largely from falling production and surging demand - not to mention unplanned production outages. Looking to the end of 2019 from today, the backwardation we expect is greater than what is being priced into the Brent and WTI forward curves presently. Growth In U.S. Shales Dominates Non-OPEC Gains We are expecting U.S. crude oil production growth will dominate the increase in non-OPEC output in 2018 and 2019 (Chart 2, top panel). U.S. shale-oil output rises by 970k b/d and another 1.18mm b/d, respectively, this year and in 2019. By our reckoning, this will lift total U.S. crude oil production to 10.22mm b/d this year, a record level of output, and to 11.44mm b/d on average next year. Total U.S. crude and liquids output therefore rises from just under 17mm b/d in 2018 to 18.5mm b/d by the end of 2019. If our estimates are correct, the U.S. will join Russia in producing more than 11mm b/d of crude oil next year, and may even exceed it. Russia is expected to raise production slightly. As one of the putative leaders of OPEC 2.0, we expect Russia to maintain its 300k b/d production cut in 1H18, which will keep its overall liquids production steady at ~ 11.17mm b/d through June. In 2H18, Russia will gradually restore production to an average of 11.24mm b/d, reaching 11.4mm b/d by December. For 2019, we expect total Russian liquids production to average 11.35mm b/d, up ~ 140k b/d yoy. OPEC's return will be led by the Cartel's Gulf producers, which are expected to raise crude production 450k b/d this year and 350k b/d next year (Chart 2, bottom panel). Total production in Gulf OPEC states will reach 25.25mm b/d on average in 2019. This will, of course, be dominated by KSA, which we expect will lift crude production to ~ 10.36mm b/d in 2H18 after holding crude output steady at ~ 10mm b/d in 1H18 over-delivering vs. its quota under the OPEC 2.0 Agreement. For 2019, we expect KSA to maintain production above 10.1mm b/d.2 Non-Gulf OPEC producers, on the other hand, will see their production fall 140k b/d this year, and another 240k b/d next year, leaving it at 7.49mm b/d on average in 2019, in our estimation. The contribution of these states to the OPEC 2.0 production cuts has been "managing" their respective decline curves. It is highly unlikely they will see production surge following the expiration of the OPEC 2.0 agreement at the end of this year. Overall, we expect global crude and liquids production to reach 100mm b/d this year, and 102.2mm b/d next year (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Demand Surges This Year, But Slows In 2019 The global economic expansion will lift oil demand above 100mm b/d this year to 100.3mm b/d. This will be led, as always, by non-OECD growth, which we expect to increase 1.24mm b/d this year to 52.8mm b/d (Chart 3, top panel). DM demand - i.e., OECD consumption - will increase 440k b/d this year, to 47.5mm b/d, based on our estimates. Overall global demand rises 1.68mm b/d this year, by our reckoning (Chart 3). We expect tighter financial conditions this year and next will, with the lags typical of monetary policy, slow the rate of growth in oil demand next year. This will be delivered by tightening monetary policy, led by the U.S. Fed, and a mild recession next year, most likely in 2H19. We expect global demand to grow 1.57mm b/d next year, rising to just under 102mm b/d. EM demand will grow 1.21mm b/d, while DM demand will be up 360k b/d next year. Tightening Balances Will Reverse In 2H18 The yeoman effort put forth by OPEC 2.0 in reducing output and draining commercial inventories globally will reach its apotheosis by the end of 1H18 (Charts 4). Thereafter, as production grows and demand begins to slow, our balances indicate inventories will start to grow again (Chart 5). Chart 4Supply-Demand Balances##BR##No Longer Tightening In 2019 ... Chart 5... Leading To##BR##Inventory Accumulation Markets likely will start focusing on the implications of OPEC 2.0 returning production to the market and the surge in shale in 2H18 and during 2019. Non-forecastable events notwithstanding - e.g., a breakdown in Venezuela's production and exports - markets will be looking to OPEC 2.0 leadership for guidance on how the coalition will manage member-state production from 2H18 forward. If the OPEC 2.0 coalition is allowed to dissolve - something we do not expect - and a production free-for-all resumes similar to that of 2015 - 16, another round of supply destruction, brought about by lower prices, likely will ensue. This would greatly restrict E&P and services companies' access to capital, should it occur, and would, once again, imperil the economies of OPEC 2.0. In addition, because such volatility would discourage investment once again, it would set up a powerful price rally in the early 2020s following the attendant collapse in capex and E&P spending, as occurred in the previous down-cycle. We doubt this is the desired outcome of the OPEC 2.0 leadership, particularly KSA, as the Kingdom will be looking to IPO Saudi Aramco later this year to fund its Vision 2030 diversification efforts. We also doubt this is the desired outcome of Russia, given the economic pain it endured in the 2015 - 16 episode. More Frequent OPEC 2.0 Guidance Expected Given these considerations, we expect KSA and Russia to increase the frequency of forward guidance, directing market participants toward a preferred price band. Right now, this looks like a $50 to $60/bbl range - the 2018 forecast given by Russia's Energy Minister Alexander Novak earlier this week.3 It would be incumbent on OPEC 2.0 leadership to guide markets to expect production and inventory responses consistent with such guidance. We think the combination of OPEC 2.0 production restraint and the powerful synchronized global growth already in place puts Energy Minister Novak's guidance out of range for this year, and we are sticking with our forecasts for Brent and WTI. However, beginning in 2H18, a 2019 Brent forecast in Novak's range appears reasonable, based on the fundamentals discussed above. And, our WTI forecast of $53/bbl also is reasonable, given the average marginal cost of producing in the most prolific fields in the U.S. are at or below $50/bbl, according to the Dallas Fed's periodic Energy Survey.4 We believe the massive drawdown in global oil inventories to be the first step in a longer-term strategy by OPEC 2.0 countries. Lower OECD commercial inventory levels will diminish their shock-absorbing capacity, leading to a higher responsiveness of oil prices to supply-demand shocks. This will allow the coalition to exert greater control over oil prices via rapid, flexible storage adjustments and spare capacity management. Therefore, this year's out-of-range prices will be tolerated by Russia and KSA to achieve their optimal level of global inventories. A $50-to-$60/bbl Brent range for OPEC 2.0 would be consistent with a longer-term strategy to maximize the period of time hydrocarbons are the primary transportation fuel in the world. This is the only way to achieve the development goals set out by leaders of various oil-exporting states seeking to diversify the economic underpinnings of these economies. To do so, they have to keep oil-based transportation competitive for decades. Too much volatility - i.e., frequent excursions between very high and very low prices - will severely limit the access to capital these societies need to pull off this diversification. Managing production in a way that limits this volatility and keeps oil competitive in transport markets therefore is critical. Bottom Line: High prices will cause crude oil production to surge this year and next, particularly in the U.S. shales, and demand growth to slow. We expect Brent prices to average $67/bbl this year and $55/bbl next year. WTI prices will average $63/bbl this year and $53/bbl next year. We expect OPEC 2.0 to increase the frequency of its forward guidance - and to follow through on production and inventory adjustment in a manner that supports a desired price range for Brent prices in 2019 and into the 2020s. Right now, that range looks like $50 to $60/bbl. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is a name we coined to describe the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed at the end of 2016 to rein in out-of-control global oil production by cutting production some 1.4 to 1.5mm b/d last year (vs. a target of 1.8mm b/d). The coalition has been remarkably successful in maintaining production discipline in 2017 and extending their deal to the end of 2018 with an option to review quotas in June. We expect OPEC 2.0 to gradually return production taken off the market over the course of 2H18, which will, by next year, most likely reverse the draws seen in global inventories. 2 KSA's production should lift next year as pipeline repairs at its giant Manifa field are completed. Corrosion problems took some 300k of 900k b/d total production offline. In addition, there is another 500k b/d of capacity offline in the Neutral Zone shared with Kuwait. KSA's capacity likely will remain ~ 11.7mm b/d, versus its historical 12.5mm level, but as Energy Intelligence notes, it will have to balance actual production with spare capacity for the next year or so. Please see "A Headache for Aramco," published July 2017 by Energy Intelligence on its website. 3 Please see "CORRECTED-UPDATE 5-Brent oil falls by $1 but demand underpins near $70/barrel," published by uk.reuters.com on January 16, 2018. 4 In its December 2017 Dallas Fed Energy Survey, the Federal Reserve Bank of Dallas reported the WTI price shale operators needed to profitably drill a new well in Texas and Oklahoma averaged $49/bbl (simple, unweighted survey average). The lowest cost was in the Permian Midland formation ($46/bbl) and the highest costs was in so-called Other U.S. (shale) at $55/bbl. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017